You hear about the stock market every day, but there are still many people who don't know what a stock really is. Even if you invest through a workplace retirement plan like a 401(k), the mutual funds that most plans provide don't necessarily educate you about the basics of stock investing. Let's explore what a stock is and why so many people invest in stock.
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What a stock is
Businesses that are set up as corporations have stock to represent ownership interests in the business. The articles of incorporation that a business has to establish to set up a corporation defines the number of authorized shares of stock, and the company can choose to offer up to that amount of stock to investors, typically at the discretion of its board of directors and existing shareholders.
Owning a stock gives you certain rights, and those rights can differ depending on the type of stock you own. Most of the stock that investors focus on is called common stock, which gives the shareholder the right to receive any dividends that the company declares on its common shares as well as rights to vote at annual and special shareholder meetings. In the event of a liquidation of the company, common shareholders are entitled to divide any remaining corporate assets on a pro-rata basis, once claims of creditors and others with higher priority are paid off.
Preferred stock is a different type of stock that isn't seen as much as common stock. Owners of preferred shares typically don't have the right to vote at annual shareholder meetings, but they do have a higher priority in receiving dividends or payments in liquidation of the business. Specifically, a company has to pay preferred shareholders all dividends owed under its terms before it can pay any dividends to common shareholders. Similarly, preferred stock has a liquidation preference that allows preferred shareholders to receive up to a certain amount of compensation for their shares before common shareholders get anything.
Why invest in stock?
The reason why so many people invest in stock is that its value is generally linked to the long-term prospects of the business. If a business is successful over time, then its stock will usually rise in value in the long run. It's important to understand that this won't always be true over shorter periods of time, because stock trades on public markets, and its price is subject to regular market forces like supply and demand that don't always match up with the fundamental health of the underlying business.
Few other investments offer the return potential of stocks. Bonds offer more certainty by having terms that include fixed, predictable payments of interest and principal. But even if a company does well, bondholders typically don't see the value of their holdings grow. Stock investors get the benefit of corporate success, and that makes it a compelling investment for those willing to take on risk.
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Stock investing can seem intimidating, but the basics of what a stock is aren't too hard to understand. By focusing on the ownership element of investing in stock, you'll be better able to choose companies to invest in that will help you reach your financial goals.
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