What are stocks and how do they work?

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What are stocks?

A stock represents a piece of ownership in a corporation. Stocks are also known as equities, which signifies that anyone who owns them has a stake in the company’s performance.

The stock market’s movements are always in the headlines. However, many of the people reading about those ups and downs are standing on the sidelines: According to a Bankrate poll in March 2021, 39 percent of Americans have no money invested in stocks. Struggling to understand the market — cited by 32 percent of respondents who have been steering clear of the market — is one of the most common reasons for the aversion.

By investing a bit of time to learn the basics of stocks now, you can get comfortable enough to invest money for your future.

How do stocks work?

When a corporation is looking to grow, it needs money to help pay for expenses such as designing new products, hiring more people and expanding into new markets. They issue new shares of stock to help raise that capital. Anyone who buys those stocks is poised to profit if that growth becomes a reality.

In addition to profiting if the value of the company’s stock appreciates, stockholders can profit from dividends. These are regularly scheduled payouts of a portion of the company’s profits to shareholders. For example, a company might pay an 18-cent dividend each quarter. If you own 10 shares, you’ll receive $1.80 with each payment. There are also stock dividends, which reward stockholders with more shares. If you own 100 shares and the company issues a 5 percent stock dividend, you would receive five additional shares.

It’s important to note that dividends are not guaranteed. Companies can slash their dividends. Not all companies pay them, either. Younger, rapidly expanding companies often don’t pay dividends. Instead, they reinvest all profits back into the company with the hopes of growing further and generating more profits that will ultimately lead to a higher stock price.

What are the downsides of stocks?

While stocks offer the potential for growing your money, the appeal of those returns comes with some sizable risks. If the company falls on hard times, posts losses or misses their earnings expectations, the stock price could drop. Wherever the stock goes, your money follows.

There’s a chance you could lose all your money, too. For example, if a business that you invested in closes its doors, your investment is likely gone for good. Investors are last in line when it comes to claims on the assets. Employees, vendors, lenders and bondholders are all in line to get paid before the stockholders.

How can you invest in stocks?

The stock market is accessible to everyone, and there are two ways to own stocks.

Direct ownership: You can buy stock in individual companies through a brokerage account. As competition has increased in recent years, most online brokerages no longer charge commission fees. So, rather than paying to invest, you’ll be able to put all of your money into your investment. Some companies such as Walmart, Coca-Cola and Home Depot also offer direct investment plans, which allow you to buy shares from them — bypassing the need to open a brokerage account altogether.

While direct investing can put you in the driver’s seat, it also creates a massive workload. Studies have shown that building a properly diversified portfolio of individual stocks requires holding approximately 30 different stocks. (Diversification refers to owning a range of assets vs. holding just one or a small few. This reduces the overall risk in your portfolio.) That’s 30 different companies to monitor, tracking how their business is performing and whether they are on a positive trajectory — a tall order that requires a great deal of time and expertise.

Indirect ownership: Indirect investing is a much easier approach. Rather than reading annual reports, comparing performance data and hand-picking stocks, you can own stocks through a mutual fund or an exchange-traded fund (ETF). These funds invest in hundreds — sometimes even thousands — of stocks. Instead of tying your fortunes to a single company, you can benefit from exposure to a wide range of companies. Think of this as instant diversification from the first dollar you invest.

Do you have to buy one full share?

It’s important to note that owning stocks doesn’t mean you need a mountain of money. If you want to invest in Amazon, you don’t have to have more than $3,331 (the current price of one share as of Aug. 2). Fractional investing is available via many brokerages, and it allows you to invest a small amount — as little as $5 — in a company. An indirect investment will also spread that money into smaller fractions across companies. For example, buying one share of a fund might make you an investor in Amazon, Google and a number of other high-profile companies.

Bonds vs. stocks: What’s the difference?

In addition to buying stocks, many investors include bonds in their portfolios. Corporations can also issue bonds, but buying one does not make you an owner. Instead, you are making a loan to the company, and the bond comes with a maturity date. The best-case scenario of owning a bond is that you get your money back on that date with some additional interest paid out along the way. Bonds have a higher priority of repayment in the event of a company’s liquidation, which means they are safer than stocks – though you can still lose some or all of your money. And when you’re trying to grow your money, it’s important to remember a key principle: Taking the safer route typically leads to lower returns.

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Written by
Greg McBride, CFA
Chief financial analyst
Greg McBride, CFA, is Senior Vice President, Chief Financial Analyst, for Bankrate.com. He leads a team responsible for researching financial products, providing analysis, and advice on personal finance to a vast consumer audience.
Edited by
Senior editorial director
Reviewed by
Founder of Financial Staples