Stocks, or equities as they’re also known, represent partial ownership of a company and an opportunity to partake in its successes (and failures) over time. A key tool for growing savings and achieving long-term financial goals like retirement, stocks are one of the core investments many use to build a diverse portfolio. But it’s important to understand what stocks are and how they work before jumping in with both feet.
By selling shares of their company, public companies can raise capital and grow their business. Investors then buy these shares, and if the price increases over time, they can see capital gains. But if the share price falls, you can lose some or all of your investment.
The price of a stock can rise or fall for a number of reasons, including economic trends, government policies, changes in corporate performance, or just investor sentiment. But a stock’s price is ultimately determined by supply and demand, which can be measured by its market capitalization. This value is calculated by multiplying the number of outstanding shares by its current price.
A company can issue additional shares by selling them to investors, which can dilute existing shareholders’ ownership stake. This is often done if the company needs cash to grow or pay a dividend. However, a company can also buy back its own shares, which is an effective way to return money to shareholders.
Some of the most popular tools used by investors to evaluate stocks include analyst reports and valuation techniques, such as price-to-earnings ratios, price-to-sales ratios, and price-to-book values. These methods are meant to help investors determine if the company’s stock is priced at fair or overvalued relative to its peers.
Valuation methodologies vary by industry and company, since different businesses make money in very different ways. For example, banks accumulate assets, so their stock is typically valued by price-to-book values; while retailers are usually valued by sales or price-to-sales ratios.
Another benefit of owning stocks is that, unlike partnerships, you are not personally liable for the company’s debts if it fails. This limit on personal liability is called limited liability and helps protect investors from losing their entire life savings if the company goes bankrupt. However, it is worth noting that even when a company pays its debts in bankruptcy, you can still lose some or all of your investments, as bonds have priority for repayment before equity. This is why diversifying a portfolio with both stocks and bonds is an important part of investing. Bonds offer a safer investment than stocks, as they’re less vulnerable to interest rate fluctuations. But they still have a higher risk than stocks, so you should always consider your level of comfort with risk before making any purchases. The good news is that over the long term, stocks have historically offered better returns than bonds. This means that, with the right plan and due diligence, stocks can be a great addition to your portfolio.
