The Basics – What are Stocks?

What are Stocks? Stocks, which are also called shares or equity, are a share of the ownership of a company, representing claim on the company’s assets and its earnings. Thus, in holding the stock of a company you have a claim to everything that the company owns, typically a very small claim as an individual investor, entitling you to a share of earnings and potential voting rights belonging to the stock. However, this does not mean you have a say in how to run this publicly traded company day to day.

Stockholders elect company management. The shareholders elect a board of directors, which is the means of how the shareholders can get their say at annual company meetings. This management team’s job is to increase the value of the company for the shareholders. If things go wrong, then the shareholders can remove the directors, and in practice this tends to occur through the large institutional investors, such as pension or retirement funds and extremely high net worth individuals. As an individual investor, when you buy a share you are generally not interested in attempting to direct the company management, but instead you are either investing for the dividends, a share of the profits, or that you believe the stock will increase in value due to the company performing well.

Stocks give ownership without liability. If the company does so poorly that it becomes bankrupt, the stock allows you to have a claim on assets but only after the creditors have been paid (so likely very little if anything at all). However, in owning the stock you only have limited liability, so that you are not liable to pay company debts. This is different from other types ownership of companies that for example includes a partnership, where the partner shareholders may be held personably liable if the company goes bankrupt.

Why does a company issue stocks? Why would a company issue common stock to share in the profits, rather than the original owners/founders keeping all the profits to themselves? Stocks are used to allow the company to raise money, where stock is issued for selling a portion of the company. Initial stocks are issued by the company that was in private ownership up until that point, by them making what is known as an initial public offering (IPO). Issuing stock is advantageous because money is raised for the company without it being a loan that has to be paid back with interest, so is a good way to raise investment capital that allows the company to grow further/faster. The new shareholders hope to be benefited by the shares being worth more than the original price, as the company grows and increases in value.

Stocks provide increased risk, more gains or more losses. Instead of issuing stocks, the company could issue a bond, where the company promises to pay back the money used to buy the bond (the principle) plus fixed interests payments (usually a little above inflation). If the company cannot make its debt payments and becomes bankrupt, the claim of the investments goes to banks and these bondholders before the shareholders. Thus, in being a shareholder you hold the riskier asset, which allows for potential gains much higher than that for bonds, but at the same time the stock can go to 0 value, and with little claim to the remaining assets. However, you shouldn’t be too negative, as stocks historically have returned an average of 10-12% yearly appreciation, much higher than bonds, CDs or interest on bank savings accounts. Just choose stocks wisely, learn how to buy and sell them appropriately, and add some diversification to your portfolio to further limit downside risks.

Investopedia has a nice intro video into stocks, which you can watch here: