- Stocks are also referred to as equities because they represent an ownership stake in a company.
- Stocks and stock funds, such as mutual funds and exchange-traded funds (ETFs), can be an important component of your portfolio.
- New investors may want to consider stock funds rather than individual stock picking as a way to cost-effectively diversify their stock investments.
- While stocks have historically outperformed bonds over the long term, stock prices fluctuate and can go down, sometimes quite dramatically.
- Investing in stocks to meet a short-term financial goal can be risky because of stock price volatility.
When you invest in stock, you buy ownership shares in a company—also known as equity shares. Your return on investment, or what you get back in relation to what you put in, depends on the success or failure of that company. If the company does well and makes money from the products or services it sells, its stock price is likely to reflect that success.
There are two main ways to make money with stocks:
1. Dividends. When companies are profitable, they can choose to distribute some of those earnings to shareholders by paying a dividend. You can either take the dividends in cash or reinvest them to purchase more shares in the company. Investors seeking predictable income may turn to stocks that pay dividends. Stocks that pay a higher-than-average dividend are called "income stocks."
2. Capital gains. Stocks are bought and sold constantly throughout each trading day, and their prices change all the time. When the price of a stock increases enough to recoup any trading fees, you can sell your shares at a profit. These profits are known as capital gains. In contrast, if you sell your stock for a lower price than you paid to buy it, you'll incur a capital loss.
In either case, your fate as an investor depends on the fortunes of the company. A company generally needs strong earnings to pay a dividend, and there needs to be investor demand for you to see capital gains.
Investor demand typically reflects the prospects for the company's future performance. Strong demand—the result of many investors wanting to buy a particular stock—tends to result in an increase in a stock's share price. On the other hand, if the company isn't profitable or if investors are selling rather than buying its stock, your shares may be worth less than you paid for them.
The performance of an individual stock is also affected by what's happening in the stock market in general, which is in turn affected by the economy as a whole. For example, if interest rates go up, some investors might sell off stock and use that money to buy bonds. If many investors feel the same way, the stock market as a whole is likely to drop in value, which in turn may affect the value of the investments you hold. Other factors influence market performance, such as political uncertainty at home or abroad, energy or weather problems, or soaring corporate profits.
However—and this is an important element of investing—at a certain point, stock prices will be low enough to attract investors again. If you and others begin to buy, stock prices will tend to rise, offering the potential to make a profit—and to reverse any “paper losses” those who stayed in the market experienced during the dip. That expectation may breathe new life into the stock market as more people invest.
This cyclical pattern—specifically, the pattern of strength and weakness in the stock market overall or a majority of stocks that trade in the stock market—recurs continually, though the schedule isn't predictable.
There are two types of stock, common and preferred—and a wide array of classes and subclasses.
All publicly traded companies issue common stock. If you hold common stock, you're in a position to share in the company's success or feel the lack of it. The share price rises and falls all the time—sometimes by just a few cents and sometimes by several dollars—reflecting investor demand and the state of the markets.
The issuing company may pay dividends, but it doesn’t have to. If it does, the amount of the dividend isn't guaranteed, and the company can cut the amount of the dividend or eliminate it altogether.
Some companies also issue preferred stock, which usually guarantees a fixed dividend payment similar to the coupon on a bond. This might make preferred stocks attractive to people looking for income. Dividends on preferred stock are paid out before dividends on common stock.
The price of preferred stock, however, doesn't move as much as common stock prices. This means that while preferred stock doesn't lose much value even during a downturn in the stock market, it doesn't increase much either, even if the price of the common stock soars.
An important additional difference between common stock and preferred stock has to do with what happens if the company fails. In that event, there is a priority list for a company's financial obligations and obligations to preferred stockholders must be met before those to common stockholders. On the other hand, preferred stockholders are lower on the list than bondholders.
Learn more about what bankruptcy means for shareholders.
Classes of Stock
Certain companies may have different classes of shares, typically designated by letters of the alphabet—often A and B.
A company might offer a separate class of stock for one of its divisions that was a well-known company before an acquisition. Or a company might issue different share classes that trade at different prices, have different voting rights or different dividend policies.
