What Are Stocks and How Do They Work?

Simply put, stocks are shares of ownership in a publicly traded company. Stocks are the easiest and most common way for the every day investor to invest in some of the best companies in the world. When you buy a stock, you now own a very small piece of that company.

Now of course this does not mean that you will be on the next Zoom call with the business executives running the company as companies issue millions of shares. However, when you own shares in good companies that become more valuable over time, your stock also becomes more valuable.

Companies sell shares of ownership in their business to investors in order to raise capital. The money that companies raise from selling stock can be used for a variety of business purposes such as creating new products, aqcuiring other companies, expanding operations, and more.

A company goes through a process called an IPO when they first begin to issue shares of stock. An IPO is an initial public offering. It is the first time that the company offers shares of ownership to the general public. Once the IPO process has been completed by a company, the stock of that company can be bought and sold among investors.

You typically don't buy stock directly from the company that is issuing the stock. Instead, you buy it from another investor who wants to sell, or sell to another investor who wants to buy. This is where the stock exchange and stock brokers come in.

The stock exchange can be thought of as the marketplace where stocks can be bought and sold. A stock broker represents you and helps you execute trades within the market. Most investors buy stocks through an online broker which connects them to the stock exchange.

Common and preferred stock

Stocks can typically be broken down into two kinds: common and preferred. Most ordinary investors have common stock. Common stock entitles you to have one vote at shareholder meetings, and entitles you to receive dividends. A dividend is simply a portion of the profits that a company makes that is paid out to you for holding a share of ownership through a stock.

Preferred stock is slightly different. When you own preferred stock, you don't get any voting rights, but you do get dividend payments before common stock holders. Additionally, preferred stock holders have priority over common stock holders if the company goes belly up and assets need to be liquadated.

When you first buy stocks don't get to wrapped up in common vs preferred. For the everday investor, common stock is probably the way to go.

Other categories of stocks

1) Stocks by cap size

Beyond common and preferred, stocks can also be categorized by their market capitilization. A company's market capitlization is simply the total value of all outstanding shares. There are large-cap stocks, mid-cap stocks, and small-cap stocks. In general, large cap stocks have a market cap of $10 billion or more, mid-cap stocks have a market cap between $2 and $10 billion and small-cap stocks have a market cap less than $2 billion.
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2) Growth stocks

As the name implies, growth stocks are any shares in a company that is anticipated to grow at a rate that is above the average growth of the stock market. In general growth stocks don't pay investors dividends as the company is focusing on reinvesting all earnings to to quickly grow the company.

3) Value stocks

Value stocks are shares of companies that appear to be at a price that is less than what the underlying fundamentals of the company indicate it should be. In other words, these are undervalued stocks. Legendary investors such as Warren Buffet have made fortunes off of finding and buying stocks below their intrinsic value.

In short, evey single investor should own stocks. Stocks can provide long term growth and higher returns when compared to other asset classes. Now, this does not mean that you should just go and buy the first stock that is recommended to you by the "finance expert" you saw on TikTok.

You need to buy stocks the smart way and understand how they fit into your broader investing plan and portfolio, which we will discuss later on.

In general, you can make money with stocks in one of two ways.

1) Capital gains: A capital gain is when the price of a stock appreciates and you sell it for more than you bought it for. If you bought a stock for $15, held onto it for a year, and then sold the stock for $20, you would have a profit, or capital gain of $5.

2) Dividends: Dividends are a portion of a companies profits that are paid out to you as the investor for owning a share of stock in the company. Not all companies pay a dividend to their shareholders. In general, a good dividend yield would be between 2% to 6% of the stock price. In other words, if you own stock that is valued at $100 a share, a good divedend would be between $2 and $6.

We should also note that most investors do not make money in stocks quickly. Most of the money to be made in stocks is by holding good companies over long periods of time. The stock market averages around a 10% return over long stretches of time, but is volatile and subject to crash within the short term.

As we previosuly mentioned, stocks should be a part of every investors portfolio. The question is, to what extent? Should you only invest in stocks, or should you invest in other assets as well? Should you focus on buying individual stocks or funds that contain stocks? Lets address a few concepts so you can understand how stocks should fit into your portfolio.

Understand asset allocation

Simply put, your asset allocation is what portion of your total portoflio you will invest in different asset classes. In general most investors allocate their dollars to three different investments: stocks, bonds, and cash or cash equivalants.

Imagine that your investment portfolio was a pie. You could allocate 80% of the pie towards stocks, 10% towards bonds, and 10% towards cash. The question then is how do you determine what your asset allocation should be? You can use the Rule of 100 and your risk tolerance to determine what portion of your portfolio you should allocate towards stocks.

The Rule of 100 states that you should subtract your age from 100 and have the difference be the percentage of stocks you hold in your portfolio. In other words if you are 25 years old, you subtract that from 100 and are left with 75. In this scenario, you would allocate 75% of your portfolio towards stocks.

While the Rule of 100 is a great guideline to help you get started, it does not completely factor in your risk tolerance. Your risk tolerance is simply the amount of risk you are willing to stomach as you invest. Think of it like this. What would your emotional response be if the value of your stocks went down by 20%?

Would you be extremely stressed out and want to sell to stop further loss? If so you probably have a lower risk tolerance. Would you be excited that you would be able to buy more stock at a cheaper price? If so you probably have a higher risk tolerance.

In order to truly determine what portion of your portfolio you should allocate towards stocks, you can start with the Rule of 100 and adjust your number based upon your risk tolerance. Lets use the same example above where you are 25 and get an allocation of 75% towards stocks using the Rule of 100.

If you have a high risk tolerance, you could bump up your number to 80% or 85%. If you have a low risk tolerance, you could bump your number down to 70%, or even 65%. We should also note that some financial experts recommend subtracting your age from 110 or 120 since life expectancy is increasing.

Keep in mind that asset allocation is not just a one time set it and forget it. Over time, you should revisist your portoflio and adjust it using the Rule of 100 and your risk tolerance. When you get older, you can't afford to take on as much risk.

Since stocks are a risky investment, older investors tend to hold a small percentage of them than younger investors. It is typically recommended to revisit your portoflio once a year. Now this does not mean you have to make drastic changes each year, but it is simply a check in to make sure your allocation is set up correctly.

Individual stocks vs funds

Now that you understand how to figure out what percentage of stocks you should have in your portfolio, another question arises. Should you buy individual stocks, or funds that have stocks in them? Lets get straight to the point. Unless you are a professional investor, which is unlikely if you are reading this article, you should buy stocks through a fund.

What does this mean exactly? Funds pool the resources of many investors to buy a wide range of stocks and other assets. The most common funds are mutual funds, ETFs, and index funds. Funds invest in the stocks on many different companies all at once.

When you buy a fund, you are instantly investing in the stocks of many great companies. This is a great way to buy stocks as your money will be diversified accross a range of companies. This will lower your exposure to risk. When some of the stocks in the fund don't perform well, others in the fund can make up for it.

After you have figured out your asset allocation using the methods discussed above, you can take whatever portion of your portfolio that should be in stocks, and simply buy a fund or two. So if 80% of your portfolio should be in stocks, you can have 80% of your portoflio be made up of stock funds.

The bottom line is that stocks are shares of ownership in a publicly traded company. Companies issue stock to raise money for a variety of business purposes. Every single investor should have stocks in their portfolio due to the potential of high returns over long periods of time.

The portion of stocks that you should have in your portfolio will depend upon a variety of factors including your age and your risk tolerance. Keep in mind that stocks can be a risky investment so it is best to diversify what stocks you hold by buying a fund.