What Are Stocks And How Do They Work?

Part of growing your wealth is through investing, and understanding stocks and the stock market will help you figure out how you can use this type of asset to your advantage. Whether you invest in stocks through your retirement portfolio or a taxable brokerage account, stocks (or shares of equity) are how you can own a part of a publicly traded company. Even if you know some of the basics of how stocks work, having a deeper understanding of stocks and how you can use them to make money should be part of your financial wellness plan.

What Is A Stock?

A stock represents part ownership of a publicly traded business, and it’s one of the most popular types of investing. Corporations sell stocks to raise money. If you own shares of a company's stock, you have the right to claim part of their earnings and assets. What's more, you will also be able to view the company's annual report, which outlines how the business is doing. The annual report is useful to help you determine if you want to purchase more or sell your shares.

How Do Stocks Work?

Companies create stocks to sell shares in order to receive more money to grow their business, whether it's hiring more employees, buying more inventory or investing in other business goals. Investors who purchase stocks want to sell them for a profit, which happens when the stocks increase in value (usually because the company shows potential for a very profitable future). If the company’s value goes down, the stock value goes down with it as well.

Companies who want to sell shares of their stock need to go through an initial public offering (IPO). This process is where a company wants to offer initial shares of their company to the public. These companies need to meet the requirements of the Securities and Exchange Commission (SEC), as well as the stock exchange they want to be listed with. After the stock goes on the stock market, a company's shares can be purchased and sold. Most investors buy and sell stocks through a stock exchange, most likely going through their brokerage account themselves or with the help of a stockbroker.

There are private stocks available, but these are typically out of reach for most investors and may require you to invest much more money.

How Do You Make Money From Stocks?

You make money from stocks when you buy shares at a lower price than you sell them. For example, if you purchased 10 shares of a stock at $150 each and sell them 3 years later at $200, then you’ll earn a profit of $50 per share, or $500 overall. Since you’re not doing much other than investing your money and hoping it grows, many look to investing in stocks as a form of passive income. You can also earn money from stocks if a company pays out dividends. That’s when a company distributes part of their earnings to their shareholders. In most cases, you'll receive dividends quarterly, either in stock or investing in more shares of the company's stock.

Types Of Stock

The main types of stock include common stock and preferred stock. There are other types as well that have to do with the type of companies you can invest in.

Common Stock Vs. Preferred Stock

While common and preferred stock both mean you own a share in the company, there are some distinct differences. For one, preferred shareholders take priority over common shareholders when it comes to dividends. However, common shareholders have voting rights during the company's annual shareholder meeting. Common stockholders also only have rights to a company’s assets if it goes into liquidation after debtors and preferred stockholders have been paid.

Companies may offer one or both types of stock. So even if you want one type over another, you can still typically invest with the company of your choosing.

Other Types Of Stock

Understanding other types of stock can help you determine the best way for you to grow your wealth. There are plenty of other types, so it's worth it to take the time to learn about as many as you can.

Here are some more common types of stock:

• Growth stocks: Growth stocks are for companies that have expectations of growing faster than the overall market. In many cases, growth stocks typically perform better during times of economic growth.
• Value stocks: Value stocks are typically bought at a lower price compared to the expected performance of a corporation. These are seen as having more "stability" as these stocks tend to perform best when economic conditions aren't great.
• Income stocks: Investors can purchase these types of stocks that offer consistent income by paying out company profits through higher than typical dividends. The value of the stock won’t go up or down as much as other stocks.
• Blue chip stocks: These are stocks that are from very established companies with a long reputation of steady earnings within their industry. They’re usually also some of the largest companies in the market.
• Cyclical stocks: Cyclical stocks tend to be affected more by economic cycles, so they may have more volatility. In other words, when the economy is strong, these stocks may do well, but the opposite is true when the market sees a downturn or recession.
• Noncyclical stocks: These stocks are generally the opposite of how cyclical stocks perform. They're companies that are seen as more recession-friendly since their stocks can do well even in economic downturns.

Pros And Cons Of Stocks

Though stocks offer many investors the opportunity to build wealth, there are also some downsides to this type of investment.

Advantages Of Stocks

• Easy to trade: Investors can easily trade stocks by buying and selling them through their brokerage account. Many brokerages also offer a mobile app, making it easy to invest on the go. Stocks are also relatively accessible, because you don’t need a large amount of money to get started.
• Ability to invest for long-term goals: Since the stock market can go up and down a lot, parking your money in this type of investment over a number of years can help you grow wealth over time. Plus, you can also take any dividend earnings and reinvest them, helping your money grow even more.
• Owning part of a company: By buying stocks, you may feel a sense of pride knowing you own part of a company and are helping it get the money it needs to grow.

Disadvantages Of Stocks

• Risk of losing money: You're not guaranteed to earn money when you invest in the stock market. There may be times when there is an economic downturn, or a company faces an unexpected loss. That's why many experts recommend investing in other assets in addition to stocks, such as bonds.
• You’ll be taxed on earnings: When you sell your stocks at a profit, the earnings count as taxable income. The amount you'll need to pay will depend on how long you've held on to your stocks.

The Bottom Line

Now that you know about stocks, you can start figuring out the best way to make investments. Use your newfound knowledge as a launchpad to learn more, like your level of risk and which brokerage you want to go with. To help monitor your investment portfolio, consider using free apps like the Rocket Money^℠ app to see your assets all in one place.