What Is a Stock? Beginner’s Guide To Investing

eclipse_images / iStock.com

Commitment to Our Readers

GOBankingRates' editorial team is committed to bringing you unbiased reviews and information. We use data-driven methodologies to evaluate financial products and services - our reviews and ratings are not influenced by advertisers. You can read more about our editorial guidelines and our products and services review methodology.

20 Years
Helping You Live Richer

Reviewed
by Experts

Trusted by
Millions of Readers

Stocks can be difficult to grasp at first glance, but anyone can learn how to invest in individual companies. They’re an excellent tool for long-term wealth creation, but what is a stock and how does it work, exactly? Read on to find out.

What Is a Stock?

A stock is a type of security that represents partial ownership of a company. When you buy shares of stock, sometimes referred to as “equities,” you actually purchase a small part of the business. With them, you hold a proportional claim on that company’s assets and earnings.

Stocks play a key role in the portfolios of many investors because of their potential to generate high returns and build wealth. There are two main ways investors make money from stocks:

• When the value of the stock increases over time, you can generate income. For example, if you buy a stock for $20 a share and then sell it at $50, you earn a profit of $30 for each share you sell. 
• Stocks can also earn investors money through dividends, a percentage of company profits that are shared with investors. Not all stocks pay dividends, and some offer larger dividends than others. Dividends are typically paid on a quarterly basis.

Stocks also benefit the businesses that sell them. Companies sell stock to raise money that they can use to expand or invest in new projects. By selling stock, businesses have access to large amounts of cash without taking on debt.

How Stocks Work

Investors buy and sell shares of a company through a stock exchange. This process is facilitated by a broker.

Before you can begin trading stocks, you’ll need to set up a brokerage account. Many investors choose to open accounts at online trading platforms, such as Fidelity, Robinhood or Charles Schwab.

Here are some key points to know about brokerage accounts:

• On these platforms, you can see the current price of a stock.
• You can put in an order to buy shares to add to your account or sell shares you already own.
• When buying and selling stocks, you’re typically trading existing shares with other investors rather than with the company itself.
• When private companies decide to issue shares to the public for the first time, they typically hold an initial public offering, or IPO.

How Stock Prices Are Determined

A stock’s price goes up or down largely due to supply and demand. If more investors want to buy a stock, the price will increase. If more are looking to sell, the price decreases. 

Many factors can influence whether investors want to buy or sell a stock, and therefore the movement of the stock’s price.

• A stock price may rise if the company announces strong earnings and forecasts future growth.
• However, an earnings report that falls below expectations can cause the price to drop.
• General market conditions, interest rates and even the political environment can also lead to the movement of a stock’s price.

Common Stocks vs. Preferred Stocks

Shares of stock typically fall into two categories: common stock and preferred stock. Both types of stock represent partial ownership of a company, but there are some important differences between the two.

What Are Common Stocks?

As the name suggests, common stocks are the type of stocks most people invest in. Common stock comes with voting rights — usually one vote per share. These rights allow investors to have a say in electing the board of directors and can influence other company decisions.

Common stock tends to fluctuate in price more dramatically than preferred stock, which gives it greater potential for growth. Common stockholders are not guaranteed to be paid a dividend, although many companies do pay dividends on common stock.

If a company becomes insolvent, common stockholders are the last to hold a claim to company assets.

What Are Preferred Stocks?

Preferred stocks are generally considered to be safer and less volatile than common stocks. They typically pay a fixed dividend that is often higher than the common stock, and they don’t tend to move up and down in price as much.

Preferred stockholders have a higher claim to company assets and earnings, but they usually don’t have voting rights.

Because fewer shares are bought and sold on a typical day, preferred stock may not offer as much liquidity as common stock. So you may not get as good of a price if you choose to sell it.

Key Differences Between Common and Preferred Stocks

Types of Stocks

There are several different categories of stocks, each with its own purpose and valuation metrics. Three of the most common types of stocks you’ll come across are growth stocks, value stocks and dividend stocks.

Growth Stocks vs. Value Stocks

Growth stocks and value stocks each have very different characteristics, and many investors choose to hold at least some percentage of both types of stocks in their portfolio.

