STOCKS

Everyone has heard about the stock market, stock trading, and Wall Street. But not everyone knows what that means beyond a way that savvy investors make a lot of money (or lately, help bring about the recession that’s plaguing the world). Well this article will help explain exactly what stocks are and how they relate to the economy.

Stocks representing ownership in a company

The first thing to understand is that a stock represents ownership in a company. A corporation will create a pool of stock that has a certain value. As an example let’s say that a new company decides to sell stock. They value their pool of stock at $100,000 (This is what they value the company at). They then decide how many shares of stock they want to sell; this decision is based on how big of chunks they think investors will want to spend on their shares of stock. This company decides that they want their stock to be fairly cheap at only $25 per share so they have a total of 4000 shares ($100,000 total / $25 per share).

Each one of these 4000 shares of stock represents owning 1/4000th of the company. Corporations have a large amount of requirements they have to follow under the law, one of these being the right for shareholders to vote on the functioning of the company. Under these laws, if someone owns 2001 shares of stock for this new company, they own a majority of the company and can make decisions that affect the company. If a company is issuing new stock they will likely want to keep the majority of the ownership in their company in the hands of their managers. So while they may create 4000 shares of stock, they may only attempt to sell 1999 of those so they keep the majority in their own hands and can run the company how they want.

The next question is, why would a company want to issue stocks at all?

Stocks as a source of capital

There are two main reasons a company may issue stocks. The first is that the owners would like to sell the company including all control of it by “going public”. The second reason is that the managers of the company believe that, in order to grow more quickly, they need more money. Stocks provide this increased source of money because investors are willing to buy the stocks with the expectation that they will go up in value in the future.

Stocks as investment

So we have given a quick breakdown of what exactly stocks mean for a company, now it’s time to explain what they mean for the people buying the stocks. Everyone who buys a share of stock is doing it as an investor. They are buying the stock right now with the expectation that they will get more money out of it in the future than they put in. These investors can be split into two groups: the first is small investors who may buy the stock as part of an investment portfolio or based on a tip from a friend. The second group is one that buys a very large amount of stocks from a company in an attempt to gain some control or a large voting share. These groups generally consist of holding companies or rich individuals who have a lot of experience in managing a company successfully and believe they can put that experience to use by gaining control of a company through stock purchases.

Stocks have two ways of providing money to the investor. The most basic is through equity, since a stock represents an owning share of the company, it will increase in value if the company is successful. If a company is successful, a stock that was purchased for $25 may be worth $500 in the future. Investing based on this can be very difficult because it’s extremely hard to predict how a company will do in the future.

The other way that stocks provide value to investors is through the payment of dividends. Dividends are payments that companies decide to make at the end of the year to shareholders. For example, an investor has 100 shares of the new company used in the example above. This company made $6000 in profits this year and decides it wants to give out $4000 of that to the shareholders. They split this equally between all shares (4000 total shares) and every shareholder gets $1 per share they own. So this investor will get a check for $100 from the company for the 100 shares he owns.

The risk of stocks

Everyone has heard stories of people making a fortune from selling stocks. These stories always have a different side where another investor may have lost a fortune on the stock market. The stock market follows the same risk / reward principle that all other investments follow. This means that the more money an investor can potentially make from an investment, there is also a larger chance of that investor losing money. Stocks are on the high end of this risk / reward scale, they can provide great profit for an investor, but at the same time the investor could lose all of their money if the company goes out of business.

Types of stocks

This risk can be somewhat mitigated through the purchase of different types of stock. When a company goes out of business it goes through a bankruptcy process. The purpose of bankruptcy is to attempt and get money to anyone that the company owes money to. There is an order of who gets their money back and the very last people to receive any money from a bankrupt company are stock owners.

Every example used above has been in reference to the most common type of stock: