What is a Stock, Anyway?

Published on May 15, 2013, by in Personal Finance.

As with anything in life it’s always best to start at the beginning. If you’re considering investing in the stock market one of the first things that you really need to know is what, exactly, is a stock. The answer to this question is quite simple; when you own a stock you have ownership in whatever company issued that stock. If, for example, you purchase FaceBook stock,  you literally will own a piece of Facebook (albeit a very, very small piece).

The more stock that you buy the more of the company that you will own. Buy enough stocks and you could actually own enough of the company to start making actual decisions for that company and be a part of their board of directors.

Of course being on the board of directors of a company that is ‘in the red’ isn’t exactly going to help you financially. That being said, the next most important thing that you need to know about a stock is how stocks are valued. Simply put, the value of any stock changes daily based on the daily (and ever changing) value of that company on the stock market. The value of any company on the stock market is determined by a number of different factors including how well it performed in the previous quarter, the success of its recently released product and quite a few more factors.

For example, if Facebook has just lost a court battle with the Justice Department you can bet that their stock value is going to take a little bit of a tumble. On the other hand, if their newly launched feature is a huge hit and is getting great reviews by the critics the value of their stock will more than likely increase.

Of course the most important factor to determine the value of a stock is the earnings that the company that issued the stock is making. As such this is the factor that most investors obsess on and companies know this, reporting their profits 4 times a year as quarterly returns. This is stated as what they call ‘earnings per share’ and investors pick over these numbers with a fine tooth comb as they try to not only gauge a company’s present health but also their potential for future earnings.

The value of the stock is rewarded by a number of other things including companies whose earnings grow with stability and also companies whose earnings grow quickly. Even stocks being sold by companies that are losing money can gain in value if traders believe that their earnings in the future will be high. On the other hand, the value of any stock can be degraded quickly if there are unexplained losses or earnings that decline constantly. You can safely bet that any company that reports a bad quarter will take a hit as far as their stock value is concerned and, if they have several bad quarterly reports, their stocks can be reduced in value significantly.

Another factor that’s vitally important to know about stocks is the risk that they involve. Unlike bonds that promise a specific payout and specific interest payments, a stock will only pay you back if it grows in value after you purchase it. While it is true that there are many companies that pay shareholders dividends the fact is that they are not obligated to do this.

The biggest risk with stocks is that a company that you have purchased stocks from goes bankrupt and you lose every stock, and every dollar, that you put into it. While this is rare it certainly is not impossible and even short-term problems can bring the value of the stock down for what can seem like an insupportable amount of time.

Luckily there are several ways that you can manage this risk. Probably the best of them is simply to diversify your stock portfolio. What this means is that, instead of owning stock in one specific company only, you own stocks in several different companies. If you do, even if one company does poorly or even goes bankrupt the other stocks that you have in your portfolio will continue to keep their value and may even increase in value.

Another thing to keep in mind is that even though bonds are less risky they also return approximately 5% over their lifetime whereas, historically, stocks have delivered approximately 11%. This 6% difference, spread out over 10, 20 or 30 years, can mean a huge difference as far as the interest and gains that an investor makes. (Remember our good friend, compound interest.)

One interesting thing about stocks is that, along with the ownership that they give stockholders (or shareholders), they also give the right to vote on how a specific company is managed. Simply put, companies that issue stocks also give shareholders say about how they are run. If a company’s equity doesn’t increase in value, by law its shareholders can have management removed and a new management put in place that will (hopefully) do what’s needed to increase that value.

Of course there are very few people that are able to amass enough stock to really have any sway, at least as individuals, over any specific company. What that means is that, rather than try and invest in a company so that you can start making company decisions, you instead research any company that you’d like to invest in before buying their stock. If their stock price is reasonable and they have shown that they are able to consistently deliver earnings and increase their stock’s value, you’ve probably found a company whose stocks, as well as the company itself, are worth owning.

One Response

  1. […] to produce fruit. (And by ‘fruit’ we mean profits.) even though stocks historically have the highest rate of return this still is only around 10% and, if your expectations are more than that, you may wish to consider […]

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