Many people first hear about the stock market through movies like “The Wolf of Wall Street,” “The Big Short,” or “Wall Street.” These films show the excitement—and sometimes chaos—of trading, but they focus on drama more than reality. In everyday life, stocks aren’t about fast profits or big risks. They’re a practical way for regular people to build wealth by owning small pieces of a company.
What Are Stocks?
To explain stocks to a beginner, imagine stocks as a piece of paper that says you own part of a company. A company will sell (also called issuing) stocks to investors to raise money for new projects; in exchange investors are given some control over the company. However, that doesn’t mean you get ownership over the actual stuff that the company has! You only own part of the profit of the company.
Individual units of stock are called shares. One of the most important things about stocks is that one share in a company is the same as any other share in the company, which is called fungibility. That fungibility allows stocks to be resold or traded by investors.
There are two main types of stock to keep in mind:
- Common stocks grant the owner the right to vote at shareholder meetings, and possibly dividends.
- Preferred stocks do not grant voting rights, but they do give you priority access to dividends and bankruptcy liquidation money.
How Do Stocks Make Money?
There are two main ways that stocks can make owners money. The easiest way is dividends. Some companies decide to share a portion of their profit with stockholders. As a shareholder, you don’t have to do anything. However, to have the money for dividends, a company must make profit and do well financially.
Which leads to the second way that stocks can make money. When a company is doing well, people are more interested in owning a part of it. That interest will raise the price of each share. If the price of a stock goes above the price you paid for it, you can sell your stock to make a profit. That gain of profit is called capital appreciation. When you sell a stock for a profit, the profit is called capital gains.
How Do Stock Prices Increase?
After a share is sold by a company, there’s no fixed price for a stock. The prices of shares are entirely in the hands of the shareowner and the people who want to buy the share.
One of the most common ways that stocks are traded is through “limit orders.” When a shareholder wants to sell stock, they will make an offer to sell at a certain price or better. If a buyer comes along and agrees to that price, you get a sale. At the same time, buyers can offer to pay a price or lower, with sellers agreeing to sell at that price.
When a stock is unpopular or the company looks like it’s struggling, buyers may want to pay less for each share. Therefore, sellers will accept a lower and lower price, which makes the stock less valuable for everyone who owns it. On the other hand, when stock is popular or the company is doing well, more buyers may want the stock, and they’ll pay more to get it. That makes the stock more valuable for everyone who owns shares in that company.
What Are the Risks of Owning Stocks?
Due to the way that stock prices are created, there’s no guarantee that the stock price will go up. Even worse, if a stock’s price falls quickly or the company stops existing, there may be no one to buy the stock that you have. The amount of risk you take when you buy a stock depends on how likely it is for the company to do well in the long term, which is why it’s important to do your research before investing in a company. However, the most money that you can lose from buying shares is the amount that you invested.
Investment Styles
Something to keep in mind is that many price reductions are temporary. As an investor, you can decide to be patient to take advantage of this characteristic. Just make sure to invest in companies that you think have a solid foundation and a path to growth.
More aggressive traders might do day trading, taking advantage of tiny price changes to make their money. The reason it’s called day trading is that all trades take place while the market is open. In fact, many day traders end their days owning zero stock to avoid overnight price changes. Day trading can be very lucrative, but it’s time intensive, stressful, and requires a lot of skill to do correctly.
In the middle is swing trading. Swing traders hold on to stocks for a few days to a few weeks, which evens out a lot of the fluctuations in price. However, it’s still an active investment style. To make money, a trader has to track statistics to find stocks that are likely to go up (or in some cases, down) in the next bit of time.
The Bottom Line
To summarize, stocks are a contract that gives an investor a portion of the ownership of a company. In some cases, companies will divvy up their profits and pay shareholders dividends. Stocks can be bought from, and sold to, other investors. When investors think that a company is doing well financially, the price of a stock is likely to go up. If a shareholder sells stock for more than they paid, they profit.
