What Are Stocks?
A stock, also known as equity, is a financial security that signifies ownership in a corporation. When a corporation issues stock, it shares ownership of the company with its shareholders. Stocks are divided into units called shares, which allow investors to own a fraction of the corporate entity. Shareholders are entitled to a portion of the company's assets and profits in accordance with the number of shares they hold compared to the total outstanding shares.
Stocks serve as the foundation of many individual investors' portfolios and are predominantly traded on stock exchanges such as the New York Stock Exchange (NYSE) and the Nasdaq. Trading activities are heavily regulated by governmental bodies to protect investors against fraudulent practices.
Key Takeaways
- A stock is a security that represents ownership in an issuing corporation.
- Corporations issue stock to raise capital for business operations.
- Two primary types of stock exist: common and preferred.
- Over the long term, stocks have historically outperformed most other investment assets.
How Stocks Function
Corporations issue stocks primarily to raise funds essential for operations and growth. The entities that buy stocks become shareholders, who maintain a claim on the company’s assets and earnings proportional to their ownership stake. For instance, if a corporation has 1,000 shares outstanding and a shareholder owns 100 shares, that individual owns 10% of the company.
Shareholder Ownership Explained
While shareholders do own shares in the corporation, it is essential to recognize that they do not directly own the corporation itself. This is known as the separation of ownership and control. The corporation is considered a separate legal entity that can own assets and liabilities independently of its shareholders. Shareholders have rights including voting on important corporate matters, receiving dividends, and selling their shares.
If a majority of the shares are owned, shareholders can exercise significant influence over corporate decisions, including the appointment of the board of directors. This board is primarily responsible for enhancing corporate value, and they may hire professional managers, such as a CEO, to oversee daily operations.
Types of Stock: Common vs. Preferred
Common Stock
Common stock typically grants shareholders the right to vote at shareholder meetings and receive dividends when declared. The common shareholders are generally last in line when it comes to claims on assets, meaning in the case of liquidation, creditors and preferred shareholders are paid first.
Preferred Stock
Preferred stock, on the other hand, generally does not come with voting rights but offers other advantages such as priority in dividend payments. Preferred shareholders receive dividends before common shareholders and have a superior claim on assets in case of liquidation, offering a safety net that appeals to conservative investors.
Historical Perspective
The first common stock was issued by the Dutch East India Company in 1602, marking a significant point in financial history as it transitioned business ownership into public markets.
Stocks vs. Bonds
While stocks are a way for corporations to generate capital, bonds represent a different mechanism of financing. When individuals buy bonds, they are essentially lending money to the corporation and become creditors. Bondholders receive periodic interest payments and are paid back their principal before shareholders if the company goes bankrupt, making bonds generally a safer investment than stocks.
How to Buy Stock
Most stocks are purchased through stock exchanges following an initial public offering (IPO) when a company first sells its shares to the public. Investors typically use brokerage accounts to execute their trades, benefiting from market supply and demand dynamics, which drive fluctuations in stock prices.
Ways to Earn Income from Stocks
Investors primarily earn income from stocks in two ways: 1. Dividends: A portion of a company's profits distributed to shareholders. For example, if a company declares a $5,000 dividend and has 1,000 shares, shareholders receive $5 each. 2. Capital Appreciation: The increase in share price. For instance, if shares bought for $10 increase in value to $11, the investor gains a profit of $1 per share upon sale.
Risks of Owning Stocks
All investments carry risk, and stocks are no exception. Market conditions, corporate decisions, and economic factors can cause stock values to rise or fall. On a historical basis, stocks tend to produce higher returns than other investment vehicles over the long term, but they also come with a risk of loss.
Conclusion: The Bottom Line
Stocks represent a fractional ownership in a corporation and serve a vital role in a company’s ability to raise capital for growth and expansion. Understanding the distinctions between common and preferred stocks, as well as the mechanisms of buying and trading stocks, is essential for any investor. By recognizing the risks and opportunities associated with stock ownership, investors can make informed decisions that align with their financial goals.