What is a stock

A stock (typically called a “share”) is a type of security or investment that represents a partial ownership of a company. When you hear people saying “I am buying stocks”, it generally means they’re investing in a company by buying a portion of that company.

Now, you might ask, how and why do companies sell a portion of themselves? There are a number of reasons. For example, when a company wants to expand their business, they may need more money (capital) to fund that expansion. For them to do that, they can either borrow money or sell portions (or shares) of their company. The latter is what happens when you buy a stock. You buy a share of that company and in return, you become a shareholder of that company and also fund the company’s expansion.

For this to happen, most companies go “public” in a process called Initial Public Offering (IPO). During the IPO process, a company issues shares to investors to raise the money they would need. Once an IPO is complete, stocks will be available for trading in the stock market.

As an investor, you might be looking at different types of investment options such as stocks, bonds, ETFs, etc. Below are some reasons why investors might choose to invest in stocks:

Liquidity

A stock’s flexibility on when you can buy and sell shares makes it attractive to some investors. This is because you could trade stocks anytime during market hours, which makes it usually a liquid investment option if you need to access the funds. Depending on your investment goals, this may be advantageous.

Diversification

You can buy stocks from different companies and industries (from different regions) which can help with diversifying your portfolio. In addition, you could complement your portfolio with other investment options that are potentially lower risk (or not subject to the same type of risk). This allows you to potentially balance your portfolio for any losses if one of the investment options performs poorly - helping to reduce the risk your portfolio is exposed to.

High historical performance

Although the performance of specific stocks can vary, stocks as a whole have performed well historically. The S&P 500, a stock market index which comprises the 500 largest companies traded in the US,  is typically considered as the benchmark for annual returns. Looking at its performance, it averaged approximately (excluding inflation) 12% in the last 10 years (2011-2020) and 9% in the last 30 years (1990-2020). This may be helpful if your time horizon is long and you can gain the profitability in stock appreciation over time.

Company ownership

When you invest in a stock from a particular company, you’re not only a consumer of their products and services but also a shareholder of their company. Depending on the type of stock you buy, you could also get the opportunity to vote for certain business decisions in the company.

Capital Gains

Capital gains (or stock appreciation) happen when a stock value goes up (or down when it’s shorted) and you sell that stock for a profit. For example, let’s say you invested in XYZ company and you bought 50 shares of their stock at $20 for each share (Total of $1000 = 50 shares x $20/share of XYZ company).

After three years, XYZ company becomes successful and the stock price goes up to $40 per share. Now, if you decide to sell it at $40 per share since you’re happy with that price, then you get a return of $2000 (50 shares x $40/share). Because of this, you’ve locked-in $1000 in capital gains or profit from your initial investment. On the other hand, it may be the case that you want to continue holding the stocks hoping that the price continues to go up in the coming years. If that happens, you may gain more profit from your investment.

Dividends

Dividends are distributions made as a form of  “payment” from the company to you (shareholders) that usually comes from their profits. The company board of directors decides on the amount of dividends they want to pay on a per-share basis and the company distributes it twice a year or quarterly (though some other frequencies exist).

Suppose after three years, XYZ company is making enough profit and wants to pay out dividends to its shareholders. They decide to give a $1 dividend payment twice a year (or 0.50 cents each payment) meaning you, as a shareholder, will receive $1 dividend per share of XYZ company. If you’re holding 50 shares of XYZ company, that means you’ll receive a total of $50 dividend (or $25 each payment) annually.

Not all companies pay dividends to their shareholders, and companies are not required to pay dividends. However, some choose to do so and that can be a source of income for investors in the stock.

A company could issue two kinds of stocks namely common stocks and preferred stocks. Both common and preferred stocks are traded in the stock exchange however common stocks are issued more than preferred stocks. The following are other differences:

Profits:

Common stocks are what we typically think of when we see shares being traded on the stock exchange. They can rise (or drop) in price depending on the demand for shares and investors may lock in a capital gain (once it’s sold) if the common stock appreciates. Common stocks can also provide dividend payments (but typically at a lower rate than preferred stocks). In contrast, preferred stocks are shares that typically pay higher (and fixed) dividends than common stock dividends. The reason for this is that companies pay out their profits to preferred shareholders first through dividends and whatever is left there will be distributed to the common stockholders.

Risk:

Since common stocks are often more prone to price volatility (both up and down), they have a higher risk to hold than preferred stocks. On the other hand, preferred stocks typically have a lower risk because of the fixed dividend that comes along with it.

Voting rights:

Common stockholders typically get voting rights to certain business decisions on a company they hold. Preferred stockholders, on the other hand, usually don’t get voting rights on the companies they hold.

Note: The information in this blog is for educational purposes only and should not be used or construed as financial or investment advice by any individual. Information obtained from third parties is believed to be reliable, but no representations or warranty, expressed or implied, is made by Questrade, Inc., its affiliates or any other person to its accuracy.