What are stocks?

What are stocks?

Stocks

You may have heard popular definition of what a stock really is “A stock is the share of ownership in the company. Stock represents a small percentage of all company’s assets and incomes. The more stock you buy, the higher is your ownership of the company. Well, that’s not quite the case.

To begin with, stockholders do not claim ownership over particular company, instead they own financial securities issued by these companies. But corporations belong to different type of organization as law treats them as fully legal entity. In other words, corporations pay taxes, can borrow, be sued and so on. The fact that corporation is a “person” means that company claims possession of its own assets. A corporate office supplied with furniture and electronic equipment belongs to the company, not its shareholders.

It is very important to understand this distinction, which separates corporate property from the property of shareholders. In case of corporation going bankrupt, a court might regulate all of its assets to be sold with no risk to  your personal assets. The court has no legal authority to tell you to sell your shares, though in case of bankruptcy you would have most likely done it yourself or otherwise suffered losses. At the same time, if a major shareholder goes bankrupt, he has no legal right to sell corporate assets to pay off his debts.

The ownership of the shareholder is limited to the shares issued by the corporation. Having purchased 33% of the company’s shares will not entitle you to the right to put a claim on 33% of company’s assets and under no circumstances will give you authority to have any control over company’s businesses and operations. This is known as a “separation of ownership and control”.

So why so many people round the globe are investing into stocks when they actually give no ownership rights. Well, investing in a stock market opens endless opportunities from investment perspective. Buying shares of profitable and stable corporate entity opens lucrative investment opportunities, gives you the right to receive dividends and simply provides an opportunity to capitalize on the market price movements of shares on the stock market, by buying low and selling high.

Stock prices are driven by expectations of how company will perform in the future. If investors expect the profits of company to rise they will buy company’s shares. On the other hand, negative profit expectations will mostly likely cause investors to sell. Speculation is also part of the game, and prices constantly rise and fall based on rumors, speculations and general economic environment. For example, if an Oil Drilling corporation is expected to find new oil reservoirs its shares will most likely start appreciating once the information goes public. On the other hand, news of impending changes in company’s performance can be nothing short of rumor and as such cause stock prices fall fast after facing short-term price boost.

So how can you profit from stocks?

The easiest and most common way to profit from stocks is to buy low and sell high. If the company faces problems or its profits start to fall, so will the price of its stock. In such case the best scenario will be selling your shares or simply holding them in expectation of price reversal. Understanding how to predict stock prices requires vast knowledge of both technical and fundamental analysis and basic accounting principles to have understanding of company’s balance sheets and quarterly reports. After that you can open a trading account with a stock broker of your choice and start trading. Most stock brokers out there offer professional trading platforms enhanced with charting and market analysis tools. There are many things however that traders should take into consideration when choosing a stock broker. This should be researched deeply to avoid misunderstanding and conflicts of interest.

Another way how you can profit by investing in stocks is through corporate dividends. These are mostly corporate payments distributed to shareholders. The dividends are calculated as percentage from corporate earnings. This can be a great investment opportunity if you invest in a profitable company with huge potential for future growth.

Why companies issue stocks?

Stocks are issued by companies to raise funds in order to expand operations and open new projects. There are important distinctions between whether somebody buys shares directly from the company when it issues them (in the primary market) or from another shareholder (on the secondary market). Companies may instead raise capital through corporate borrowing, by taking loans directly or issuing bonds. Bonds have very few similarities with Stocks; bonds are liabilities and imply payments of interest and principals. Bondholders will be the first to take advantage of companies assets in the event of bankruptcy. Stock holders on the other hand will be on the low priority list should the company go bankrupt and will unlikely receive anything – so is the risk they take. As such, it is safe to assume that stocks pose higher risks to investors than bonds do.

But there is a cloud in the silver lining for bondholders – they receive only what was initially agreed upon the purchase of the bond and will not receive anything from company’s profits. Generally, bonds are fixed-return instruments while profits from stock may generate hefty returns relative to company’s performance. Stocks have historically returned around 8-10% annualized, while bonds return 5-7%.

Types of Stocks

Stocks are generally classified in two types: common and preferred.

Stocks included in Dow Jones and S&P 500 indices are common. The value of common stocks is driven by supply and demand and general market environment. Common stock owners can take part in company’s affairs, vote on board meetings, participate in mergers, acquisitions or takeovers.

Preferred stocks combine properties of both common stocks and bonds. Their values rise and fall along with the company’s common stock prices. They are like bonds in that they always make a fixed payment. For that reason, most people don’t sell their preferred stocks.

In addition to basic types, stock can by classified by market capitalization and type of industry the issuing company belongs. This classification is important to reflect varying demands of different shareholders.

  1. Market Capitalization: The total stock market value of the company is referred to as market capitalization. To calculate it, you need to multiply the number of shares outstanding by the share price. Market capitalization has three sectors:
  • Small-cap stocks have a market capitalization of 2 billion dollars or less. They are pretty risky, even though they are likely to grow.
  • Mid-cap stocks have a market value fall between 2 billion dollars and 10 billion dollars.
  • Large-cap stocks have a market capitalization of 10 billion dollars or higher. They increase more slowly but don’t carry a high level of risk. (Bear in mind that these category levels differ slightly depending on the person making the definition.)

Growth Potential: Growth stocks typically don’t pay dividends, but are expected to undergo rapid growth. Sometimes, the firms they represent may not even have profits yet, but investors are confident the stock price will increase.

Value stocks are not expected to rise much, but they usually pay dividends. These are often large companies that aren’t appealing, and so the market has neglected them. Smart investors see the price as undervalued compared to what the company produces.

Blue-chip stocks have established over the years to be stable companies in steady industries. Therefore, they are fairly valued, even though they are not likely to grow quickly.

Unlike growth or value stocks, are considered a safer investment, and they usually pay dividends. They are also referred to as income stocks.

Sector: Industry sector is also used to group stocks. Here is a list of the most common sectors:

  • Basic Materials – Companies that extract mineral resources.
  • Conglomerates – Global firms in various industries.
  • Consumer Goods – Companies that produce goods to market at retail to the public.
  • Financial – Real estates, insurance, banks.
  • Healthcare – Healthcare providers, medical equipment suppliers, drug companies, and health insurance.
  • Industrial Goods – Manufacturing companies.
  • Services – Firms that get the goods to the consumer.
  • Technology – Telecommunications, computer, and software.
  • Utilities – Water, gas, and electric companies.

Stock Derivatives

Most people make money from stocks by either buying low and selling high, or by purchasing, holding, and collecting dividends. There is a third, albeit risky way to make money from stocks: derivatives. As the name implies, these investments derive their value from underlying assets, like bonds and stocks.

Stock options give you the opportunity to buy or sell a stock at a specified price at a specific date. A call option is the right to purchase at a particular price. You make profits when the stock price increases, by buying it at the set lower price and selling it at the current price. A put option is the claim to sell at a particular price. When the stock price declines, you make money; this is called a market correction. In that instance, you buy it at tomorrow’s lower price and sell it at the fixed higher price.

Short selling is when your broker lends you stock, and you sell it at a higher price today, and then purchase it at tomorrow’s lower price and then give the capital back to your broker. Short selling is very risky because you are out the difference if the stock price rises. In theory, there is no limit to how high the stock price could grow. That’s why most financial advisors suggest that individual investors stick to purchasing and holding stocks for the long term within a diversified investment portfolio to gain the highest profit for the lowest possible risk.