Stocks can help you build your wealth and are one of the core tools in most people’s portfolio. But there are many ways to approach stocks that can delay your progress, or cost you a lot of money and heartache (like the hare in the classic tale). Before you buy shares in companies, take some time to understand exactly what they are and how they work.
Stocks are ownership shares in public corporations. The value of a stock depends on how well the company does and whether it’s able to grow its business in the future. If a company does well, its earnings per share will typically increase and its stock price will rise. Stock prices are also affected by the overall economy and by short-term news events, such as political uncertainty abroad or natural disasters at home.
A share of a stock doesn’t give you a seat on the board or the right to rub elbows with company bigwigs. A share of a stock is a piece of the company and can be sold for cash or traded with other investors, either in exchange for more shares of the company or for other types of assets like bonds.
In general, when a company needs more capital to pay for things like designing new products and expanding into new markets, it issues additional shares of stock to raise money. This is known as an initial public offering (IPO). Investors can then buy and sell shares of the company on the secondary market.
Most stocks are traded on a stock exchange, where professional traders act as brokers and match buyers and sellers. Some exchanges are regulated by the Federal Reserve and require investors to put up 10 percent or less of their investment before they can buy shares. This helps prevent speculators from being able to buy shares without any risk and then immediately selling them for profit.
While stocks can be a great way to grow your savings over the long term, they don’t offer any guarantees that you will make money from buying them. Stock prices can fall as easily as they rise, and some stocks can lose all their value if the company goes out of business.
Investors can own stocks directly, or they can invest in mutual funds and exchange-traded funds (ETFs). These investment vehicles generally offer a low minimum investment amount, making it easy for even beginners to get started. Mutual funds and ETFs often hold hundreds — or even thousands — of stocks, providing instant diversification from the very first dollar you invest.
Over the long term, investors who hold stocks in a diversified portfolio have historically earned about 10 percent per year. This doesn’t mean that you can expect to earn this return, and in reality, most people who invest in stocks see lower returns than this.
A key reason for this is that stocks are typically more volatile than other asset classes, such as bonds and real estate. This makes stocks more susceptible to sudden drops and losses when a market crisis arises. In addition, changes in interest rates can hurt or help stocks, depending on whether the Fed succeeds in taming inflation or not.