Stock BasicsSubmitted by Headwater Investment Consulting on July 13th, 2016
By Kevin Chambers
Stocks are probably the best known and most widely used investment instrument. Even though millions of Americans own stocks, and everyone hears about the stock market almost every day, many people still don’t fully understand what they are or how they work.
The basic concept of stocks is pretty simple. They are shares of ownership of a company. Owning a stock gives the owner a claim to the company’s assets and earnings. Owners are also called shareholders and have the right to vote on structural changes to the company, e.g. CEO compensation, the electing board of directors, and approving mergers and takeovers. When companies issue stock, they give up partial control in order to raise money. Companies often prefer raising money through equity (issuance of stocks) because they are not required to make interest payments or pay back principals like in more traditional debt financing (issuance of bonds).
So how do stocks make investors money?
There are two primary ways. First is price appreciation or the increasing price of the stock. If investors can sell shares of a stock for more than they paid to initially purchase the shares, they make a profit. Prices change based on basic supply and demand. If more people want to buy a stock than there are people who want to sell it, the price will go up. However, it is difficult to predict how prices will change. Demand can change with new information about the company, general market trends, or investor sentiment. However, the most important factor in determining if a stock price will change is how successful a company is. This is most often measured by a company’s earnings.
The second way investors can make a profit is by the issuance of dividends by a company. Because shareholders have a claim to earnings, companies will periodically distribute a piece of their earnings to their shareholders. This is income that investors make off their partial ownership of the company.
Types of Stock
There are two main types of stock that investors own: common stock and preferred stock. Common stock is the most prevalent. When people talk about stock, they are referring to common stock. Preferred stockholders give up their voting rights, but are guaranteed a set dividend payment that must be paid before common stockholders receive dividends. Although they are technically an equity investment, most investors think about preferred stock as more akin to fixed income investments. Read more about types of stock shares.
Stocks are traded on various exchanges all over the world. The most famous exchange is the New York Stock Exchange (NYSE), where many of the largest companies in the United States are listed. Other exchanges include the NASDAQ, where many technology stocks are listed, London Stock Exchange, and Hong Kong Stock Exchange. No stock is listed on multiple exchanges. If you want to buy McDonald’s stock, you need to go to the NYSE. But if you want to buy Microsoft, you need to go to the NASDAQ.
Individual investors can’t walk into the NYSE and buy or sell stocks. Instead, stocks are sold through brokerage firms, who have traders on the floor of the exchange that take and execute orders. Although you might have the quintessential picture of the chaotic NYSE trading floor with traders yelling out orders, this process is now mostly done electronically.
Individual Stocks vs. Stock Mutual Funds
Individual stocks can have a lot of risk. Individual companies can have financial trouble, or have problems with a CEO, or fall victim to forces beyond their control. It is also very difficult to predict if a stock is going to rise or fall on any given day. For that reason, at Headwater Investments we do not trade individual stocks and try to “time the market.” Instead, we favor buying mutual funds, which hold hundreds, and sometimes thousands, of different stocks, and therefore mitigate some of the risk involved in stock market investing.