For many companies that have dual share classes, one share class might trade publicly while the other does not. Nontraded shares are generally reserved for company founders or current management. There are often restrictions on selling these shares, and they tend to have what's known as super voting power. This makes it possible for a group of shareholders to own less than half of the total shares of a company but control the outcome of issues put to a shareholder vote, such as a decision to sell the company.
How Stocks Are Grouped or Described
Industry experts often group stocks into categories, sometimes called subclasses. Each subclass has its own characteristics and is subject to specific external pressures that affect the performance of the stocks within that subclass at any given time.
Here are some common stock subclasses.
You'll frequently hear companies referred to as large-cap, mid-cap or small-cap. These descriptors refer to market capitalization, also known as market cap and sometimes shortened to just capitalization. Market cap is one measure of a company's size. More specifically, it's the dollar value of the company, calculated by multiplying the number of outstanding shares by the current market price.
There are no fixed cutoff points for large-, mid- or small-cap companies, but you might see a small-cap company valued at less than $2 billion, mid-cap companies between $2 billion and $10 billion, and large-cap companies over $10 billion—or the numbers might be twice those amounts. You might also hear about micro-cap companies, which are even smaller than other small-cap companies.
Industry and Sector
Companies are subdivided by industry or sector. A sector is a large section of the economy, such as industrial companies, utility companies or financial companies. Industries, which are more numerous, are part of a specific sector. For example, banks are an industry within the financial sector.
Part of creating and maintaining a strong stock portfolio is evaluating which sectors and industries to invest in at any given time. Having made that decision, you should always evaluate individual companies within a sector or industry you've identified to focus on the ones that seem to be the best investment choices to help you achieve your goals.
Defensive and Cyclical
Stocks can also be subdivided into defensive and cyclical stocks, depending on the way their profits, and their stock prices, tend to respond to the relative strength or weakness of the economy as a whole.
Defensive stocks are in industries that offer products and services that people need, regardless of how well the overall economy is doing. For example, most people, even in hard times, will continue filling their medical prescriptions, using electricity and buying groceries. The continuing demand for these necessities can keep certain industries strong even during a weak economic cycle.
In contrast, some industries, such as travel and luxury goods, are very sensitive to economic ups and downs. The stock of companies in these industries, known as cyclicals, might suffer decreased profits and tend to lose market value in times of economic hardship as people try to cut down on unnecessary expenses. But their share prices can rebound sharply when the economy gains strength, people have more discretionary income to spend and their profits rise enough to create renewed investor interest. Thus, their stock price generally tracks with economic cycles.
Growth and Value
A common investment strategy for picking stocks is to focus on either growth or value stocks, or to seek a mixture of the two since their returns tend to follow a cycle of strength and weakness.
Growth stocks, as the name implies, are issued by companies that are expanding, sometimes quite quickly, but in other cases over a longer period of time. Typically, these are young companies in fairly new industries that are rapidly expanding.
Growth stocks aren't always new companies, though. They can also be companies that have been around for some time but are poised for expansion—perhaps because of technological advances, a shift in strategy, movement into new markets, acquisitions or other factors.
When a growth stock investment provides a positive return, it's usually because the stock price moved up from where the investor originally bought it—and not because of dividends. Most growth stock companies tend to plow gains directly back into the company rather than pay dividends.
Value stocks, in contrast, are investments selling at what seem to be low prices given their history and market share. If you buy a value stock, it's because you believe that it's worth more than its current price. Of course, it's also possible that investors are avoiding a company and its stock for good reasons and that the price is a fairer reflection of its value than you think.
If you deliberately buy stocks that are out of fashion and sell stocks that other investors are buying—in other words, you invest against the prevailing opinion—you're considered a contrarian investor. Contrarian investing requires considerable experience and a strong tolerance for risk, since it may involve buying the stocks of companies that are in trouble and selling stocks of companies that other investors are favoring. Being a contrarian also takes patience since the turnaround you expect may take a long time.
