Stocks, company shares or equities are a big part of many people’s plans to build wealth, and they can play a crucial role in a well-diversified portfolio. But they’re not easily understood, and misunderstandings about them can potentially lead to financial loss. NerdWallet is here to help you get up to speed on how stocks work so that you can choose the right ones for your portfolio goals.
Companies issue stocks to generate capital they can use to grow or develop their business. Public companies sell shares of their stock to investors on a market called the stock exchange, which allows them to raise funds quickly and efficiently. Investors can then buy and resell these shares at their own discretion.
Stockholders can expect returns through two main mechanisms: capital appreciation and dividend payments. Capital appreciation occurs when the value of a stock rises over time, and it can be triggered by the company becoming more profitable or expanding its operations. It can also be the result of positive news about a company, or even a general market rally.
A company’s profits are the foundation of its stock’s value, and shareholders have a claim on a proportional share of those profits. Some companies distribute a portion of their profits as dividends to stockholders, while others retain the earnings to invest in the company’s growth. In either case, those retained earnings have an impact on a stock’s value, although the amount may be less than if a company distributed dividends every quarter.
The stock market’s unpredictability can make it difficult to predict a stock’s future price, and sudden market downturns can result in significant losses for investors. For this reason, it’s important for potential investors to carefully consider their risk tolerance and capacity before investing in stocks.
There are different types of stocks, including common and preferred shares. Both types typically entitle shareholders to voting rights and may pay dividends. But common stock also carries the greater risk of volatility.
Depending on your investment objectives, you can invest in stocks directly or indirectly through mutual funds and exchange-traded funds. Both approaches offer the ability to diversify your portfolio, and you can often find low-cost options in each. However, investing in stocks is typically more expensive than other options, and you’ll usually need to commit a higher percentage of your assets.
Stocks can be an excellent addition to a long-term investment strategy, but they’re not appropriate for everyone. Investors seeking a higher return with lower risk should consider alternatives like bonds and cash, which tend to yield a lower return but have a lower chance of volatile fluctuations. If you’re planning to retire or switch careers soon, you might want to consider using your retirement account or individual retirement account to invest in stocks before transitioning to a fixed income.