Stocks, company shares, equities — no matter what you call them, they’re an important part of many investors’ plans to build wealth. But they can be confusing. Stocks are complex financial instruments that offer the potential for growth but also come with risk. It’s a good idea to understand how they work before jumping feet-first into the market.
A stock is an ownership share in a corporation. Companies issue stocks and sell them to investors through a process called an initial public offering, or IPO. Investors then purchase the stock, and its value can rise or fall over time, depending on a variety of factors, including how well the company performs. Companies may use profits earned from the sale of stocks to pay dividends to shareholders or reinvest them in business. The value of a stock can be increased or decreased by the value of other stocks and bonds in the marketplace.
There are different types of stocks, including common stock (stock that comes with voting rights) and preferred stock (stock that doesn’t). The most commonly bought stock is called a blue-chip stock because it’s owned by the largest companies in the country. These stocks have the greatest liquidity and are less volatile than smaller, more speculative stocks.
Historically, stocks have provided the highest returns of any investment asset, but they’re not without risk. In the short term, the stock market can experience significant ups and downs, called a “market crash.” The 2008 Financial Crisis is an example of a major market crash. Over the long term, though, the stocks in your portfolio have the potential to grow in value over time — and to provide you with the income you need for retirement or other goals.
When it comes to understanding stocks, there’s a lot of information available. In addition to news articles, research firms and industry publications, there are online tools that can help you find the right stocks for your investing needs. These tools typically compare a company to its competitors and use data such as price/earnings ratios and enterprise value/earnings before interest, taxes, depreciation and amortization, or EV/EBITDA, to determine if a stock is under- or overvalued.
Ultimately, stocks are worth the price that someone is willing to pay for them. That’s why it’s wise to diversify your investments, by buying stocks in several different industries and geographies. That way, if one of your stocks loses value, it will be offset by the gains from other investments.
While a stock’s price can fluctuate up and down, overall market history has shown that large-company stocks as a group have increased in value about 10 percent every year. That’s not guaranteed to continue forever, but if you stick with stocks over the long term, they’ve historically provided strong returns that compensate for inflation. NerdWallet writer Arielle O’Neil has appeared on the Today Show, NBC Nightly News and other national media. She’s a NerdWallet authority on retirement and investing, and is an expert in helping consumers reach their long-term financial goals.