Stock

What is a Stock?

Stock, also known as equity, represents ownership interests in corporations. Whether you own one, 100 or 100 million shares of stock in a company, you're an owner of the company.

How Does a Stock Work?

Corporations sell stock, or ownership in the company, in return for cash to run their businesses. Much of the time, only a few people (the founders of the company, for example, who have put their life savings into the company) own the company. But when several owners want to cash out their investments or the company needs more cash for whatever reason, the corporation might "go public," meaning that it sells some of, all of or more of its shares to the general public via a stock exchange.

There are a number of different kinds of stocks, and their classifications largely depend on the rights they confer on the holder. Investors evaluate these categories based on their investment objectives and they look for stocks that meet those objectives. The two most popular categories of stock are common stock and preferred stock.

The most prominent characteristic of common stock is that it entitles the shareholder to vote on corporate matters (typically, the shareholder gets one vote for every share he or she owns, though that is not always the case) such as whether the company should acquire another company, who the board members should be and other big decisions. Common stock also often comes with preemptive rights, which means the shareholder has a "right of first refusal," or first dibs on buying any new stock the company tries to issue.

Perhaps the most important attribute of common stock is that holders are the last in line when it comes to getting their money back. If the company goes bankrupt and has to sell off all its assets, the cash from the asset sale first goes to pay off lenders, employees and lawyers. The shareholders get whatever is left (which is usually nothing, or just a few pennies for every dollar they originally invested).

This pecking order is why preferred stock, the other popular category of stock, exists. Although preferred stock owners don't usually get any voting rights, they usually receive a steady dividend and their claim to the company's assets "outrank" the common stockholders' claims (i.e., in the event of bankruptcy, the company must pay off lenders, preferred shareholders, employees and lawyers before the common shareholders get anything).

The nature of a company's business also determines many of the characteristics of its stock. For example, blue-chip stocks are stocks issued by high-quality, large companies and generally have steady dividend payments. Their values don't "jump around" as much as shares of smaller, riskier companies, generally speaking, and so conservative investors who like dividend payments and not much risk tend to like blue-chip stocks. Companies that pay out dividends are typically income stocks, and they are generally mature companies that feel that the highest and best use of its excess cash is dividends rather than, say, research and development or other investments.

Some stocks move in accordance with the economic cycle, and some move in the opposite direction. Knowing which stocks are which can help you decide when to buy and sell some of your holdings. Cyclical stocks, for example, increase in value when the economy is growing and decrease in value when the economy is shrinking.

Briefly, here are some other categories of stock that investors look at:

• Growth stocks: Shares of fast-growing, higher-risk companies. They offer a higher chance of higher returns and a higher chance of bankruptcy.
• Tech stocks: Shares of technology companies. Like growth stocks, they are generally riskier than other types of companies, but they also offer a chance at very high returns.
• Small-cap, mid-cap and large-cap stocks: Stocks from small, mid-size and large companies. The "cap" is short for capitalization, which is simply the number of shares outstanding times the current price per share. It's important to note that a company's stock can fall into more than one category. Large-cap stocks can be blue-chip stocks, growth stocks or income stocks, for example. Small-cap stocks can be growth stocks, income stocks or tech stocks.

Why Does a Stock Matter?

Finding a stock to buy is about as easy as logging onto the Internet, opening the newspaper or picking up the phone. The trick is deciding which stock to buy. Buying and selling stocks can be done with a simple trading account that you set up and manage yourself, but many investors (both individual and institutional) still call their brokers.

Deciding which stock to buy, or which kinds of stocks to buy, requires you to consider your goals in life, your age, your cash needs, future cash needs you might have (retirement, college, etc.), your tax situation, the nature of your other investments and how much risk you're willing to take. That's a lot to consider, which is why financial advisors come in handy for investors wondering what to do.