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Jan 20, 2025

Basics

How do stocks work?

What Are Stocks and How Do They Work?

What are stocks?

A stock is the ownership of a tiny fraction of a company. As part-owner, the investor is entitled to a portion of the company’s profits and assets, commensurate with the amount of shares they hold.

The value of stocks can fluctuate based on the company’s performance, market conditions, and investor sentiment.

Stocks are a pillar of many investment portfolios. They are risky, but the flip side is higher potential for making significant money over time.

Benefits of being a stockholder

  • Potential for high returns

  • Ownership of an asset

  • Dividend income

  • Liquidity

  • Companies can raise prices as an inflation hedge, often leading to higher profits

  • Portfolio diversification, leading to reduced risk.

Pitfalls and risks

  • Market volatility can lead to losses

  • Company-specific risks

  • Unlike bonds, stocks do not guarantee returns or dividend payouts

  • Economic sensitivity

  • Emotional decision making can lead to losses

  • Brokerage fees

  • Fraud

What kinds of stocks are there?

Common stocks

The vast majority of stocks out there. Common stockholders vote and receive dividends.

Preferred stocks

Fixed dividends, but no voting rights. Higher priority in case of liquidation.

Growth stocks

Stock of fast-growing companies that are pushing hard to expand and are less likely to pay dividends as their goal is reinvesting in capital appreciation.

Value stocks

Stocks of companies perceived as being worth more than their current price and expected to increase in value.

Dividend stocks

Investors who rely on their investments to provide a steady income often like stocks of companies that regularly pay dividends.

Blue-chip stocks

Shares of well-established companies with a history of financial stability and reliable performance.

Penny stocks

Cheap stocks (usually under $5/share). High potential returns, but low liquidity and high volatility.

Sector stocks

Sometimes, stocks are categorized according to the sector they belong to, such as tech, healthcare, finance, or consumer goods.

When do companies issue stocks?

Issuing stock is a strategic decision that helps companies support their growth initiatives, manage financial structures, and reward stakeholders.

Here are some key reasons a company may issue stock:

To fund expansion

If you need capital to develop a new product, or expand operations in some other way, and don’t want to go into debt, you can sell shares of your company.

To improve cash flow

A company may need to re-enliven its day-to-day operations or pay off existing liabilities, and the influx of cash is just what the doctor ordered.To attract investors

Investors are not just money bags, they also represent networks of valuable connections and reservoirs of expertise.

To incentivize employees

Including stock options to employees is a cunning double-pronged strategy: it aligns employees’ interests with those of the shareholders, and serves to attract and retain talent.

To reduce debt

Companies can use the money that comes in from sale of shares to pay down loans or other obligations to reduce financial leverage and advantageously shift their capital structure.

To provide liquidity

Early investors and founders can monetize part of their investment and still retain ownership if stock is issued.

How to get started with stocks

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Getting started with stocks can seem daunting, but a structured approach will help you navigate the process effectively. Here are the steps to begin investing in stocks:

1. Educate yourself

Learn the basics

There are many places where you can seek knowledge on fundamental concepts: books, online courses, and financial news websites are a good start.

Stay updated

Follow financial news and market trends and get comfortable with how everything works through observation.

2. Set financial goals

Determine your investment objectives, risk tolerance, and time horizon. Are you investing for retirement, a major purchase, or growing wealth? Knowing your goals will help shape your investment strategy.

3. Choose a brokerage account

Select a broker

Look at various brokers’ fees, the services they offer, and how easy they are to use. Online brokers tend to offer lower fees and greater flexibility.

Open an account

Provide the required information to apply.

Fund your account

Link your bank account to deposit funds into your brokerage account. Many brokers allow electronic transfers for quick funding.

4. Develop an investment strategy

  • Decide whether to invest in individual stocks, exchange-traded funds (ETFs), or mutual funds. Diversifying your investments can help manage risk.

  • Consider strategies such as value investing, growth investing, or dollar-cost averaging.

5. Research stocks

Use the brokerage platform’s research tools to analyze stocks. Look at financial statements, performance metrics, and market trends.

6. Place your first order

When you’re ready, execute a buy order for the stocks you’re interested in. Start with a market order for immediate execution or a limit order to specify your purchase price.

For your first time, invest only a little bit of the capital you have on hand. This will allow you to gain some real-world experience without too much risk.

7. Monitor your investments and the the market

Be aware of your portfolio’s performance, and about market conditions. Be flexible and willing to adjust your strategy, but don’t act impulsively.

If you don’t feel totally comfortable managing your own investments, a financial advisor can provide personalized guidance.

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