Chances are that you first heard about the stock market as a child. You heard the phrase “Wall Street” so often that you imagined it was some far-off, mythical place, like Oz.
But even as you grew up, went to school, and became gainfully employed, the stock market may have remained a mystery that you couldn’t wrap your head around. You might have known it was complex or that people could get rich from it, but you may not have a firm grasp on the idea of owning or trading shares.
What are stocks? How do stocks work?
What Are Stocks? How They Started
The stock market was started in the 17th century when European countries were increasingly engaged in international trading. Colonization of the American continents had started. Merchants were creating large-scale shipping businesses to make transatlantic voyages.
But this was prohibitively expensive. Single business owners couldn’t possibly afford all the capital they needed to fund their operations themselves. Some hit upon a plan in which outside parties could provide the funds they needed to keep business growing. In exchange, these outside partners would receive a share of ownership in the companies. As long as they maintained ownership, the partners would see their shares gain in value as the company grew.
The Dutch East India Company was the first business to offer paper shares in their shipping and export business in 1602. These shares made trading extremely easy. Investors could buy and sell their shares as they pleased. The concept took off, and soon other European companies were formed and built using funds provided by shareholders.
Trade with the New World and the rise of the Industrial Revolution supercharged the growth of the stock market. Companies needed more capital to trade with the Americas, and industrial companies needed more capital to build and expand their mechanical operations. Investors were beginning to see real profits from their partnerships.
Eventually, the stock market became such a big business that merchants decided they needed to be more organized about it. In 1773, businessmen in London established a marketplace at a local coffee house that they had been using as a meeting place for decades. They called it a “stock exchange,” and it became the model for similar ventures in America.
Propelled by the economic growth in the U.S. and the development of the New York Stock Exchange, the shareholder system quickly became the standard means of capital investment in developed countries across the world.
Soon, everyday people — rather than just wealthy individuals and institutional investors — were taking part in the stock market themselves. The stock market model has remained in place ever since.
How Does Selling Stock Work?
The times and methods of selling stock have changed and evolved, but the basic transaction remains the same. How does selling stocks work?
The owners of a privately held company decide that they want to grow their business through public funding. They go through all sorts of bells and whistles to get their company approved for listing on the stock exchange.
Once this happens, they set a price at which the first publicly available shares will be sold and launch the sale at an initial public offering (IPO). This is typically a big deal — often complete with party streamers and a few cocktails.
Investors then buy stock shares, most often through online brokerage sites. If a lot of shareholders buy the stock, the price usually goes up. If buying is slow, the value usually goes down. Several other outside factors can affect the share price, but by and large, trading volume is the most significant.
The company takes all of the money they earn through shareholders and they apply it to operations and business expansion. This includes mundane things like employee salaries, equipment, office leases, marketing, and so forth. It also includes more exciting things like new product lines, global growth, research, and development.
The shareholder gets a slice of ownership in the company. As long as they hold onto their shares, they’ll either earn or lose money as the stock price goes up or down. After the share price goes up to a certain point, the shareholder may decide to sell their shares and take the profits. Or they may decide to bail out if the share price goes down a lot and they don’t want to lose any more money.
There’s really not much more to buying and selling stock. You buy into a company, they take your money to build the business, you sit back and hopefully watch the value increase, and you get profits if and when you decide to sell your shares.
How Do Stocks Work When I Own Them?
So you’ve decided you want in on the action. Terrific! Here’s how stocks work when you’ve got them in your portfolio.
Common Stock vs. Preferred Stock
Most shares that retail investors own are known as “common stock.” They’re called that because they’re the most commonly traded kinds of shares. That was easy, wasn’t it?
Common stock is the simplest, most hassle-free kind of stock. It represents ownership in the company. You have a vested interest in the company because you’ve bought into it and reap a share of the profits (if any). You also get a say in how the company runs (more on that in a bit).
There’s another tier of share ownership called “preferred stock.” As the name implies, shareholders with this kind of stock get a little more preferential treatment than common stockholders. All this really means is that preferred stockholders get dividend payouts — if any — before those who have common stock shares. They’re also more likely to recoup at least some of their losses in case the company goes bankrupt.
Preferred stock is less volatile than common stock. The share price doesn’t go up or down quite as sharply as common stock does. It’s more geared toward investors who use their holdings as a form of regular income. Therefore, preferred stock is less viable as a source of long-term growth than common stock.
But for those who can afford to buy a lot of preferred stock, it’s possible to earn a tidy living through investments.
