In this week’s post, I explain the basics of stocks.
From my experience, many people hear about the stock market and are familiar with some of its related terms, such as the major indices: the DOW, NASDAQ, and S&P500. However, I have noticed confusion about the basics of what a stock is, how the stock market works, and why investors buy stocks to begin with.
Keep in mind that investment securities, such as stocks, are distinct from the type of investment account in which they are held, as we covered in a post several weeks ago. Each type of security has its own characteristics that are separate from the rules and tax treatment of the investment account. This post will explore some of the characteristics of stocks.
Stock is ownership interest in a company
Stock is ownership interest in a company - if an investor owns stock in a company, they are a co-owner. This ownership interest is divided into different units called “shares.” Owners of shares of stock in a company can be called “shareholders.”
A shareholder, is (typically) able to:
Vote on certain types of company business.
Vote to elect members of the board of directors.
Receive dividends, which are a portion of the company’s earnings (at the discretion of the board of directors).
Owning shares of stock in a company is similar to a businessperson who owns their own business. The biggest difference is the amount of a control. A businessperson has a lot of control over how their business is run, including if profits are left in the business or distributed. Shareholders in a public company, do not have this same degree of control. Rather, shareholders vote to elect members of the board of directors, which is a committee that is tasked with governing the company. The board of directors will hire management to lead the company's day-to-day operations. The board of directors will also decide what portion (if any) of the company’s profits to distribute to shareholders via dividends.
Here is a visual example comparing a small business to a public company:
What is the stock market?
The stock market is exactly what it sounds like - a market where investors buy and sell shares of stock in different companies. When a company’s shares are widely available to be purchased by anyone, typically on a stock exchange, the company is considered “publicly traded.”
The stock market can be divided into the “primary” market and the “secondary” market. The “primary” market is when companies sell their shares to investors. When a company first sells shares to the public, it is called an “initial public offering” or “IPO”. The “secondary” market is when investors buy and sell shares with each other – and the company is not involved. When most people talk and think about the stock market, they are most often referring to the “secondary” market.
Because a company’s shares are all uniform (although a company can have multiple classes of shares, which we won’t discuss here), the only thing that investors decide on when buying and selling is the price per share.
Many people think of the stock market separate from the actual performance of the underlying companies. The market is often associated more with gambling than buying small pieces of businesses. Because of rampant speculation, there can be at least a short-term separation between a company’s stock and its actual business. However, it is still important to remember that investors are not buying random pieces of paper or letters on a screen - they are buying and selling small pieces of businesses.
Why do investors own stocks?
A businessperson starts a small business with the hope and expectation of making a profit. This profit may come from the earnings of the business each year or from eventually selling the business to someone else. Investors own stock in a public company for the same reasons. Public companies may distribute a portion of their earnings to shareholders in the form of dividends. Also, if the company does well, the price of the stock will likely appreciate, and the investor can sell their shares for more than they originally paid (price appreciation).
From the investor’s perspective, the total return (dividends + price appreciation) from owning stocks may be more attractive than other investment options. Of course, there is an element of risk to owning stocks, like the risks that exist in any business venture. The company could go out of business, or have poor performance that could result in dividends being cut or the stock price dropping. Balancing risk and return is a fundamental part of creating a portfolio.
If you have any comments, questions, or ideas for future posts, please let me know
I hope you found this post helpful and educational. If you have any comments, questions, or ideas for future posts, please let me know. You can reach me directly via email at crawford@ulmerfinancial.com.
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