Stock

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Stocks: What They Are and How They Differ From Bonds

Key takeaways
* A stock (or share) represents fractional ownership in the company that issued it.
* Companies issue stock to raise capital; investors buy shares to gain exposure to potential profits and growth.
* Two main types of stock are common and preferred, each with different rights.
* Stocks are generally riskier than bonds but have historically offered higher long-term returns.

What is a stock?

A stock is a security that represents ownership of a fraction of a corporation. Each share entitles the owner to a portion of the company’s profits (if distributed) and certain shareholder rights. Stocks trade primarily on public exchanges subject to regulations designed to protect investors.

How stocks work

  • Ownership and shares: Shareholders own shares issued by the corporation; the corporation itself owns the firm’s assets. Ownership is measured by the proportion of outstanding shares held.
  • Limited liability: Shareholders’ personal assets are protected from the corporation’s creditors. If a company is liquidated, shareholders may lose their investment but are not personally liable for corporate debts.
  • Governance: Shareholders can vote on major issues and elect the board of directors. Majority shareholders can exert significant control by appointing directors.
  • Profit claims: Shareholders have a claim on company earnings, either through dividends or through retained earnings that contribute to the company’s value.

Common vs. preferred stock

  • Common stock
  • Typically includes voting rights at shareholder meetings.
  • Dividend payments, if any, are paid after preferred shareholders.
  • More common among retail investors and most public companies.
  • Preferred stock
  • Generally lacks voting rights.
  • Holds a higher claim on assets and earnings than common stock.
  • Preferred shareholders receive dividends before common shareholders and have priority in liquidation.

Fast fact: The first common stock was issued by the Dutch East India Company in 1602.

Stocks vs. bonds

  • Nature of claim: Stockholders are owners; bondholders are creditors.
  • Payments: Stocks may pay dividends (not guaranteed); bonds pay fixed interest and return principal.
  • Bankruptcy priority: Creditors (bondholders) have legal priority over shareholders if a company goes bankrupt.
  • Risk/return: Stocks are typically more volatile and risky but have historically offered higher returns over long horizons. Bonds are generally more stable but offer lower expected returns.

How to buy stocks

  • Public exchanges: Most stocks trade on exchanges such as the NYSE or Nasdaq after a company goes public via an initial public offering (IPO).
  • Brokerage accounts: Investors buy and sell shares through brokerage accounts that access these exchanges.
  • Market pricing: Share prices are determined by supply and demand, influenced by company performance, economic conditions, and investor sentiment.

How investors earn money

  • Dividends: Periodic cash payments distributed from company profits. Payment amounts depend on the company’s dividend policy.
  • Capital appreciation: Selling a share for more than the purchase price. Total return combines dividends and price appreciation.

Risks of owning stocks

  • Market risk: Share prices can decline due to economic downturns, industry shifts, or company-specific problems.
  • Company risk: Poor management decisions, failed projects, or unexpected liabilities can reduce shareholder value.
  • Liquidity and timing risk: Selling at an unfavorable time can lock in losses; small-cap stocks can be less liquid.
  • Bankruptcy risk: In liquidation, shareholders may receive little or nothing after creditors are paid.

Summary

A stock is a claim on a company’s equity that gives investors ownership rights and exposure to the company’s profits and growth. Common and preferred stocks offer different rights and priorities. Stocks differ from bonds in risk profile and creditor status. While stocks can be volatile and risky, they remain a primary vehicle for long-term capital appreciation.