Value Stocks vs. Growth Stocks
Stocks are not universal, one-size-fits-all instruments. Some share prices break out quickly, then settle back down. Others don’t spike in value that often, but they may accrue profit over long periods. Both types can be of great use to you as an investor.
“Value stocks” are usually associated with established, long-time companies who have a commanding share of their market — Johnson & Johnson, Apple, 3M, AT&T, Amazon, and so forth. They keep on existing and earning money every year. They’re not likely to experience a huge, immediate surge in share price. But they’ll rarely experience significant drops in share price, either — if they do, they’ll recover more quickly.
Value stocks are solid things to have in your portfolio because they can provide a good foundation. They’ll sit there and quietly earn money over the long term without having to attend to them very often.
“Growth stocks” are a little riskier, but potentially more profitable. They’re associated with smaller companies that are poised to make market breakthroughs. For example, a growth stock could be a medium-sized IT company that manufactures tech components for 5G phones and is closing in on a big government contract. If everything goes as planned, their share price could go up very quickly, and you could make a mint.
Of course, it can also go in the other direction. The company hasn’t quite established itself as a dominant force, so they’re still basically unproven. That’s the risk. But many investors hang on to growth stocks for just long enough to gain a tidy profit. A series of well-maintained, closely watched growth stocks can be very beneficial.
Both value and growth stocks have places in your portfolio. It’s important to learn the difference between the two and to research each company thoroughly.
How Stocks Work in Your Portfolio
There are several different ways to approach stocks and strategize to grow wealth.
One way is passive: Buy shares and leave them alone. Just hold onto them in your portfolio. Over time, they should go up in value as the company thrives and expands. If you’ve picked a winning stock at the right time, you may find yourself with a sizable profit if the company turns out to be successful.
Then there’s the more aggressive, active approach. You’ll buy stocks expecting them to gain value fairly quickly. You’ll hold them until they reach a certain profit margin, then attempt to sell them and reap the gains. This strategy is far more hands-on, requiring a lot of careful attention, research, and risk tolerance.
Speaking of risk tolerance — that’s what keeps a lot of people away from the stock market. The fear of past stock market crashes and a wiped-out investment account is enough to make anyone uneasy. Investing carries a high level of risk by definition — it’s just part of the game.
How Stocks Work: Other Aspects of Being a Shareholder
The main point of owning stock is to build wealth. Especially for passive investors, there’s not much more to being a shareholder than just watching value appreciate over time. But there are a couple of other things that being a shareholder may entail, depending on the ways that the companies you invest in conduct their business.
Many companies issue quarterly dividend payments to their shareholders. These payments represent a certain percentage of their earnings. Companies like Microsoft, Coca-Cola, and Exxon Mobil pay out stock dividends essentially as “thank you” rewards for investing in their companies.
Dividend payments can come in the form of physical checks or direct deposits. Some companies simply give their investors additional stock shares as dividends. A lot of investors set up their online brokerage accounts to reinvest their dividends in the companies that issue them; instead of taking the cash, they get an equivalent amount of additional stock.
Companies that choose to issue dividends are usually established, solid companies and steady, strong earners. They don’t have aggressive needs that require reinvestments or have alternate sources for funding those needs. Investors appreciate dividends because — well, it’s extra money. Some investors with thousands of stock shares basically live off of their dividend payments as regular income.
Other healthy, large companies choose not to issue dividends, including big guns like Apple, Amazon, Alphabet, and Tesla. They simply reinvest their profits in business operations and expansion. Their shareholders’ profits are strictly based on their holdings. Startups or smaller companies rarely issue dividends because they’re still growing.
As a shareholder, you own a portion of every company you invest in. That means, believe it or not, you have a say in how the company is run. Granted, it’s a tiny say (unless you own millions of shares in the company). But it’s something.
Shareholders have voting rights in the public companies they invest in. These rights are weighted according to how many shares they own. At annual shareholder meetings, investors are invited to cast their vote on certain issues affecting the company: Board members, policies, proposed acquisitions, even the hiring or firing of executive personnel.
You can, of course, choose to attend the shareholders’ meeting in person. But that’s not feasible for those with stocks in dozens of companies unless they have frequent flier miles and a lot of time on their hands. Fortunately, your online brokerage will inform you if you have a vote coming up with a company you invest in and can link you to an online site where you can cast your vote.
Or you can just skip the whole voting thing. But it’s there if you want it.
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