Stocks can be powerful tools for accumulating wealth. But as with any type of investment, trading in stocks carries a share of risks. Before investing your hard-earned money, it is essential to educate yourself on how stocks work, the different kinds available and the pros and cons of this type of investment.
If you are a newcomer to the stock market, the information below will provide you with the core concepts you need to begin growing your portfolio.
What are stocks?
In simple terms, a stock represents ownership of a small share of a business. When you purchase a stock, you become a co-owner of the company, which entitles you to certain shareholder rights. Depending on the type of stock you purchase, you could be entitled to a vote at shareholder meetings, receive a portion of company profits and sell your trade your shares with other investors. Stocks can be a great way to earn money later, like when you retire.
Sometimes called equities, stocks are issued by businesses to raise money for business needs like research and development, projects and expansion. Businesses that offer stocks for purchase to investors in the general public are considered to be “public” companies. Once purchased, shares from public companies can be traded to other investors on a public stock market exchange like Nasdaq or the New York Stock Exchange. There are two primary kinds of stock a company can issue, common and preferred.
Common stock, as its name suggests, is the most prevalent type of stock. Common stock entitles you to voting rights and a claim of a company’s dividends or profits. Typically, you receive one vote for each share you own at shareholder meetings when board members are elected. Common stock has the potential to yield higher returns through capital gains. However, common stocks carry a higher risk potential if the company goes bankrupt. If a company goes out of business, then dividends are distributed to common stockholders last, after assets are provided to bondholders and preferred stockholders. More often than not, this means common stockholders get nothing.
Preferred stock, on the other hand, comes with less risk and lower potential for reward than common stock. As a preferred stockholder, you generally do not receive voting rights. However, you are often guaranteed set, regular dividend payments with preferred shares, while the dividend payments sometimes provided to common shareholders may fluctuate with the company’s earnings and losses. As a result, preferred stock is considered less risky than common stock, but with lower potential for profit. Another noteworthy benefit of preferred stocks is that if a company goes bankrupt, its liquidated are distributed to preferred shareholders before common shareholders, although after bondholders.
How are stocks different from bonds?
Although both stocks and bonds represent methods of investing in a company, there are some crucial differences between them. Both stocks and bonds are two strategies a company may use to raise capital. However, when a company sells a stock, it is selling a share of ownership. When you purchase a stock, you own a portion of the company that could go up in value if the value of the business rises or fall if the value of the business falls. If the company sees excess earnings, then it may pass on a portion of profits to you and other stockholders in the form of a dividend check.
Bonds, on the other hand, are a type of loan. When you purchase a bond from a company or other entity, you effectively give them money that they promise to repay with interest. During the bond contract, the company will typically make a fixed-interest payment to you, the bondholder, until it matures. Once a bond has reached maturity, you receive the full amount you originally paid for the bond. As a bondholder, you can either keep your bond until it reaches maturity or sell it to another investor.
Compared to stocks, bonds are considered a low-risk investment with a lower potential for return. Although the price of bonds may rise and fall with the market, most bonds are paid back in full to the bondholder once they reach maturity. Stocks, on the other hand, could spike or plummet in value over time. If a company goes bankrupt, then you might receive nothing in return for your investment.
How do you make money with stocks?
When you invest in stock, you have two following opportunities to make a profit:
- Dividend income. One way to make a profit on your shares of stock is to collect dividends. Dividends are periodic payments paid by the company that owns your stock. Companies usually pay a portion of their profits in the form of dividends every quarter, although this is not a requirement. However, if you invest in a business with a reputation for paying dividends, then you can count on dividends as a fairly dependable source of profits.
- Capital appreciation. Capital appreciation occurs when a stock you own goes up in price. When this happens, you can trade your stock on the stock market to receive a higher price than you originally paid.
How do you purchase and trade stocks?
To purchase and sell stocks, the vast majority of investors go through a brokerage firm. In some cases, your 401(k) may be a combination of stocks and/or mutual funds. To get started trading stocks through a brokerage company, follow the steps below.
- Set up a brokerage account. To open a brokerage account with a firm, you complete an application and deposit funds into the account electronically or with a check. Today, many major brokerage firms let you manage your account online or in person with a stockbroker. There are also a variety of online brokers that let you buy, sell and manage your account entirely online.
- Do your research. Once you have chosen your brokerage firm and opened an account, you can select the stocks you want to buy. To determine what companies to invest in, thorough research is essential. Start by reviewing the public reports of different companies you are interested in. If you do not know where to begin, then try looking for companies with a business model or products you use or admire. You may also be able to take advantage of information and analytical tools from your brokerage firm’s website to compare how different companies are performing. When in doubt, consult with a financial planner.
- Buy. After deciding on the stocks you want to invest in, you can choose between a market order and a limit order. With a market order, you chose to buy the stock at the best available market price. Alternatively, with a limit order, you chose to buy a stock only if it falls to a certain price.
Once you have purchased your stocks, you can choose to hold onto it and collect dividends or sell your stock when the price rises. Find out more about other types of investments here.