Stocks Basics: How do Stocks Work?
Having a source of passive income is not only convenient but also assures a source of livelihood even in times of sickness. And what better way to supplement your active with earnings from stocks. The chief reason of investing in stocks is to reap big in the future as Warren Buffett puts it.
If you are new to stock trading and you are wondering how stocks work, this is the right article for you. We will look at all that encompasses stocks. So, let’s gets started.
What is a stock?
Different types of stock
Companies have a wide range of stock that you can buy. With each category, comes different privileges such as voting rights, right to recoup principal investment, and dividend payouts, among others. Here are the most common types of stock.
1. Common and preferred stocks
This is the most common among investors. It represents fractional ownership in a company. Shareholders can therefore get a certain portion of the company’s value should it go under the water. While they give shareholders unprecedented control, they are at a higher risk of losing their investment if the company gets dissolved.
On the other hand, preferred stock guarantees shareholders of returns should the company dissolve. It gives them more privilege compared to normal shareholders. Besides, shareholders with preferred stocks receive dividends before other shareholders. This stock is however not common in most companies as shareholders are interested in common stocks.
2. International and domestic stocks
As the name suggests, domestic stocks are those whose company headquarters are within your country. However, this is not always straightforward since it is hard to tell where some companies’ headquarters are located. This is especially the case with large multi-nationals.
3. Cap stocks (large, mid, small)
when referring to market capitalization, stocks can be categorized into large-cap, mid-cap, and small-cap. Companies with big market capitalization have large-cap stocks while smaller companies have mid-and small-cap stocks.
While these stocks have no distinctive difference, companies with a market capitalization of more than $10 billion are referred to as large caps. Those with a market capitalization of $2 billion to $10 billion are referred to as mid-cap stocks. Companies below $2 billion market capitalization have small-cap stocks.
Shrewd investors often invest in large-caps since they are more stable and have high returns. Small and mid-cap companies are thought to be riskier to invest in. however, some show potential for future growth.
4. IPO stocks
These are stocks of recently gone public companies. Every stock was once an IPO stock. They generate euphoria among investors as they look forward to a profitable company. However, this is not always the case as pivoting or disagreement between board members can inhibit the growth of a company.
Before investors can buy IPO stocks, the company has to meet U.S. Securities and Exchange Commission (SEC) requirements. with the help of underwriters, the company sets the initial price of a share which will be used on stock exchange.
5. Income stocks
While stable, they have a slow growth. That said, their payment is higher compared to other forms of dividends.
How do stocks work?
Companies sell shares because of numerous reasons, among them, to raise capital. This is especially true for startups. Established companies might use the money raised to launch and market a new product. Other reasons to sell shares include pay off debt and expanding operations.
Most behemoth companies had to sell shares in their formative years. Take Facebook as an example, started by Mark Zuckerberg in his dorm room, the company is now among the largest. To reach where they are, they had to sell shares to generate money.
How are share prices set?
The most common way of setting share prices is through auction. Here, buyers and sellers place their bids which either increases or decreases the value of the share. The trade is successful when the ask and bid price is the same.
Factors that affect the price of a share include:
1. Supply and demand
Once the company is listed on the stock exchange, trading of shares begins. If the company shows growth potential, it is more likely to attract buyers. This is return increases the price of its shares. On the contrary, companies with unpredictable or poor growth potential attract more sellers than buyers.
As such, its share prices plummet. Ideally, increased demand causes prices to rise while increased supply causes prices to fall.
2. Global happenings
Another aspect that affects share prices is global news. This can be political, economic, environmental, and others. For example, if political unrest erupts in a certain country, share prices of companies in the country will fall. However, some industries such as gas and petroleum are less likely to be affected by such news.
3. Herd Instinct
This happens when certain news breaks about a company. For example, if its something positive, most traders will buy shares. As the price rises, other traders are likely to join the trend, pushing prices higher.
Why should you buy stocks?
1. Financial growth
Companies grow as the economy grows. As such, they will have billions of shares in their disposal. This means regular traders like you and I can buy them improving our financial status. Besides, as the companies grow so do job opportunities.
2. Safety against inflation
It’s no doubt that stock markets have outperformed inflation guaranteeing traders of a safe investment option. As such, if you want invest that provides security for your future, you should buy stocks. Particularly those of blue-chip companies.
Stocks are one of the most liquid assets since you can easily convert them to cash. In addition, millions of people are willing to buy them in an instance. As such, should have emergency need for cash, you can sell your shares and get the money you need.
If you want investment that awards you unmatched diversity, stock market is your perfect choice. You can buy as many shares as you want from different companies. For example, you can divide buy stocks of 10 companies with $1000 if the share price of each is $100.
How can you buy stocks?
Here are different ways to buy stocks:
1. Through an online broker
You can buy company stocks through an online broker. Unlike traditional brokers, they come with fewer requirements when opening an account. Most brokers allow you to trade even with a minimum balance of $0. Besides, you get much-needed educational material and industry insider insights. They are also generous with industry happens through their newsfeed feature.
Unlike online brokers, robo-advisors do the legwork for you. They use algorithms to make investment decisions based on you risk tolerance. Betterment is the most popular roboadvisor in the market. it is easy to use and does not require prior trading experience.
Before it can make trading decisions for you, you’ll need to feed it with information about yourself. It will also ask questions to assess your risk tolerance.
3. Through your employer
If you want to learn trading ropes, buying stocks through your employer is an ideal option. It is also a perfect choice if you are on a tight budget. You can dedicate a small portion of your salary to buy shares every month.