Shares in companies, sometimes called stocks or equity, are one of the core tools investors use to help grow their savings and investments for short- and long-term financial goals like retirement and education. However, they also can be one of the most volatile investment products in an investor’s portfolio, so it’s important to understand how stocks work and their benefits and drawbacks before making any decisions about investing in them.
A stock is simply a share in the ownership of a company, with a claim on the assets and earnings of that company. It’s an important way for investors to participate in the success of publicly traded businesses.
The value of a stock is determined by the market. When a stock is first offered to the public through an initial public offering (IPO), it’s often sold at a price set by the company and investment bankers, based on valuation and demand from institutional investors. As the stock trades on secondary markets, it’s constantly bid and asked for at various prices by buyers and sellers. The higher the demand for a stock, the higher its price. Over time, a stock’s value can increase through earnings growth or from dividend payments.
Over the longer term, history shows that stock prices closely track corporate profit growth. As a result, over periods of five years or more, about 90% of a stock’s return is due to earnings trends, not just random movements in the market.
There are many other factors that can drive a stock’s price, including supply and demand, economic conditions, political events and even perceptions of the company’s future. For this reason, it’s important to build a portfolio that includes different stocks from many different companies, including both large and small, in a variety of industries.
Investors can further categorize stocks based on their capitalization, or size. They can also be grouped by sector, which is a way to group similar types of companies together. Sectors tend to react differently to economic conditions, so it’s a good idea to diversify your portfolio by avoiding over-concentration in any sectors.
Stocks provide a unique opportunity to participate in the success of the largest businesses in the world and, when chosen wisely, can help build a strong foundation for your financial future. But it’s important to develop a comprehensive financial plan that considers your goals, investment horizon and level of risk tolerance before making any decisions about investing in stocks. A financial advisor can help you determine how much of your portfolio should be dedicated to stocks and make recommendations for diversification.