Stocks basics - What is a stock?
Investing in stocks is an established way to build up savings and achieve financial goals. However, for beginners, the stock market can seem daunting. This article is the first in a series that provides a step-by-step guide on how to invest in stocks, covering essential concepts, strategies and tips to help you get started.
Understanding stocks
A stock, also known as equity, represents a share in the ownership of a company. Companies sell shares in their business in order to raise capital so that they can grow. Essentially, stocks are a way for individuals and institutions to invest in businesses and, in turn, for businesses to raise capital.
When you purchase stock in a company, you are buying a piece of that company. This ownership entitles you to a portion of the profits generated by the company, which can be distributed through dividends or reinvested back into the business.
You can also trade your share in the company with anyone who would like to buy it.
The value of a stock is influenced by the performance of the company and the perception of its future potential.
Types of stocks
Stocks can be categorised into several types, each with distinct characteristics and benefits:
Common stocks
- Common stocks represent the majority of stock issued by companies.
- Holders of common stock have voting rights, typically one vote per share, which allows them to influence company decisions at annual general meetings.
- Common stockholders receive dividends, but these dividends are not guaranteed and can vary depending on the company’s profitability.
Preferred stocks
- Preferred stocks provide no voting rights, but they have a higher claim on assets and earnings than common stocks.
- Preferred stockholders receive dividends before common stockholders and these dividends are usually fixed.
- In the event of a company’s liquidation, preferred stockholders are paid off before common stockholders but after debt holders.
How stocks are traded
Stocks are bought and sold on stock exchanges, which are platforms that facilitate the trading of securities. These exchanges provide a transparent and regulated environment for buying and selling stocks.
The most well-known exchanges include the New York Stock Exchange (NYSE) and, in Europe, Euronext. Euronext encompasses the stock exchanges of Belgium, France, Ireland, Italy, Norway, Portugal and the Netherlands.
There are two main ways in which stocks can be bought and sold:
- Primary market
When a company first issues stock to the public, it does so by selling its stocks in the primary market through an Initial Public Offering (IPO). This process allows the company to raise capital from public investors. - Secondary market
After the IPO, stocks can be traded among investors in the secondary market. Here, the stock’s price is determined by supply and demand dynamics. Trading on the secondary market is generally done on a stock exchange. It’s also possible to trade on a multilateral trading facility (MTF) or in over-the-counter (OTC) markets, where participants trade directly without a third party.
Investors can execute their orders to buy or sell stocks via a brokerage firm or online brokerage services.
Brokerages
Investors typically buy and sell stocks through brokerage firms. These firms act as intermediaries between buyers and sellers, facilitating transactions for a fee or commission. Brokerage firms often provide analysis, information and advice to their clients.
Online trading platforms
With the advent of technology, online trading platforms have become popular, allowing individuals to trade stocks conveniently from their computers or smartphones.
Investment firms
Alternatively, investors can also leave the investment decisions and transaction in the hands of an investment firm. These firms trade with the available funds on behalf of the investor.
Possible profits from trading stocks
Dividends
Dividends are payments made by a company to its shareholders, typically from its profits. Not all companies pay dividends; some prefer to reinvest earnings back into the business. Dividends provide a regular income stream for investors and can be issued in cash or additional shares of stock.
Capital gains
Capital gains occur when an investor sells a stock for more than they paid for it. If the stock price increases from the purchase price, the investor realises a capital gain upon selling the stock. Conversely, if the stock price falls below the purchase price, the investor incurs a capital loss.
Possible losses from trading stocks
Capital depreciation
Stocks prices can go down. A drop in stock price can result in substantial losses, especially in the short term. Such losses happen when the stock is sold against a price lower than the purchase price. The owner of the stock can also choose to keep the stock in the hope that the market will recover and the stock price goes up over time.
Even though it is very rare, a listed company can go bankrupt. Investors then have to either sell their stocks at a loss in a declining market or are ultimately left with worthless stocks once the bankruptcy has been declared.
The risk of losses increases if the investor is using time-sensitive financial resources to invest. Temporary market trends can lead to losses if an investor needs to pull their investment during a ‘bear’ market (a market on a downward trend).
Stocks represent a fundamental component of the financial system, providing a mechanism for businesses to raise capital and for investors to build wealth. Understanding the different types of stocks, how they are traded, and the factors influencing their prices is essential for anyone looking to invest in the stock market. While stocks offer the potential for substantial returns, they also come with risks that require careful management through strategies like diversification. By grasping these concepts, investors can make informed decisions and participate effectively in the stock market.