Stocks

Stocks are a type of financial instrument regularly purchased and traded by investors. They fall into the category of equity instruments, which are financial instruments that represent ownership of something. In the case of stocks, each share of stock represents a share of ownership of a particular company. This ownership often conveys certain benefits, including access to up-to-date financial information through the company’s shareholder meetings and voting rights in regard to the company. Some stocks pay dividends, which are small amounts of money paid to shareholders for each share they possess. Although some privately held companies offer shares of stock to investors, the majority of stocks held or traded in the United States are of publicly held companies and are typically first made available to qualified investors through initial public offerings (IPOs). The bulk of stock-trading activity occurs on secondary markets such as the New York Stock Exchange, where investors purchase shares from each other rather than from the issuing company.

Background

Stocks have long played an important role in the financial industries of many countries. The first known company to issue shares of stock was the Dutch East India Company, which in the early seventeenth century used the proceeds from its stock offering to fund its fleet of trading ships. In the centuries since, countless companies have issued shares of stock to raise funds for operational expenses, research, and other business activities. Along with the increasing prevalence of stocks came the rise of stock exchanges, institutions through which investors or their brokers could trade stocks and other securities. The first two such exchanges, the Amsterdam Exchange and the Paris Bourse, were established in 1602 and 1724, respectively.

The first stock exchange in the United States was the Board of Brokers in Philadelphia. It opened in 1790, after several decades of work toward that goal by Philadelphia investors, and was renamed the Philadelphia Stock Exchange (PHLX) in 1875. Over the centuries, stock trading became an essential component of the US finance industry, and various other exchanges were established, including the New York Stock Exchange (NYSE) and the NASDAQ stock exchange, the latter of which purchased PHLX in 2007. New York City’s Wall Street and the surrounding Financial District became the center of American finance, housing not only the NYSE and the NASDAQ but also the headquarters of many banks and major companies.

Unlike debt instruments such as bonds, which indicate that the bond holder has essentially lent money to a government or company and thus holds a portion of that institution’s debt, stocks are generally considered equity instruments, meaning that they represent ownership of a portion of a company. As a stock’s price is based on its market value rather than some underlying asset, stocks are known as cash instruments. The market value of a stock can be affected by several factors, including the company’s latest earnings and other financial data, projections by financial experts, and current events in the United States and around the world.

Perhaps the most significant factor in a stock’s market value is supply and demand. If numerous shares are available for purchase but there is little demand, the price of the stock will likely go down, while high demand and low supply will generally drive the price up. Ultimately, a stock’s price is based on the overall market’s willingness to buy or sell shares at a particular price. Because of those factors, prices fluctuate significantly over time, making stocks a highly risky but potentially lucrative investment.

Overview

The basic concept of stocks is a simple one, but investing in such instruments can be a complex process, as numerous complicated trading strategies have developed around them over the centuries. Because of the risks inherent in investing and the expertise needed to conduct certain kinds of transactions, stock buying and trading is subject to significant regulation by stock exchanges and brokerage firms, regulatory bodies within the financial industry, and government entities such as the Securities and Exchange Commission (SEC). As stocks offer the potential for both significant profits and significant losses, investors should gain a thorough understanding of the benefits and risks of such investments prior to entering the field themselves.

Stocks can generally be divided into two types, common and preferred. The majority of stocks are common stocks, and as such, those are the type of stocks with which most people are familiar. Common stocks are equity instruments that typically offer benefits such as voting rights within the company in question and may pay shareholders dividends. However, the monetary value of dividends offered by common stocks often fluctuates, and dividend payments generally are not guaranteed. Preferred stocks are similar to common stocks in that they represent partial ownership of a company. However, they often limit shareholder privileges, such as voting rights, in exchange for offering a guaranteed, fixed dividend payment. At times, a company’s financial circumstances will force the company to liquidate its assets and distribute the funds to its creditors and shareholders. In such cases, investors who hold preferred stock are paid before those who hold common stock and thus have a better chance of recouping their investments.

Professionals within the finance industry also loosely categorize stocks based on their growth or income potential. One notable category is that of blue-chip stocks, which are stocks belonging to established companies with demonstrated growth and dividend payments. Stocks commonly considered to be blue chips include General Electric and Coca-Cola. Blue-chip stocks are considered by some investors to be less risky than those without a proven track record. However, as with any stock, investors must remember that a blue-chip stock’s past performance does not guarantee future results.

Stocks may also be categorized based on their price. For example, some very low-priced stocks may be considered penny stocks. Such stocks generally are not traded on the major stock exchanges and can represent significant risk due to their volatility. They may also be subject to manipulation by unscrupulous investors, so one must be cautious when considering purchasing such a stock.

To buy stocks, an investor must typically open an account with a brokerage firm, which acts as an intermediary in all transactions. Some brokerage firms actively manage one’s investments, providing professional advice and assistance in selecting and purchasing stocks, in exchange for often-substantial fees. Other firms offer little professional guidance, allowing the investor to manage his or her own trades and use various analytical tools for a low fee per transaction.

At times, certain investors may be able to purchase stocks without the aid of a broker. Those purchasing shares of stock in privately held companies, for example, generally buy directly from the company in question. Some major public companies have programs that allow prospective investors to make direct purchases as well. Institutional and experienced individual investors who meet certain requirements may also qualify to purchase stock during a company’s IPO. However, such options are not suitable for most average investors, the majority of whom purchase stocks through their brokerages.

While some investors choose to buy stocks and hold them for an extended period of time in the hope that prices will rise in the long term, others prefer to trade actively on the secondary market. The most basic trading strategy is simply purchasing stock when the price per share is low and selling the shares after the price increases. For example, an investor might purchase one hundred shares of stock in Company X at ten dollars per share. He or she might then sell all hundred shares when the stock price hits twelve dollars, thus making a profit of two hundred dollars, minus any transaction fees. This philosophy of buying low and selling high is the foundation of most stock-trading strategies.

Some advanced trading strategies are far more complex. One such strategy, short selling, is used when an investor believes that the price of a stock is going to decrease in the near future. The investor borrows shares of a particular stock from his or her brokerage firm and sells them for the current market price. If the stock price goes down, as he or she predicted, the investor then purchases an equal number of shares at the new, lower price and returns them to the brokerage, keeping the difference between the sale price and the purchase price. While short selling has the potential to be highly lucrative, it is also a very risky strategy, as it relies on the stock price decreasing within a limited period of time. If the price increases, the investor will still need to purchase shares to replace the ones he or she borrowed and thus will be required to spend more money than he or she originally made in the sale. Because of the risks inherent in short selling, brokerage firms typically restrict the ability to borrow shares of stock or purchase stock on margin—that is, with funds loaned by the brokerage—to experienced investors who meet certain financial requirements.

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