What Are Stocks and How Do They Work?
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 how do stocks work, exactly?
Read: 3 Things You Must Do When Your Savings Reach $50,000
How Do Stocks Work for Beginners?
Those new to stocks and trading should understand some key points on what stocks are and how they work:
Stocks are a small piece of ownership of a company.
Stock prices go up and down based on demand and supply.
Not all stocks are good investments.
Stocks are a risky asset class and money invested can be lost as well as gained.
What Are Stocks?
The simple definition of a stock is that it represents ownership of a business. When you buy shares of stock, sometimes referred to as “equities,” you actually own a fractional percentage of the underlying company. Stock that is publicly traded on the open market allows anyone to buy or sell a proportional amount of the business.
However, not all companies list a portion of their business for public trading — some companies remain privately owned. Private companies will also sell shares, but purchases are generally limited to accredited investors, institutional investors and high net-worth individuals.
What Is Market Cap in Stocks?
Market capitalization is the total dollar amount representing a company’s value as dictated by the market. This metric gives investors a better understanding of size, risk and value. Investors can use a simple formula to work out market capitalization:
The number of outstanding shares x price per share = market capitalization
Despite commonly held beliefs that the price per share dictates value, this is not correct. Stocks are divided into individual shares that are sold on the open market with varied amounts of shares issued. For example, two companies with different share prices could have the same market capitalization, as illustrated in the table below.
Calculating Measures | Company A | Company B |
|---|---|---|
Outstanding shares | 100 million | 1 billion |
Stock price | $1,000 | $100 |
Market capitalization | $100 billion | $100 billion |
Though each company has a different stock price, both arrive at the same market capitalization.
Market capitalization also categorizes total size and is generally split into five types:
Types of Stocks | Total Market Capitalization |
|---|---|
Mega Cap | $200 billion+ |
Large Cap | $10 billion to $200 billion |
Mid Cap | $2 billion to $10 billion |
$250 million to $2 billion | |
Micro Cap | Less than $250 million |
How Do Investors Make Money With Stocks?
Economies are supported by gross domestic product. Businesses that are publicly traded support the growth of GDP when they make money. When an investor owns a stock that is growing rapidly, generating a profit and creating value, investors are rewarded through price appreciation.
As a company scales or generates profit, the market will deem whether it is above, below or at fair value. Stocks don’t directly correlate with economic cycles, but they are a key indicator of stock market performance. Another way stocks earn investors money is through dividends, a percentage of company profits that are shared with investors.
How Does Someone Invest in Stocks?
There are multiple online platforms, known as brokerages, which facilitate stock market trading. Of the many available options, Fidelity and Robinhood are two of the most popular trading platforms.
Fidelity
Fidelity is a financial planning and wealth management platform that offers stock trading. It’s an ideal option for those that would like to keep all of their finances in one place and have expert advice available if needed.
Robinhood
Robinhood is an investing platform that has been a winner among younger generations due to its low costs of entry and ease of use. It has been dubbed a great platform for beginners to learn about the stock markets and start trading stocks as well as other financial assets. Investments can be made easily through its mobile app or online.
However, Robinhood has faced legal issues and criticism for its gamification of investing, which may lead to the unwary investing — and potentially losing — more money than they can afford.
What Are the Best and the Riskiest Stocks for Investment?
There are several different categories of stocks, each with its own purpose and valuation metrics. While a long time ago you might have discussed the four types of stocks – growth, value, income and speculative – nowadays there’s a wide range of stock categories. It’s up for debate as to which makes the best investments, but there are a few that tend to appear most often.
Blue Chip Stocks
Blue chip stocks are reputable companies that have been around for years or decades. In general, a blue chip stock will have demonstrated strong shareholder returns or has a history of outperformance. In a lot of cases, they will also pay a dividend.
Examples of common blue chip stocks in 2023 include the FAANG stocks — Facebook (META), Apple (AAPL), Amazon (AMZN), Netflix (NFLX) and Google (GOOG) — along with companies such as Microsoft (MSFT), Coca-Cola (KO), McDonald’s (MCD), Nike (NKE) and Starbucks (SBUX).
Value Stocks
Value stocks refer to companies that appear to be undervalued at a certain point in time. 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. Growth stocks don’t necessarily have to be profitable, but investors will invest on the basis that someday they will be.
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 or Income 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.
Penny Stocks
Penny stocks are businesses with small price tags and high risk. They are one of the most speculative classes of stocks and tend to have very low market capitalizations, falling into the micro-cap category. Usually, they have very little earnings, if any, and do not offer a dividend.
Investors should approach penny stocks with caution due to these factors.
Meme Stocks
Lesser known, and less appreciated, are meme stocks. These are companies that seemingly trade purely based on speculation rather than business fundamentals. Many stocks, such as GameStop (GME), AMC (AMC) and Bed Bath and Beyond (BBBY), fall into this category and have fallen victim to short squeezes in the past.
Can an Investor Lose Money in Stocks?
Yes. All stock investments will greet investors with a warning, “Past returns are not indicative of future performance.” This is a clear message that any investment made could potentially lose some or all of its value.
In order to minimize the chances of losing money, inexperienced investors should consult a financial advisor. Popular methods suggested by Charles Schwab and Scotia Bank to reduce downside risk are:
Assess risk tolerance
Maintain a balanced portfolio without overexposure to any one stock
Diversify across geographies and industries
Diversify by company size and risk
Invest incrementally to average out the cost basis
Hold stocks for the long term
Focus on fundamentals rather than emotion
Other useful strategies include dollar-cost averaging and due diligence. Dollar-cost averaging is the process of investing incrementally to even out the cost basis of investments. Due diligence is a crucial aspect of research that includes analyzing historical results, such as published quarterly results, for better decision-making.
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.
FAQ
Here are the answers to some of the most frequently asked questions regarding stocks.
What is the simple definition of a stock?
A simplified definition of a stock would be that it represents a share of ownership of a business.
What is a stock and how does it work?
A stock is a small piece of ownership of a company. The prices of stocks increase and decrease based on supply and demand. While you can sell stocks for a profit, it is also possible to lose money on your investment as well.
What are the four types of stocks?
Today there are a lot more than four types of stocks, but the four most commonly known are growth, value, income and speculative.
What is an example of a stock?
Here are a few stocks:
-Exxon Mobil (XOM) is an example of a dividend stock.
-Apple (AAPL) and Amazon (AMZN) are examples of common blue chip stocks.
-GameStop (GME) and AMC (AMC) are examples of meme stocks.
John Csiszar contributed to the reporting for this article.
This article originally appeared on GOBankingRates.com: What Are Stocks and How Do They Work?
