Cashay logo

Empowering your money

What are stocks and how do they work?

At a glance:

  • What are stocks? Here are the basics

  • Types of stocks

  • Stock volatility

  • How to choose a stock broker

  • Summary of stocks

  • Practical ideas you can start with today

What are stocks? Here are the basics

Owning stocks is not for the privileged few alone.

Nearly everyone with a retirement plan has some stock-focused mutual funds among his or her investments, and the growth of mutual funds and online trading has made participation in the stock market more popular than ever.

A look at a piece of stock. (Photo: Getty Images)
A look at a piece of stock. (Photo: Getty Images)

Stocks are about ownership of companies

A share of stock represents a share of ownership in a company. When you buy shares of stock, you are becoming a part owner in the firm and are entitled to a share of its assets and earnings. In other words, you are buying equity in the company. Companies sell stock to raise funds, often to invest in growing the business.

Ownership confers other rights as well

Depending on the kind of stock you buy, you may also have the right to vote, along with other shareholders, to elect members to the company's board of directors and decide other key matters. The most important distinction about this kind of company ownership is that stocks are a form of equity that is designed to be traded – bought and sold.

Unlike buying bonds, which represent loans, holding stock represents actual ownership of equity. Another important difference is that the return on common stock is not fixed, but varies with the performance of the company.

Two common ways you can make money on stocks

There are two main ways to make money with stocks. Many stocks pay dividends, which are shares of the company's profits that shareholders receive as income. You can also make money on fluctuations in the stock's market value if you can sell it at a higher price than you paid for it.

Because the value of stock depends on so many factors, investing in the stock market often seems risky. However, over time the stock market has historically outperformed other kinds of investments, even with the occasional crash. That is why stocks are such an attractive investment for high-risk day traders and long-term investors planning for a financially secure retirement.

It’s important to remember that high-quality stocks may be appropriate for some investment strategies. Ensure that your investment objectives, time horizon, and risk tolerance are aligned with stocks before investing, as they can lose value.

Types of stock

Stocks represent shares in the equity of a company. There are two basic kinds of stock: common and preferred.

Common stock

Common stock is the kind most investors own. When you own common stock, you generally receive voting rights, and you receive dividends if and when the company's board decides to pay them. If the company were to be sold, common stockholders would have a right to a share of the value of the company's assets – that is, if any are left after the company pays off creditors, bondholders, and owners of preferred stock.

Preferred stock

Preferred stock is called "preferred" for that reason – its owners have a prior claim to the company's assets over the owners of common stock. Preferred stock usually doesn't include voting rights, and it pays a fixed dividend. As a result, while preferred stock pays off in a more predictable manner, its holders don't share in the company's changing fortunes in the way common stockholders do. For that reason, preferred stock isn't preferred by most investors!

While both types of stock represent a share of ownership in the company, the performance of each is unique, both while you hold your shares and when you trade them on the secondary market.

Stock volatility

Stock traders generally want to buy stocks when their values are low and sell when their values are high. The distinguishing characteristic of stocks is their potential to change in value in ways that can be hard to predict.

The ups and downs of volatility

A stock that is likely to have great or fast changes in its value is called volatile. Volatility gives stocks the capacity to have high returns if values rise, but it can also make stocks a risky investment if you can't sell them before they fall. Volatility is a major key to investment strategy.

Blue chip stocks are less volatile

Blue chip stocks, a term for the stocks of older, well-established companies with strong track records, tend to have lower volatility. They are more likely to pay dividends and may tend to grow steadily, if slowly, in value. Because of their generally low volatility, you often have to hold these stocks a longer time to enjoy large value gains.

Who buys volatile stocks?

Highly volatile stocks – for instance, those of new companies in hot industries – have appeal to those interested in sophisticated short-term trading strategies. The goal of such strategies is to watch for stocks that can be bought at low prices and sold relatively soon when the values potentially grow. These investors have no real way to be sure this will happen. So while volatile stocks have the potential for high and fast returns, they also present a greater risk of losing your money. This risk includes the loss of principal, the amount of money you invested.

How to choose a stock broker

When you want to buy (or sell) shares of a publicly traded stock, typically you will use the services of a broker. A broker (stockbroker) must pass an examination on securities law to be licensed to trade securities. Licensed individuals are registered representatives of brokers.

Brokerage houses are large firms that deal in securities and may belong to an exchange such as the New York Stock Exchange or the American Stock Exchange.

Brokers do more than execute trades

Besides buying and selling securities for customers, brokers may provide other services such as doing market research. Most people do not have the time or resources to adequately research companies they consider for investment.

The broker can be of assistance. With vast resources, brokers can provide investors with the "market intelligence" to allow them to make wise investment decisions. Other people prefer to do it themselves.

Full-service brokers

Full-service brokers research investments and assist their clients with their investment decisions. For this service, a commission compensates a full-service broker for the transaction. Here are some other services a full-service broker may provide:

  • Investment planning

  • Suggesting good investments

  • Monitoring performance

  • Limited tax advice

  • Margin accounts

  • Access to initial public offerings

Full-service commissions are higher than commissions to brokers who do not provide research services.

Discount and deep-discount brokers

Discount brokers simply execute your trades. They typically do not provide many other services. Discount brokers are compensated with commissions on transactions. Their commissions typically are lower than those of full-service brokers.

Deep-discount brokers execute trades only. Because their customers trade in large quantities regularly, they are able to charge the lowest commissions.

Online brokerages and what they offer

The introduction of online brokerage services – brokerages that assist investors in trading over the Internet – has changed the rules considerably in the brokerage industry. Technically speaking, online brokerage services can be classified into the categories of full-service, discount, and deep-discount.

However, the cost effectiveness of this new medium has allowed many brokerage houses to expand their services while reducing their prices. Many online brokers offer services comparable to those of full-service brokers (such as online research materials and online educational materials) at prices similar to or below those of the prices of traditional discount brokers.

When you are choosing the broker and brokerage house that are right for you, it is important to consider all the options. You should select the type of brokerage firm based upon the kind of trading you plan to do and services you require.

Summary of stocks

Because the value of stock can depend on so many factors, playing the stock market often seems overwhelming. Even though all investors should understand that past performance does not guarantee future returns, the stock market has historically outperformed other kinds of investments, even with the occasional crash.

That is why stocks can be such an attractive investment for high-risk day traders and help long-term investors prepare for a financially secure retirement.

Practical ideas you can start with today

  • Research stocks that fit your investment goals and risk tolerance.

  • Identify growth stocks or income stocks that are attractive buys, based on their advantages and disadvantages.

  • Meet with a broker, set up an online brokerage account, or contact a company to begin buying stocks.

This content was created in partnership with the Financial Fitness Group, a leading e-learning provider of FINRA compliant financial wellness solutions that help improve financial literacy.

Read more information and tips in our Stocks section

Read more personal finance information, news, and tips on Cashay

Follow Cashay on Instagram, Twitter, and Facebook