What Are Stocks, Exactly? How Do They Work?

In this article, we discuss: 

• How stocks work
• Types of stocks
• Pros and cons of stocks
• Considerations for buying stocks

How stocks work

Investors who own stock in a company become shareholders, which gives them a claim to a portion of that company’s profits. Companies typically issue a limited number of shares that will be available when they first “go public” during their initial public offering (IPO). These shares are then traded among investors who are buying and selling on the stock market. The price of these shares will rise and fall depending on supply and demand, as well as other market factors. 

But what are stocks supposed to do for investors? Well, once they’ve purchased shares, investors can earn money in one of two ways:

• The stock’s price goes up. Investors can sell shares at a profit if the stock price increases after they buy. As a business’ value fluctuates, the value of the stock fluctuates with it. Consequently, the value of an investor’s stock holdings will fluctuate over time. 
• The stock pays dividends. Dividends are payments made to shareholders from a company’s profits. These payments provide an opportunity for profit regardless of whether your shares increase in value. Not all companies offer dividends; those that do typically pay them quarterly. 

Types of stocks

There are two primary types of stocks: preferred and common stock. Both types represent investor ownership in a company, but they have some distinct differences. 

• Common stock: These shares are the most common type offered by companies and purchased by investors. They grant shareholders ownership rights in a company, usually come with voting rights, and their value typically comes from growth in share price. Common stocks tend to outperform preferred stocks but are considered higher risk.
• Preferred stock: These shares combine characteristics from stocks and bonds. Unlike common shareholders, preferred shareholders have rights to company profits but generally have no voting rights. Preferred stocks are prioritized over common stocks when dividends are paid and assets are distributed, so they are typically lower risk but have a lower potential for long-term growth.

Pros and cons of stocks

Investors primarily buy stock to earn a return on investment and grow their wealth, especially in the long term. But investing in the stock market comes with both potential benefits and notable drawbacks.

Pros of owning stocks 

• Possibility for returns: Investors can earn money through long-term investing in stocks, especially because of the impact of compounding returns. Historically, the stock market has an average 10% return, which is higher than what can typically be earned through bonds or interest on savings.
• Possibility of earning dividends: Investors who receive dividends can either reinvest them to build their portfolio in the long term or use them as a regular stream of passive income.
• Liquidity: Your shares are liquid; you can sell them anytime for quick access to your money if you need it. That said, you’ll want to be aware that the stock market can be volatile, so you always run the risk of selling at a loss. 
• Variety: Investors in the stock market have access to a wide variety of potential investments, including exchange-traded funds (ETFs), mutual funds, and index funds in addition to individual stocks. You have a lot of room to build a well-diversified portfolio that matches your risk tolerance. 
• Ease of purchase: Once you’ve set up a brokerage account, investing in the stock market is easy. You can work with a broker directly to advise you on your investments, use a robo-advisor for automated guidance, or self-manage your account online. You can even automate your investing for a hands-off approach.
• Low cost to get started: You can start investing with whatever amount of money works for your budget. Many brokers allow you to buy fractional shares so you can gain a stake in companies whose share prices are too expensive for you to purchase a full share right away.

Cons of owning stocks

• Risk of losing money: Investors can lose money, even their entire investment. Share prices can fall dramatically and businesses can go under, leaving investors with big losses, and there is no guarantee they’ll make that money back. This risk can be minimized with a well-diversified portfolio, but it can’t be fully avoided.
• Common shareholders get paid last: If a company goes bankrupt, there’s a chance common shareholders won’t get paid. Creditors and preferred stockholders get priority in the case of liquidation. 
• Taxes: Profitable stock sales are subject to taxes, and some of your earnings will likely go toward capital gains tax when you turn a profit. 
• Emotional buying and selling: The stock market is volatile, and prices rise and fall regularly. This can be emotionally difficult for investors who are risk-averse or stressed by seeing red in their portfolio.

Considerations when buying stocks

How you invest in stocks will be unique to your specific needs, timeline, and goals. To choose the best investing strategy for you, you’ll want to consider several key factors, including:

• Market factors like the volatility of the economy, sectors, and companies you’d like to invest in
• The amount of risk you’re comfortable with
• Your investing goals and timelines for reaching them
• Your cash flow, any existing investments, and predicted future income
• Your short-term and long-term investing goals
• How investing affects other financial priorities like getting out of debt or building an emergency fund

As your goals, income, and lifestyle change, so will your investment strategy. You may want to revisit your portfolio periodically to rebalance and adjust your approach, especially when you experience big life changes like relocating, switching jobs, or changing marital status. 

How to buy stocks

Stocks are sold on the stock market, a broad term representing all the shares available in a particular country. The stock market is made up of exchanges, and the U.S. has three major stock exchanges: 

• The New York Stock Exchange (NYSE)
• The Nasdaq Stock Market (NASDAQ)
• The Chicago Stock Exchange

Investors will trade stocks through a brokerage by opening an account, transferring money, and selecting and purchasing individual stocks, mutual funds, ETFs, or index funds. 

Shares can be purchased through several different types of accounts, including standard brokerage accounts, retirement accounts like a 401(k) or IRA, and educational accounts. 

If you want to start investing in stocks, be aware that you cannot purchase them directly on an exchange; a licensed broker must make the purchases on your behalf. There are many options for brokerage firms, from brick-and-mortar companies to online platforms and apps.  

The role of stocks in your investment portfolio

Stocks generally represent the higher-risk, higher-potential-return portion of your overall investment portfolio. Many investors offset this risk with lower-risk investments in things like bonds and index funds. 

How you allocate your investments among stocks and other securities depends on your risk tolerance and your timeline for reaching your financial goals. Risk-averse or close-to-retirement investors often tend to invest in lower-risk, lower-potential-reward stocks and dedicate a larger portion of their portfolio to bonds. Investors more comfortable with risk or with more time before retirement may go for a larger proportion of high-risk, high-potential-reward stocks because they have more time to ride out market volatility.  

Get started investing in stocks

New investors often find themselves overwhelmed at the prospect of investing in stocks, but you can dip your toe in and learn as you go. As you deepen your understanding of what stocks are, how they work, and the risk involved, you’ll likely gain more confidence. It’s okay to start small and get comfortable before fully diving in. There’s an investing strategy for everyone, and the earlier you start, the more your money could grow. 

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