What is a stock?
The purpose of this upcoming series of articles is to enlighten the novice who is interested in the stock and financial markets but has little knowledge of them. It is for this reason that I am going to offer the basics, beginning with a bit of common terminology and then in latter posts how all these terms relate to you and your quest for financial security. So the best place to begin is in understanding the most common items you may come across either on television, the papers or your financial advisor.
Lets say you have a reasonably successful company and you need money to expand. Perhaps you need to hire additional staff, build new facilities or purchase new assets, these things do not come cheap and you realize you will need to raise money to accomplish this. You can go about this in two ways, you can borrow the funds needed and pay an interest rate on a common debt instrument (called a bond) or you can raise the capital (money) from investors by selling them a piece (shares of stock) of the company.
If you purchase shares of stock in this company, no matter how few shares (even one share) you become a part owner of that company and are entitled to a share of the assets and earnings of that company relative to the number of shares you own. Remember if you own 1 share or 1000 shares, the amount you own per share is the same; you just multiply dividends or stock price by the number of shares you own. Small investors who do not purchase large blocks of shares rarely consider the fact that they are owners and are merely concerned with how much the stock is worth at a particular period in time compared to the price they paid for it and although they may have voting rights relative to the number of shares they own, they usually don’t have a large say in the day to day operations of the company. Large institutions such as unions or pension funds that have huge amounts of a particular stock can sway votes in the company however, and are called institutional investors.
It is this claim that investors have on their shares of stock that create the value of that issue. Lets assume a company needs money to expand and sold stock at $2.00 a share, but the company had yet to produce and market a product to the public and could not give Its investors (you included) a piece of the earnings, but after a short time one of the products they manufactured started selling like hotcakes! The company began making great money. Remember, how Apple grew when it produced the iPods and iPhones. Well, because the company is now making a lot of money those shares you bought at $2.00 a share are worth a lot more because the earnings from that company are considerably greater. So, if a person wanted to purchase a claim on those earnings (shares of stock) you might consider selling the shares that you purchased at $2.00 a share for $10.00 a share. That is a profit of $8.00 a share (multiplied by the number of shares you own).
This process of buying stocks and holding on to them in hopes of them rising in price is known as investing. If you own shares of stock in several different companies, this would be called your portfolio of stocks. Some may rise in price while others may drop and you would then decide which you deem are worthy of keeping or increasing the number of shares owned, and those you have less confidence in and may consider limiting your loss potential by selling off shares. Investing in stocks is usually done over a longer time horizon than trading, in which stocks may be bought and sold in a relative short period of time in order to take advantage of short-term price fluctuations.
Different types of stocks have different characteristics but the most familiar to individual investors would be the type known as common stock, which is what we discussed here. Preferred stock, which usually has no voting rights, but gives the holder a priority position on claim over common stock share holders in regards to dividends and any possibly bankruptcy claims on assets. Unlisted stocks will be discussed much later but are usually purchased in direct placements from the issuer or purchased in what is called a secondary market, and these unlisted stocks may carry and even greater degree of security and yield on their investment.
Our next lesson will be on Bonds and who might want to use them as an investment.