To buy and sell individual stocks—whether you use an app, transact online or give orders to an investment professional—you almost always need to have an account at a brokerage firm, also known as a broker-dealer. The few exceptions include when you purchase or sell shares directly from a company. Here’s what you need to know about the wheres and the hows of buying and selling stock.
Using a Firm
Brokerage firms tend to fall into one of two categories, each of which offers different services and pricing structures:
- Full-service brokerage firms provide research as well as trade executions and might offer customized portfolio management, investment advice, financial planning, banking privileges and other services.
- Discount brokerage firms offer fewer services but, as their name implies, generally charge less to execute the orders you place.
Some firms offer a little bit of both, with customer tiers or levels that range from full-service to discount. And others promote themselves as “deep discount” brokerage firms, offering lower fees (even zero-commission trading on certain products) but few if any support services to investors. Deep discounters cater specifically to the do-it-yourself or self-directed investor.
Which firm is right for you will depend on your goals, the amount of money you plan to invest, level of guidance you want, the costs (commissions, account fees, etc.) you’re willing and able to pay, the range of products and services you want, and other factors. Understand what kind of investor you are. Are you a buy-and-hold investor who plans to keep an investment over an extended period of time? Or are you a trader looking to follow the short-term price fluctuations of different stocks closely and then trying to “buy low and sell high?”
Active traders who engage in day trading might look for a firm that offers “direct access” accounts to route orders directly to exchanges or alternative trading systems such as dark pools or electronic communications networks. These services—which help traders find liquidity and offer high-speed execution—typically come with additional fees.
And remember, short-term trading comes with other costs. If you sell a stock that you haven't held for a year or more, any profits you make are taxed at the same rate as your regular income, not at your lower tax rate for long-term capital gains.
You can place buy and sell orders for stocks online, through a mobile app, or by speaking with your registered investment professional in-person or over the phone. If you do trade online or through an app, it's important to be wary of trading too much, simply because it's so easy to place the trade. You should consider your decisions carefully, taking into account fees and potential tax consequences, as well as the impact on the balance of assets in your portfolio, before you place an order.
There are ways to buy stock directly through certain companies and also to have a company automatically reinvest stock dividends.
- Direct Stock Purchase Plan (DSPP): A DSPP allows you buy shares directly through the company. While there are no brokerage commissions, the company may charge an administration fee. With DSPPs, stock is generally purchased at specific times (e.g., weekly or monthly), and you may need to own one or more shares of company stock to participate. You can generally invest a specific dollar amount or purchase fractional shares. Read the company’s disclosure information to learn the specifics of its DSPP program.
- Dividend Reinvestment Plan (DRIP): DRIPs automatically reinvest any dividends a company pays out, instead of paying you the dividend in cash. You can contact the company to enroll in a DRIP, if it offers one. As with DSPs, read the disclosure information. You might also be able to direct your brokerage firm to automatically reinvest dividends from shares you have purchased through the firm.
DSPs and DRIPs are usually administered for the company by a third party known as a shareholder services company or stock transfer agent.
Buying on Margin
When you buy stocks on margin, you borrow part of the cost of the investment from your brokerage firm in the hopes of increasing your potential returns, which can magnify both your gains and your losses. For this reason, it's important to understand how margin accounts work and the risks associated with buying stocks and other securities on margin. Learn more about margin accounts.
Short selling is a way to profit from a price drop in a company's stock and, like buying on margin, tends to be a short-term trading strategy. It involves more risk than just buying a stock. To sell a stock short, you borrow shares from your brokerage firm and sell them at their current market price. If that price falls, as you expect it to, you buy an equal number of shares at a new, lower price to return to the firm. If the price has dropped enough to offset transaction fees and the interest you paid on the borrowed shares, you may pocket a profit.
This is a risky strategy, however, because you must still re-buy the shares and return them to your firm. If you must re-buy the shares at a price that's the same as or higher than the price at which you sold the borrowed shares, after accounting for transaction costs and interest, you'll lose money. And generally, the longer you wait to purchase shares, the more you will be paying in interest to your brokerage firm.
