Stocks—also known as shares, equities or equity—are a key part of most investors’ wealth-building strategy. They can have many benefits, but they also come with a level of risk that can cause some people to abandon their investment plan or sell at the wrong time.
As a result, it’s important to understand how stocks work and how they differ from other types of investments—like bonds, for example.
A stock is a share of ownership in a corporation or company. Corporations issue new stocks to raise capital for projects like designing new products, hiring more people and expanding into new markets. Buying or selling stocks is how shareholders get their slice of the profits if those plans become reality.
Historically, stocks have provided higher returns than other investments such as bonds and cash alternatives. Investors who stick with stocks over long periods of time—a minimum of 15 years—are often rewarded with strong, positive returns.
To buy or sell a stock, you place an order with your brokerage. This tells your broker how many shares you want to purchase or sell and at what price you’d like to pay. It can be executed immediately, or it might take a while depending on how busy the market is and how much demand there is for a particular stock at that moment.
Stocks can be categorized by the size of the company or its market capitalization, which includes the number of shares of small-, mid- and large-cap companies. There are also categories based on whether or not the company pays dividends. Then there are smaller groups, including penny stocks. Generally, companies with higher liquidities—meaning there are a lot of buyers and sellers in the market for their shares—can be more easily bought or sold, which can affect their price.
While a stock’s price may change over time, the true value of a stock comes from the company’s business fundamentals. Revenue and earnings growth, for example, are key indicators of a company’s health. Revenue growth indicates that customers love the products or services a company offers, while earnings growth reveals how efficiently the company manages its resources. Companies with competitive advantages, such as defensible economic moats, network effects and brand recognition, typically have more durable stock prices.
A stock’s price is also affected by broader economic trends and market conditions. For instance, a company’s stock price may decline if it seems likely that competitors will launch similar products or that interest rates will rise. Or, a company’s stock may drop if the market is nervous about whether it can deliver on its growth plans.