Stocks: Answers To Common Questions

What is a stock?

A stock is a financial instrument, or monetary contract, denoting partial ownership of a corporation. A unit of stock is called a share. A company issues shares when it divides ownership among investors or employees. Both public and private companies may issue shares, but they are traded and valued differently. The valuation, or market capitalization, of a publicly-traded company is equal to the number of shares outstanding multiplied by the current stock price.

Why are stocks also called equities?

Equity means ownership. For example, you may have heard of home equity, which is the portion of your home that you own (calculated by taking the appraised value of your home and subtracting your mortgage). Since a stock represents partial ownership of a company, it is also called an equity.

What do people do with stocks?

They buy or earn shares of stocks as part of a compensation package, and then they hold them for some time and eventually may sell them. While holding these shares, they may vote at a company’s annual meeting (with voting rights proportional to their ownership) on some corporate actions, membership on the board of directors, and issuance of new securities or dividend payments. During the holding period, shareholders hope that the value of the shares increase so that selling the shares will result in a capital gain.

How are stocks traded?

Shares of publicly traded stocks are traded on a stock exchange, generally through a broker such as Vanguard, Charles Schwab, or Fidelity. Shares of private companies are more difficult to trade and require the shareholder to find a willing buyer and obtain approval from the company that issued the shares.

What is a retail investor?

A retail investor is a non-professional investor, also known as an individual investor. Basically that means you and me and everyone just trying to grow their nest egg. The opposite of a retail investor is an institutional investor. This is a large organization, typically a bank or an insurance company, that makes use of professional investors to grow its capital.

Why do stock prices change over time?

Stock prices are determined by supply and demand. When there are more buyers (demand) than sellers (supply), stock prices go up. On the other hand, when there are more sellers (supply) than buyers (demand), stock prices go down. Why people (or institutions) buy or sell stocks at any particular time is much more difficult to understand. There are many factors that may play a role, including company fundamentals (earnings, revenue, assets, liabilities, etc.), investor sentiment, governmental regulation, or world events. Most of the time, it is unknown why stock prices move in any one direction. People ascribe reasons to these moves in an effort to better understand what is happening or what has happened, but it all boils down to people buying or people selling.

What is trading volume and how does it affect liquidity?

Trading volume is the number of shares of a stock traded over a particular time period. The higher the volume, the smaller the bid-ask spread and the more liquid the investment. This is because more people are trading the stock, and so it is easier to find someone to sell it to you or buy it from you.

What is a bid-ask spread?

When you’re trading stocks, you don’t buy or sell at the market price. Instead, the prices to know are the bid and ask prices. This is because the stock market is essentially an auction. The bid price is the highest price a buyer will pay for a share, while the ask price is the lowest price a seller will sell a share for. The ask price is always higher than the bid price. If you are buying a share of stock, you will have to pay the ask price (higher than the market price), and if you are selling a share, you will receive the bid price (lower than the market price). A bid-ask spread is the difference between the higher ask price and the lower bid price. This is a measure of liquidity because the narrower (smaller) the spread, the more liquid the stock is. A narrow bid-ask spread means the stock is more highly traded, so it is easier to buy or sell shares. You can read more about bid and ask prices here.

What is a dividend?

A dividend is a distribution of profits from a company to shareholders in the form of a scheduled payment. Dividends are typically paid monthly, quarterly, or annually, and the amounts paid per share and the payment schedule are announced in advance. To receive dividends, you must hold shares of the company prior to the ex-dividend date. On the ex-dividend date, the share price will fall the amount equivalent to the dividend, but this will be recouped by the shareholder when the dividend is paid. Keep in mind that you may not notice the price drop due to normal price volatility. Most retail investors are best served by reinvesting dividends.

What is preferred stock?

Preferred stock can be considered a hybrid between a stock and a bond. Most retail investors do not invest in preferred stock, as there are fewer incentives than for institutional investors. It is called preferred because when a company experiences hard times, it must pay preferred stock dividends before common stock dividends, and in the case of liquidation, the company must prioritize reimbursing preferred shareholders. While both common stock and preferred stock are ownership shares, they differ in terms of voting privileges, dividend guarantees, and volatility. While shareholders of common stock have voting rights, shareholders of preferred stock often do not. Preferred stock pays a guaranteed dividend that does not change based on market value, while common stock may or may not pay a dividend. And finally, preferred stock prices are less volatile than common stock prices, and, like bond prices, preferred stock prices decline when interest rates rise. You can read more about the differences here.

What are classes of stock?

Some companies issue stock in multiple classes (Class A, Class B, etc.). These typically have different voting rights and are set up to give key investors more control over the company. For example, Alphabet Inc. (Google) has three classes of stock. Class A provides 1 vote per share, Class B (held by insiders) provides 10 votes per share, and Class C provides no voting rights.

How are stocks categorized?

Stocks can be categorized in a number of ways, including by market capitalization (market cap), by sector, by correlation with the economy, by fundamental analysis, or by dividends.

By market cap

Market capitalization is a valuation metric of a company describing market size. It is calculated by multiplying the number of a company’s shares outstanding by the stock price. Companies are broken into the following categories by the size of their market cap:

  • Mega-cap: greater than $200 billion
  • Large-cap: greater than $10 billion
  • Mid-cap: between $2 billion and $10 billion
  • Small-cap: less than $2 billion
  • Micro-cap: less than $300 million
  • Nano-cap: less than $50 million

By sector

The Global Industry Classification Standard (GICS) was developed in 1999 by MSCI and S&P Dow Jones Indices to categorize stocks into 11 sectors based on what the companies do. These are:

  1. Energy
  2. Materials
  3. Industrials
  4. Consumer discretionary
  5. Consumer staples
  6. Health care
  7. Financials
  8. Information technology
  9. Communication services
  10. Utilities
  11. Real estate

By correlation with the economy

Stocks can also be categorized by their correlation or lack of correlation with the economy. Those that are correlated with the economy are called cyclical, while those that are not are called non-cyclical or defensive. Cyclical stocks rise when the economy is doing well and fall when it does poorly. This includes companies that sell items people buy when they have money to spare but cut back on when their finances are tight. Defensive stocks tend to perform more stably, independent of the market cycle. This includes companies that provide services (such as utilities) or sell items (such as food, beverages, and hygiene products) that people need regardless of how the economy is performing.

By fundamental analysis

Another popular way to categorize stocks is by fundamental analysis, separating them into either growth or value. Growth stocks are considered to have the potential to outperform the overall market for a period of time because they have room to expand or products expected to sell well (and often because they have been performing well up to the current moment). Value stocks are typically well-established companies with a current share price below what analysts think they are worth based on a particular financial ratio or benchmark.

By dividends

Stocks can also be categorized by their dividends. Stocks that pay a dividend are known as dividend stocks. These can be further differentiated by the number of consecutive years over which they have increased their dividends:

  • Dividend Achievers: 10 years
  • Dividend Champions: 25 years
  • Dividend Aristocrats: 25 years (and must be members of the S&P 500 index)
  • Dividend Kings: 50 years

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