Because short selling is, in essence, the sale of stocks you don't own, there are strict margin requirements associated with this strategy, and you must set up a margin account to conduct these transactions. The margin money is used as collateral for the short sale, helping to ensure that the borrowed shares will be returned to the lender down the road.
Often discussed in connection with short selling, "short interest" is a snapshot of the total open short positions existing on the books and records of brokerage firms for all equity securities on a given date. Learn more about short interest here.
Every type of investment carries some degree of risk, and stocks are no exception. Here are some of the common risks associated with stocks.
Stock Volatility Risk
If you've seen the jagged lines on charts tracking stock prices, you know that stock prices fluctuate daily and over longer terms, sometimes dramatically. The size and frequency of these price fluctuations are known as the stock's volatility. Volatility can be an important measure of investment risk—both market-wide and for an individual stock. A common measure of a stock’s volatility relative to the broader market is known as the stock’s beta, which is how a stock’s volatility compares to the market a whole. A stock that has a beta above 1.0 means it is more volatile than the overall market. Generally, growth stocks tend to be more volatile than value stocks.
Economic and Business Risk
Frequently, events in the economy or the business environment can affect an entire industry. For example, it's possible that high gas prices might lower the profits of transportation and delivery companies.
Inflation Risk and Interest Rate Risk
These two risks can operate separately or in tandem. Interest rate risk, in this context, simply refers to the challenges that a rising interest rate causes for businesses that need financing. As their costs go up with interest rate increases, it becomes harder for them to stay in business. If rates climb during a time of inflation—which often happens since increasing interest rates is a tool the Federal Reserve commonly uses to fight inflation—then a company might see its financing costs climb as the value of the dollars it's bringing in decreases.
Investor Sentiment Risk
Sometimes an entire industry might be in the midst of an exciting period of innovation and expansion and becomes popular with investors. Other times that same industry could be stagnant and have little investor appeal. Like the stock market as a whole, sectors, industries and individual companies tend to go through cycles, providing strong performance in some periods and disappointing performance in others.
Growth companies in particular often receive intense media and investor attention, and their stock prices may be higher than their current profits seem to warrant. That's because investors are buying the stock based on potential for future earnings, not on a history of past results. If the stock fulfills expectations, even investors who pay high prices might realize a profit. If not, the stock’s price might decline dramatically.
Any changes to analyst ratings on a company’s stock (from a “buy” to a “sell,” for instance) has the potential to impact the stock’s price. It’s possible a ratings shift, whether negative or positive, causes a price swing more pronounced than might seem justified by the events that led the ratings change. It can take time for the market to digest such ratings news.
This is the risk that a company's business is going the way of the dinosaur. Very few businesses live to be 100, and none of those reach that ripe age by keeping to the same business processes they started with. The biggest obsolescence risk is that someone will find a way to make a similar product at a cheaper price.
Detection risk is the risk that the auditor, compliance program, regulator or other authority will find problems, the proverbial skeletons in the closet. With detection risk, the damage to the company's reputation might be difficult to repair; and it's even possible that the company will never recover if the financial fraud was widespread.
Legislative or Regulatory Risk
This is the risk that government actions such as new legislation or a new regulation will constrain a corporation or industry, thereby adversely affecting an investor's holdings in that company or industry. This can include an antitrust suit, new regulations or standards, specific taxes and so on. For example, a new rule changing the review process for prescription drugs might affect the profitability of all pharmaceutical companies.
Penny Stock Risk
Microcap securities, sometimes referred to as penny stocks, include low-priced securities issued by small companies with low market capitalization. These securities are primarily traded on the over-the-counter (OTC) market. While microcap companies can be real businesses developing or offering products or services, the microcap sector has a long history of bad actors engaging in price manipulation and other fraud. However, even in the absence of fraud, microcap stocks can present higher risks than the stock of larger companies. This is largely because relatively little information is available about microcap companies compared with larger companies that list their securities on national exchanges.
The following topics provide additional information about stock investing and trading.
For additional information about stocks, please see the following resources:
- FINRA Investor Insights: