Stocks are the linchpin of many financial strategies. They offer the potential to grow your wealth over time, but they can also bring big risks that you should carefully weigh. Understanding how stocks work is a crucial first step to making the right choices for your needs.
A stock represents fractional ownership of a corporation, which is what distinguishes it from other investments like bonds. When a company wants to raise money for growth, such as designing new products, hiring more employees or expanding into other markets, it may sell shares of its stock in order to do so. Anyone who purchases those shares stands to profit if the company is successful in its expansion plans.
The value of a share can go up or down depending on several factors, including the market, the economy and the company itself. In addition, some stocks pay dividends (a share of a company’s profits that are paid to shareholders), while others do not. Investors often choose to diversify their holdings of individual stocks by sector, size and geographic market, aiming for broad market exposure while avoiding overconcentration in any particular sector or company.
A common way to categorize stocks is by their market capitalization, which represents the total current value of all of a company’s outstanding shares. However, it’s important to remember that even if a company has the largest market cap in a given category, its stocks still represent only a small percentage of the total market. The price of a stock can be affected by the opinions and emotions of investors, especially in the case of companies that have experienced recent bad news or missed earnings expectations.
Ultimately, most people buy stocks to earn an investment return that exceeds the returns they can achieve from other assets like long-term debt instruments and real estate. The primary way stocks can provide this return is through dividends and stock price appreciation. Dividends are payments a company makes to its shareholders, usually a percentage of current year’s net income. They can also come from retained earnings or asset sales. Companies can grow their revenues and profits, which in turn increases the value of their shares. Investors can then sell their shares for more than they paid for them, and make money on the difference.
Another way stocks can increase in value is when their prices rise on the stock exchange, just as they would for any other asset. This happens when the market becomes more interested in a company or when the company’s products become more desirable. However, it’s important to note that the price of a stock can fall just as quickly as it rose. That’s why a well-diversified portfolio of stocks is important, and why some investors seek out dividend-paying stocks over those that do not.