What Are Stocks and How Do They Work?

How Do Stocks Work?

When you buy a share of a company's stock, you effectively become a partial owner of the company that issued it. As a result, you have a partial claim on the company's assets and profits.

When a company performs well, the value of its stock typically rises, giving you a positive return on your investment. On the flip side, poor performance can result in the stock price going down, which could result in a loss for you.

Additionally, some companies pay dividends to their stockholders, which you can cash out or reinvest in the stock.

Stocks are traded on stock exchanges, such as the New York Stock Exchange or the Nasdaq. However, you'll typically buy and sell shares through a brokerage account rather than working directly with the issuing company.

Types of Stocks

There are several different types of stocks you may come across as you evaluate your options. Each type of stock comes with its own benefits and drawbacks, and depending on your investment strategy, you may want to focus on certain types.

Common Stock

Common stockholders buy shares through a brokerage account and may benefit from price appreciation and dividends. What's more, common stockholders may also get voting rights for board of director elections and company policies.

Preferred Stock

In addition to common stock, some companies may also issue preferred stock. If you own preferred stock, you'll typically receive a dividend, even if the company's common stockholders don't.

You'll also get priority over common stockholders if the company files for bankruptcy and liquidates its assets. However, preferred stockholders don't get voting rights.

Stocks by Market Capitalization

Common stocks can fall into a handful of categories based on the company's market capitalization—the stock's price multiplied by the number of shares outstanding. Here's how they break down:

Source: FINRA

In general, stocks with a larger market capitalization—often called blue-chip stocks—are more likely to pay dividends and have steady growth. But while smaller capitalization stocks can be more volatile and are less likely to pay dividends, they may offer greater return potential.

Stocks by Strategy

There are a few different strategies you can take when investing in stocks, including growth, value and income approaches.

• Growth stocks: Growth stocks typically offer above-average returns and are expected to continue to offer price growth—though there are no guarantees.
• Value stocks: Value stocks are typically underpriced stocks that investors believe could bounce back and provide a strong return. In some cases, value stocks can also be newer companies that aren't widely recognized.
• Income stocks: Income stocks pay regular dividends to their investors and often have relatively stable prices compared to more volatile stocks.

Learn more >> Growth vs. Value Investing: Which Is Better?

International Stocks

International stocks are issued by companies that operate in other countries. You typically can't buy individual international stocks on U.S. stock exchanges, though some U.S. banks issue certificates called American Depository Receipts for some international stocks that represent shares in the foreign company.

Learn more >> What Are the Different Types of Stocks?

Benefits and Drawbacks of Stocks

Before you invest in stocks, it's important to understand the potential upsides, as well as the risks associated with the stock market. Here's what to consider.

Benefits

There are several reasons to consider including stocks in your investment portfolio, either individually or through a mutual fund or ETF. Some of those advantages include:

• Potential for growth: If a company's stock performs well, you can generate a positive return on your investment. Even if a stock's price is volatile in the short term, stock investors typically enjoy positive long-term returns as the overall economy grows.
• Easy to buy: Several brokerage firms now offer fractional shares, allowing you to invest even if you don't have enough money to buy a full share of a company's stock. In some cases, you can invest with as little as $1.
• Fairly liquid: You can buy and sell stocks anytime while the stock market is open, and some brokers now allow trades outside of regular market hours. While it can take a few days to settle the cash from a trade, you can generally access your funds more easily compared to some real estate investments or a certificate of deposit.

Risks

Although you can use stocks to build wealth, there are some risks to keep in mind, especially if you're buying individual stocks instead of diversifying with a mutual fund or ETF:

• Short-term volatility: Even more stable stocks may experience wild price swings in the short term. If you don't have a clear strategy or you're trying to time the market, you could be more at risk of losing some of your initial investment.
• Gains are taxable: If you sell a stock with a positive return on your investment, you'll typically be subject to capital gains tax. For short-term investors, this tax is typically the same as your ordinary income tax. However, if you hold a stock for longer than a year, you may qualify for a lower long-term capital gains tax rate.
• It can take time to master a strategy: When investing in the stock market, it can be easy to let your emotions drive your decisions or take on more risk than you should. If you want to manage your portfolio on your own, it can take time to develop a strategy, research different opportunities and accomplish your goals. If you're overwhelmed, however, you can enlist the help of a robo-advisor or financial advisor to manage your portfolio for you.

Stocks vs. Bonds

Stocks and bonds can be issued by the same organizations, but they serve different purposes for both investors and the corporations and government agencies that issue them.

For starters, while stocks represent ownership in a company, bonds are effectively loans, which is why they're also referred to as debt securities. Here are some other key differences:

• Income: Some stocks pay dividends to their shareholders, but not all of them. Even if you buy stock from a company that has paid dividends in the past, future payments aren't guaranteed. When you buy a bond, however, you can typically expect to receive interest payments in regular intervals.
• Pricing: Stock prices fluctuate based on the company's financial performance and other factors. Conversely, bond prices fluctuate based on prevailing interest rates for similar investments.
• Return potential: In general, stocks tend to offer higher long-term returns than bonds, albeit with greater volatility in the short term. In contrast, bonds may offer lower returns, but they also come with fewer risks than stocks, particularly if the bond was issued by a government agency.

Learn more >> Stocks vs Bonds: What You Need to Know

How to Buy Stocks

If you're interested in including stocks in your investment portfolio, here are some steps you can take to get started:

1. Open a brokerage account. Compare online brokers to determine which one offers the features you want, and open an account. Once your account is open, you can transfer money from your bank account and invest it.
2. Evaluate your options. As you get started, it's often best to invest in stock mutual funds and ETFs, which diversify your investment across dozens or even hundreds of stocks. However, if you choose to buy individual stock shares, research different companies to get an idea of which stocks will help you best accomplish your objectives.
3. Decide how much to invest. Putting all of your money into one stock can be a risky endeavor. To balance your risk and reward potential, it's best to spread your money across multiple stocks and funds, according to your strategy and goals.
4. Place your order. You can use your online brokerage account or the broker's mobile app to place your order.

Learn more >> How to Start Investing

Frequently Asked Questions

• What Are the Best Stocks to Invest In?

  There are no stocks that are best for every investor. To determine which stocks to include in your portfolio, you'll need to determine your investment strategy, research different opportunities and pick the stocks that are best suited to help you achieve your financial goals.

• What Are Penny Stocks?

  Penny stocks are common stocks that trade at a price of $5 or less. While you can find some penny stocks on major stock exchanges, most of them are listed on smaller exchanges called over-the-counter exchanges.

• What Are Stock Options?

  Stock options are derivative investments that give you the option—but not the obligation—to buy or sell a stock at an agreed-upon price, typically within a set period of time.

The Bottom Line

Stocks can be a great addition to your investment portfolio, but if you're not careful, you could end up taking on more risk than you can handle.

While it may be tempting to base your stock picks on public opinion, take the time to create a strategy for your portfolio and pick stocks and funds that contribute to your goals.