Stocks — or equities, as they are also known — are one of the most familiar types of investments and a cornerstone of many investors’ plan to build wealth. But that doesn’t mean stocks are easy to understand. For many, investing in stocks can seem like listening to a foreign language, with its complex vocabulary and confusing meanings. This article aims to break down the basics so you can better understand how stocks work and what role they play in an overall investment portfolio.
Stocks are pieces of ownership in a company, and each share represents a fractional stake in the corporation’s equity. Companies issue new shares of stock to raise money for expenses such as designing new products, hiring more employees and expanding into new markets. Investors purchase these stocks in hopes that the company will grow and their stock price will increase enough to turn a profit when they sell their shares. In addition, some companies pay out dividends to shareholders, which provide additional cash flow.
A common misconception is that a person can “make” money by simply buying and selling stocks regularly, based on short-term market fluctuations. However, a more sustainable way to invest in stocks is by building a diversified portfolio that includes companies of all sizes and industries, and from various regions of the world. The goal is to generate a long-term return on your investment that exceeds the average of other prominent asset classes, such as real estate and bonds.
In order to make a profit from owning stocks, you must earn a return on your investment that exceeds the average annual return of the S&P 500 since its inception. The most common returns on stocks are through capital appreciation and dividends. Capital appreciation occurs when the value of a share increases in the market, such as if a company’s sales or profits rise.
On the other hand, a company could experience disappointing results in its business and see its share price fall. This type of loss can occur if the company is having trouble meeting its financial goals, experiencing a slump in sales or failing to meet earnings expectations.
The smallest aspect of a stock is voting rights, which each shareholder has the right to vote on certain governance matters at an annual shareholder meeting. However, this is rarely a focus of individual investors and is more often the focus of institutions with substantial ownership stakes.
The easiest and most logical way to acquire stocks is through a mutual fund or exchange-traded fund (ETF). These funds invest in hundreds, and sometimes thousands, of individual stocks. This helps reduce the risk of tying your fortune to a single stock and offers instant diversification from the first dollar you invest.