What is a stock?

How stocks work

Stocks are shares of equity ownership in a publicly traded company. When you buy a stock, you become a partial owner of that company and get to participate in some of the benefits of ownership, such as earning dividends.

“As a stockholder of any company, you get to participate in the success (or failure) of that business,” said Ted Erhart, certified financial planner and founder of Norris Lake Retirement Planning. “Stockholders get a piece of the profits when the company chooses to pay cash dividends. They also can be rewarded by stock price appreciation if the company grows.”

Corporations issue stocks to raise capital for business activities and incentivize stock ownership by giving each stock owner equity in the company itself. Shareholders who purchase company stock have a stake of ownership in proportion to the total outstanding shares issued by the company. For example, if a company issues one million shares and you own 10,000 shares in that company, you own 1% of the company.

Owning shares of stock allows you certain rights within the company, such as:

• The ability to vote on company policies and changes
• The ability to earn dividends in proportion to your ownership
• The ability to sell your shares of stock to someone else

Types of stocks

Not all stocks are created equal. When you buy a stock, it’s important to understand what you are purchasing.

Common stocks vs. preferred stocks

You may come across the terms “common” and “preferred” stocks:

• Common stock refers to the most common type of shares issued by a corporation and what you typically buy when you search for a share of stock through your online broker.
• Preferred stock is more of a hybrid between a stock and a bond, as preferred shareholders have a claim on company assets should the company go out of business.

Preferred stockholders are first in line in the event of a company liquidation. Preferred shareholders are also first to receive company dividends. The regular payouts give preferred shareholders the benefits of a bondholder, but the potential for growth of a stockholder.

One of the big differences between common and preferred stock is that common stockholders typically have voting rights within the company, while preferred shareholders may not.

Voting rights and dividends

Voting rights are available to most common stockholders, allowing shareholders to vote on key company issues, including the election of the board of directors, governance and policy. Voting rights do not mean you necessarily get a say in how the company operates or spends money, but rather on significant corporate actions like a merger or acquisition, or company policies.

When it comes to dividends, the board of directors votes on a regular basis on what the dividends will be for shareholders. Dividends are excess company profits paid back to shareholders in the form of a monthly or quarterly basis, or other regularly scheduled payment.

Preferred stockholders get first access to dividends, but common stockholders usually have access to dividends as well. Dividend payments can be made in cash or as a reinvestment back into more company stock as part of a dividend reinvestment plan (DRIP).

Stock classes

Companies may issue different classes of stock, typically labeled as A, B, C or D shares. Stock classes typically pertain to the level of voting rights for specific classes, giving certain shareholders more control over the company.

For example, Warren Buffett’s holding company, Berkshire Hathaway, has both A and B shares available. While B shares can be purchased for just over $300 (as of November 2023), there are limited voting rights with these shares. Berkshire Hathaway A shares cost over $500,000 for a single share, and offer more voting rights.

Stock sectors

There are several different market sectors that stocks can fall into. Here’s an official list of market sectors for stocks as defined by the Global Industry Classification Standard (GICS):

• Energy
• Materials
• Industrials
• Consumer discretionary
• Consumer staples
• Health care
• Financials
• Information technology
• Communication services
• Utilities
• Real estate

How stocks are bought and sold

Buying and selling stocks happens through online marketplaces and stock exchanges. You can access these exchanges through online brokers or by using a stock trading app.

To purchase a stock, you need to sign up for an online broker, deposit cash into your account and then place a trade to purchase a share of stock.

Stock prices fluctuate based on the supply and demand in the marketplace, so if you place a “market” order, you will pay the price that is matched with a seller of that stock at the current market price.

To sell your stock, you would follow a similar process, placing a “sell order” that will be matched with a buyer through your online broker.

There are more advanced trading strategies available with stocks, including placing limit orders, conditional orders, short-selling, options trading and more.

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Why invest in stocks?

Investing in stocks can be a great way to build wealth, but there are also risks. It is important to understand how investing in stocks can earn you money, and what role it plays in your overall investment strategy.

Investing in stocks gives you the ability to earn money in several ways, including:

• Capital appreciation. When the price of a share of stock goes up, this is known as capital appreciation. This is one of the main ways investors earn money from stock investing. When you sell after a rise in share price, you earn capital gains.
• Dividends. Some companies pay dividends to stockholders. This is a regular payment (typically quarterly) from excess company profits.

In addition to the potential for earning income, stockholders may be able to vote on key issues and company initiatives to help grow the company. In turn, this can positively affect company profits and stock prices.

But there is also a potential for loss when investing in individual company stocks. If the company performs poorly or records a quarterly loss, the stock price can drop. And if things continue declining, stockholders are at risk of losing their entire investment.

“The reason to invest in stocks is they’ve historically been the greatest creator of wealth in history,” said Erhart. “If you look at the Forbes 400 or Bloomberg list of billionaires, the source of wealth for the overwhelming majority came from concentrated ownership in a business.

“The top five today are Elon Musk (Tesla), Jeff Bezos (Amazon), Larry Ellison (Oracle), Warren Buffett (Berkshire Hathaway) and Larry Page (Google). What’s intriguing is in most cases, regular individuals can participate in these exact companies via public stock ownership.”

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Stocks and taxes

When investing in stock, it’s important to remember you may owe taxes on the income you earn from it.

Dividends are typically treated as ordinary income, which means they’re taxed at your regular income tax rate. However, there are also qualified dividends, which require a longer holding period and are taxed at long-term capital gains tax rates.

When you sell a stock, how much you’ll owe depends on how long you’ve held the stock and whether or not the stock has gained value when holding it.

• If you hold a stock for less than a year and sell at a gain, you pay short-term capital gains, which will be taxed at your ordinary income tax rate.
• If you hold a stock for a year or more and sell it at a gain, you pay long-term capital gains taxes, which can be 0%, 15% or 20%, based on your income.
• If your stock is held in a tax-advantaged account, such as an IRA, you may not have to pay any taxes when selling a stock.
• If you sell a stock that has lost value, you will not pay taxes, and may be able to claim a loss against other taxable gains.

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Bottom line

Stocks represent equity ownership in a company, and you can invest in stocks to earn money through capital appreciation and dividends. Investing in stocks is just one part of a diversified investing strategy, and are best held in a portfolio of other investments as well.

Investing in stocks can be risky, and you can lose all of your money that is invested in an individual stock. It’s important to diversify your stock investments with other assets to create a balanced investment portfolio.