Many people recognize that owning a share of a stock means buying a small percentage of ownership in a company. However, some new investors have misconceptions about what owning stock entails.

Understanding stocks is vital to effective investing because stocks play a crucial role in developing a balanced investment portfolio. So, before you purchase stock, here’s what you should know about what it really means to own a share of stock.

What Are Stocks?

Put simply, stocks are securities that represent units of ownership in a company. Stocks are sold in units known as shares or equity. There are different kinds of shares, but when people talk about purchasing shares in a company, they usually refer to common stock.

Investors purchase shares in companies they believe will go up in value, meaning increasing revenue and earnings. If that happens, the company’s stock value increases as well which allows the stocks to be sold for a profit. Investors who own stock in a company are called shareholders because they share in the company’s profits.

How Do Stocks Work?

Public companies sell stock through a public stock market exchange such as the New York Stock Exchange or the London Stock Exchange. Companies choose to issue stocks as a way to raise money to pay off debt, expand operations, or launch new products. Investors choose to purchase stocks in hopes that the company will grow and stock price will increase enough to sell and make a profit. Some companies pay dividends to shareholders when they distribute earnings, providing some cash flow.

Investors generally trade stocks through stockbrokers. Stock exchanges track the supply and demand of each company’s stock. The supply and demand is one factor that affects the stock’s market price. Stock prices fluctuate throughout the day during market hours, 9am-4pm EST for US markets. Stock price varies based on supply and demand, company earnings, and investor sentiment.

Stock in Private Companies

To raise capital for funding their operations, private companies sell shares of stock, inviting investors to purchase a fractional ownership interest in the company. They do so by conducting what’s known as an initial public offering (IPO). When you hear about a company “going public,” that means that the company is conducting an IPO to make shares of their stock available for purchase via public markets.

During the IPO, the company and its advisors set an IPO price for their stock shares. Then, the funds raised by investors purchasing those shares go directly to the company. Once the initial offering is finished, shares are traded on the secondary market, or the stock market, where prices rise and fall depending on multiple factors.

Types of Stocks

There are two main types of stocks: common and preferred.

Common Stock

Most investors will buy common stock. Common stock represents a fraction of ownership in a company, with shareholders having the right to receive a portion of the value of any remaining assets if the company gets dissolved. Theoretically, common stock allows shareholders unlimited upside potential, but at the same time they also risk losing their full initial investment if the stock price plummets.

Preferred Stock

Many companies do not even offer preferred stock, so this makes up a much smaller amount of the stock market. Preferred stock gives shareholders priority over common shareholders in the case that the company liquidates. Preferred shareholders also have the right to receive dividend payments before common shareholders.

Trading Stock vs. Investing With Stocks

Traders will buy and sell stocks on a short-term basis in the hopes of benefitting from short-term fluctuations in price. Investors, on the other hand, tend to buy and hold stocks with the goal of choosing companies that have long-term growth potential. Investors will typically own a diversified portfolio of many stocks of different companies, industries, and sizes.

The Benefits of Owning Shares of Stock

When you purchase shares of stock in a company, certain privileges are conferred to you, depending on what kind of shares you’ve bought. These privilege may include:

• The right to vote at the company’s annual shareholder meeting.
• A percentage of the company’s profits, or dividends.
• Capital appreciation, meaning that when the company’s stock price increases, your shares increase in value.

Risks Involved in Owning Share of Stock

Of course, like many activities, owning shares of stock comes with both benefits and risks. The risks that you take when owning stock include:

• There’s no guarantee that companies will pay out a dividend every year. Sometimes, a company’s profitability doesn’t allow dividends to be paid out. Sometimes, the company will reinvest the excess profits instead of paying them out.
• While an increase in a company’s stock price often means an increase in the value of your share, if the company’s stock price decreases, your shares will decrease in value.
• If you own common stock, you are last in line to receive dividends from the company’s profits after debt-holders, creditors, and preferred stock owners. So by the time it gets to you, there may not be any dividends left to pay. In addition, if the company goes bankrupt, common stock owners are the last in line to receive the proceeds.

How Do Shareholders Make Money?

Stock investors have the potential to earn money in two main ways:

1. The price of a stock increases while you own it, and you sell it for more than you paid for it.
2. Some companies pay dividends to shareholders. Dividends are regular payments (generally on a quarterly basis) made up of excess profits. Dividends are paid per share of stock so if you own 10 shares of a company and it announces a $1 annual cash dividend, you will earn $10 per year. A company’s board of directors approve each dividend and announce when changes are made to the dividend price.

Why Own Shares of Stock?

Investors use stocks to expand their portfolios, grow their savings, and plan for long-term financial goals like your retirement. As stock prices go up, so do your savings. While purchasing stocks may involve some risk, it remains one of the best ways to diversify an investment portfolio. Investors purchase shares of stocks in different companies to mitigate risk and ensure profits by enjoying gains in thriving sectors while offsetting the losses from others.

If you’re the kind of investor who can handle a bit of risk, is looking to achieve long-term goals, and knows how to read the market to potentially offset losses, buying stocks is a good option for you. However, if you want to diversify your portfolio, make money with minimal risk, or desire an option with professional management, you should look to other avenues, such as mutual funds, bonds, or annuities.