One of the most popular topics discussed in personal finance, especially when discussing investing, seems to be stocks. In my opinion, this is justified. Stocks can be exciting. Discussions about stocks frequently occur on the news, there are entire stations dedicated to following each move of the stock market, and many of us invest in stocks to help achieve our long-term goals. While it may be one of the most frequently discussed topics, I doubt that it is the most understood. Unfortunately, I’ve heard horror stories of people buying or trading stocks without totally comprehending the potential consequences of their actions. Without a firm understanding of what a stock is, an investor could be in for a big surprise if things go awry. The goal of this post is to answer a simple, yet important question: What is a stock?
As complex as the concept can be, a stock can be described in one simple sentence. A stock represents partial ownership in a company. More specifically, Investopedia defines a stock as a security that represents the ownership of a fraction of a corporation. Logically, the next questions to be asked are what are the implications for ownership and why would I want to own stock? The answer to these questions comes in the form of a very long list. I’ll elaborate on just a few of the important items below.
What are the Implications for Owning a Stock?
As a company shareholder, you are entitled to certain rights. You have the right to vote in the election for the company’s board of directors. These directors are responsible for making decisions on behalf of the shareholders and ensuring that the company properly manages its resources. In addition to voting for the directors, shareholders also have the right to cast a vote for situations like an offer to purchase the company (an acquisition).
As a shareholder, you also have limited liability for the debts or actions of the company. If you invest in a company that loses a lawsuit and is ordered to pay an enormous sum, you are not personally liable to dig into your pockets to pay a portion of that sum. However, that’s not to say that the value of the company’s stock price won’t fall and cause the value of your investment to fall. In the worst-case scenario, the maximum amount of money you can lose is the amount you’ve invested.
Why Own a Stock?
In most cases, investors desire to own a tiny piece of a national or global company to make money. There are two major ways that investors seek to make money through stock ownership: 1) appreciation of the stock price 2) receipt of dividend payments from the company.
Appreciation of the Stock Price
The first is the easiest to comprehend. To make money through appreciation of the stock price, an investor would sell her stock for more than she paid for it. The concept sounds simple but can be complicated to execute in reality. The price of a company’s stock is influenced by innumerable factors, making it difficult to predict the future price of any given stock. Some investors may intend to hold shares of a company’s stock for years or decades at a time. Most of these investors take a long-term view and tout a “buy and hold” strategy. Other investors attempt to profit by buying and selling a stock within a short period of time, sometimes only owning the stock for a matter of minutes (or even seconds). These investors are often called “traders” since they trade (buy and sell repeatedly) back and forth.
As a shareholder, you may also have the right to share in the company’s profits in the form of dividends. A dividend is a payment (typically from the company’s profit) made to the shareholders of the company. Dividends are generally paid quarterly and in the form of cash. As an investor, it is common to compare the dividends of company’s by referring to the company’s dividend yield. The calculation for dividend yield is rather straight-forward: Annual Dividend Amount / Stock Price. For example, as of the close of the market on July 6th, the dividend yield for a share of AT&T (symbol T) was 6.82% (quarterly dividend of $0.52 x 4 = Annual Dividend Amount of $2.08 per share; Stock Price = $30.49; Dividend Yield = $2.08 / 30.49 = 6.82%).
As an investor that likes to invest in dividend paying stocks, the hope is that the companies will continue to grow their dividend payments over time. Personally, a sizeable portion of our investment portfolio consists of dividend paying stocks (more to come on this later). In fact, there are a handful of companies out there that have raised their annual dividend payments for more than 25 years straight! Fittingly, these stocks are known as dividend aristocrats.
It’s important to note that not all companies pay dividends, as the decision is up to the company’s board of directors. The board may feel that the capital could be used more efficiently elsewhere.
Where Can You Buy Stocks?
When a company first decides to sell shares of ownership to the public (this is known as an initial public offering or IPO), they are typically doing so to raise capital. The capital raised could be used for a variety of purposes from paying off debt to expanding marketing or manufacturing efforts. However, it is important to note that when you are buying a share of a company’s stock on the stock market, you are not buying that share from the company (usually, there are exceptions). Generally, you are buying a share of stock from another investor. The same can be said for when you are selling a share of stock. The investor on the other side of your transaction may be another person, an investment company, a pension fund, or a myriad of other entities.
The stock market is simply a “place” for investors to buy and sell stocks. With the help of technology and other advancements, the stock market has become easier to access, more efficient, and more inclusive. Actions that could previously occur only on the physical exchange floor can now be completed with a few taps on your smartphone.
If you are looking to start investing, one of the most popular platforms to emerge in recent years is Robinhood. Robinhood is incredibly prevalent among younger investors since they don’t have an account minimum and they offer commission-free trading. I’ve personally had a Robinhood account for over 4 years and I find it quite intuitive and easy to use. If you want to start investing through Robinhood, use my referral code to receive a randomly-selected share of stock for free after you’ve funded your account.
Please note, in addition to the items mentioned above, there are also tax consequences associated with investing in stocks. Do not invest without an understanding of these ramifications.
As always, please let me know if you have any questions.
Your thoughts are worth more than a penny.