One thing that you will come across with investing, especially in the stock market, is people referencing this amazing book called the Stock Market For Dummies. Now, don’t get me wrong, I’m sure it is a fantastic book, but it is most certainly not for dummies. Which is why I think most people will occasionally find themselves asking “how exactly do stocks work?” .
Stocks are one of the many ways that people can grow their wealth. They’re also a way to make money by trading and investing in various different stocks and other forms of investments. But, there is often a lot of confusion and uncertainty as to how exactly stocks work and what makes them go up and down. This article will try to shed some light on the specific details behind stocks and how they work.
What are stocks and why should you own them?
When you buy the stock of a company, you’re effectively buying an ownership share in that company.
Does that mean you get to sit next to Tim Cook at Apple’s next shareholder meeting? No. But in most cases, it does mean you get a right to vote at those meetings, if you choose to exercise it.
But the primary reason that investors own stock is to earn a return on their investment. That return generally comes in two possible ways:
- The stock’s price appreciates, which means it goes up. You can then sell the stock for a profit if you’d like.
- The stock pays dividends. Not all stocks pay dividends, but many do. Dividends are payments made to shareholders out of the company’s revenue, and they’re typically paid quarterly.
Over the long term, the average annual stock market return is 10%; that average falls to between 7% and 8% after adjusting for inflation. That means $1,000 invested in stocks 30 years ago would be worth over $8,000 today.
It’s important to note that that historical return is an average across all stocks in the S&P 500, a collection of around 500 of the biggest companies in the U.S. It doesn’t mean that every stock posted that kind of return — some posted much less or even failed completely. Others posted much higher returns.
That’s why it’s wise to buy stock not in just one company, but to build a well-rounded portfolio that includes stocks in many companies across various industries and geographies.
How do stocks work?
Companies sell shares in their business to raise money. They then use that money for various initiatives: A company might use money raised from a stock offering to fund new products or product lines, to invest in growth, to expand their operations or to pay off debt.
“Once a company’s stock is on the market, it can be bought and sold among investors.”
Companies typically begin to issue shares in their stock through a process called an initial public offering, or IPO. (You can learn more about IPOs in our guide.) Once a company’s stock is on the market, it can be bought and sold among investors. If you decide to buy a stock, you’ll often buy it not from the company itself, but from another investor who wants to sell the stock. Likewise, if you want to sell a stock, you’ll sell to another investor who wants to buy.
These trades are handled through a stock exchange, with a broker representing each investor. Many investors these days use online stockbrokers, buying and selling stocks through the broker’s trading platform, which connects them to exchanges. If you don’t have a brokerage account, you’ll need one to buy stocks.
How Share Prices Are Set
The prices of shares on a stock market can be set in a number of ways, but most the most common way is through an auction process where buyers and sellers place bids and offers to buy or sell. A bid is the price at which somebody wishes to buy, and an offer (or ask) is the price at which somebody wishes to sell. When the bid and ask coincide, a trade is made.
The overall market is made up of millions of investors and traders, who may have differing ideas about the value of a specific stock and thus the price at which they are willing to buy or sell it. The thousands of transactions that occur as these investors and traders convert their intentions to actions by buying and/or selling a stock cause minute-by-minute gyrations in it over the course of a trading day. A stock exchange provides a platform where such trading can be easily conducted by matching buyers and sellers of stocks. For the average person to get access to these exchanges, they would need a stockbroker. This stockbroker acts as the middleman between the buyer and the seller. Getting a stockbroker is most commonly accomplished by creating an account with a well established retail broker.
Benefits of Stock Exchange Listing
Until recently, the ultimate goal for an entrepreneur was to get his or her company listed on a reputed stock exchange such as the New York Stock Exchange (NYSE) or Nasdaq, because of the obvious benefits, which include:
- An exchange listing means ready liquidity for shares held by the company’s shareholders.
- It enables the company to raise additional funds by issuing more shares.
- Having publicly traded shares makes it easier to set up stock options plans that are necessary to attract talented employees.
- Listed companies have greater visibility in the marketplace; analyst coverage and demand from institutional investors can drive up the share price.
- Listed shares can be used as currency by the company to make acquisitions in which part or all of the consideration is paid in stock.
These benefits mean that most large companies are public rather than private; very large private companies such as food and agriculture giant Cargill, industrial conglomerate Koch Industries, and DIY furniture retailer Ikea are among the world’s most valuable private companies, and they are the exception rather than the norm.
What happens when you buy a stock?
Investors must carry out the transactions of buying or selling stocks through a broker, which is simply an entity licensed to trade stocks on a stock exchange. A broker may be an actual person whom you tell what to buy and sell, or, more commonly, this can be an online broker — say, TD Ameritrade or Fidelity — that processes the entire transaction electronically.
When you buy a stock, here’s the simplified version of how it works:
- You tell your broker (or input electronically) what stock you want to buy and how many shares you want.
- Your broker relays your order to the exchange, and a market maker sells you shares at the current market price.
- The shares are then delivered to your account.
What Are the Different Types of Stock?
Companies issue a variety of different types of stock. Common stock and preferred stock are among the most common varieties, and some companies have different classes of stock. These different types of stock determine voting rights, dividend payments, and your rights for recouping your investment if the company goes into bankruptcy.
Common Stock vs Preferred Stock
As noted above, buying stocks may give you the right to vote on issues at a company’s annual shareholder meeting.
Each share of common stock typically gives holders a single vote at the company’s annual meeting. However, common stock shareholders are at the end of the line after debt-holders, creditors, and preferred stock shareholders when it comes to recouping their investment should the company go into bankruptcy. Common stock generally entitles you to dividends, however you are not guaranteed to receive dividend payments. Companies can choose to pay dividends or not pay dividends, depending on their own needs.
Different Classes of Stock
Companies frequently issue different classes of stock, often designated with a letter, such as A, B, or C. Additional share classes are typically issued with specific voting rights per class and exist to help company founders or executives retain a greater degree of control over the company.
Take Alphabet, the holding company that owns Google. Alphabet has three classes of stock. Class A stock (GOOGL) gets one vote for each share. Class B stock is held by the company’s founders and gets 10 votes per share. Class B shares are not publicly traded, and exist to help the founders retain control over the company. Class C stock (GOOG) has no voting rights, and is largely held by employees and some common shareholders.
Conclusion
Stocks often get a bad rap. Everyone knows someone whose life was completely ruined by their investment in them. However, there are also plenty of people who have struck it rich by investing wisely in stock. Either way you cut it, understanding how stocks work can help to increase your investment profits or at least avoid losses that can ruin your finances entirely.