Value Stocks

• Value stocks refer to companies that appear to be undervalued at a certain point in time.
• These companies typically have strong fundamentals and steady earnings, but the stock price may be depressed due to other factors.
• A typical metric to look out for in value stocks is the price-to-earnings ratio.
• Stocks will be assigned different P/E ratios based on growth rates. If it falls below historical averages, this may present a buying opportunity, because markets have overlooked the fundamentals of a business.

Growth Stocks

• Growth stocks are fast-paced companies that are expanding rapidly and growing revenue.
• These stocks don’t necessarily have to be profitable, but investors will invest on the basis that someday they will be.
• Technology stocks often fall into the growth category.
• Since growth stocks are forward-looking for long-term returns, the primary metrics to consider are innovation, competitive advantages and a growing market share.

Dividend Stocks

Dividend stocks act as an income generation tool for investors. These are more mature companies that have a steady and predictable pace for earnings and profitability. As such, investors receive a portion of profitability in the form of a dividend. 

The terms dividend and yield are often used interchangeably. This is the percentage return investors are awarded on a per-share basis.

Dividend stocks can also benefit from price appreciation — or an increase in market capitalization. General Mills (GIS) and Exxon Mobil (XOM) are examples of dividend stocks.

Stocks vs. Other Investment Options

Individual stocks are just one type of investment that people may have in their portfolios. Some other options that can help make up a balanced portfolio include bonds, mutual funds and ETFs.

Stocks vs. Bonds

When you buy a stock, you purchase a fraction of the company. When you buy bonds, you’re lending money, usually to either a company or the government, with the expectation that you’ll be paid interest on that loan over a set period of time. 

Bonds are considered to be a lower-risk investment than stocks. However, stocks usually offer the potential for much higher returns.

Bonds can be an ideal choice for an investor looking to add steady, stable income to their mix. Stocks are usually a better choice for investors looking for greater long-term growth. 

Stocks vs. Mutual funds and ETFs

Mutual funds and exchange-traded funds provide a convenient way to invest in a large mix of assets without having to purchase each asset individually. Both mutual funds and ETFs involve many investors pooling money together. This money is invested in a diversified portfolio that may include dozens or hundreds of stocks, bonds and other assets.

Here are some key points to know:

• A mutual fund is managed by a professional fund manager.
• Investors buy shares of the mutual fund, and the value of those shares rises and falls with the value of the underlying assets in the fund.
• Mutual funds often come with management fees and other expenses.
• An ETF is a basket of assets that trades on a stock exchange.
• ETFs act similar to individual stocks in that the price fluctuates as investors buy and sell them.
• Many ETFs are passively managed and are set up to track a market index, such as the S&P 500. For this reason, ETFs often charge lower fees than mutual funds.

Mutual funds and ETFs can be ideal investment vehicles for beginning investors. They offer exposure to a broad mix of stocks and bonds without requiring the funds, expertise or time to piece together a diversified portfolio one by one. However, beginning investors should take a close look at the fees associated with a particular fund or ETF before buying it.

Tips for Beginner Investors

Investing can be an effective way to build wealth, but it also comes with risk. Consider these tips as you begin building your portfolio.

• Start small: Remember that investments come with risks. Starting with smaller investments will allow you to become familiar with how the values of those assets fluctuate under various market conditions.
• Understand your investments: Learn about the assets you’re investing in to make informed decisions. For example, if you’re considering an ETF, find out which stocks are in it and the management fee that is charged.
• Prioritize diversification: Spread your investments across a mix of assets to reduce your risk.
• Avoid emotional decisions: The market will fluctuate from day to day. Keep your eyes on your long-term goals and don’t let sudden changes influence your investing decisions.

Final Take

Putting money in the stock market carries risks, but the reward potential remains high. Beginners interested in stocks should carry out research beforehand to minimize the chance of losing money. Contacting a financial advisor or consulting online resources should be a top priority to determine risk tolerance, goals and strategies for stocks.

John Csiszar and David Granahan contributed to the reporting for this article.

Share This Article: