In short, stock is ownership of a company. For any investor, the term stock should be a familiar one. You know you have them, or probably should have them to some extent, but what does owning a stock, or several (potentially thousands of) stocks actually mean?
The basics about Stocks
An easy way to think about stocks is to think of just about any business. When a business is started, it might be started by a single individual or several people. If several owners are involved, they each will own a share of the business, likely proportionate to the amount of money they contributed to get the business up and running. These shares are known as stock. And anyone owning stock in the company is called a shareholder or stockholder.
As the company grows, they may need to bring on additional investors in order to raise more money for things like expansion, production, new buildings, etc. Those new investors will want a share of the company as well, in exchange for their investment. So new shares are issued and ownership is divided between more individuals or entities.
Going Public, a.k.a. The IPO
When/if a company decides to go public, it issues new shares that become available to the public through a stock exchange, like the New York Stock Exchange, for example. At this point, virtually anyone with access to a brokerage account is able to invest in the company. Anyone that buys a share of stock in a company becomes a fractional owner of that company. Ownership of stock in a company means you now share in the earnings, or profits, of that company.
Today’s earnings play a big role in the price of each share of a company’s stock. But a much bigger factor driving stock prices is the potential future earnings, or lack thereof, for a particular company.
Things get complicated when you add human emotions and forecasting to the mix, but that is why stocks are a particularly volatile type of investment, specifically in the short-term. That said, the ability to share in the profits of successful businesses over long periods has historically been one of, if not THE most, effective ways to build wealth over time.
How does this apply to my retirement account?
Retirement accounts like 401(k)s offer a menu of investment options for employees (participants) to choose from. These investment options are most often known as mutual funds. A mutual fund is a type of investment that owns hundreds or thousands of stocks and or bonds, and sometimes other things.
Because the mutual fund itself owns shares of many different companies, someone buying one share of a mutual fund is effectively able to own fractional shares of each company that mutual fund holds in its own portfolio. These investments, which are often an employee’s only option in a workplace retirement plan, provide broad diversification without the need to own whole shares of a bunch of individual companies.
A brief example of how stocks work
Let’s say you have $100 to invest right now. If you want to buy some stocks, most brokerages will require you to purchase whole shares of each stock, meaning you have to buy at least one entire share of each. Oh, and there is often a commission for each trade. So if you want to buy one share of a company whose share price is $50, and the commission for that purchase costs $7, once you make the purchase, you only have $43 left to buy more stock(s). And remember, you only own one single share of one single stock so far…This means your ability to grow that $50 is completely dependent upon the success of that single company over time.
If you instead invest the whole $100 into a mutual fund in your retirement plan at work, that $100 will represent small fractional ownership of each of potentially thousands of individual companies held in the fund’s portfolio. While there are still fees associated with mutual funds, these fees are internal and will generally represent a significantly smaller percentage of your $100 investment than the commission charged, per individual stock transaction, by a brokerage.
The failure or success of any single company the mutual fund owns is unlikely to make or break your account balance over time. In other words, you’re instantly diversified, reducing your risk of loss significantly, while giving you access to the potential long-term growth of each of those companies.
Why stocks can be great for long-term investors
While stocks can give investors a bumpy ride from time to time, they have averaged annual returns of about 10% over the last century, which is about twice what bonds have offered and 10 times more than a high yield savings account might offer today. There are years when stocks perform much better or worse than the average, but over time stocks held in a diversified portfolio have historically managed to reward investors willing to take the risk and stick to a long-term, disciplined investment strategy.
To be clear, there is a very important distinction to be made between holding individual stocks and holding stock mutual funds, index funds, or ETFs in a portfolio. Individual stock holdings carry significantly higher risk than more diversified options like stock funds. In fact, according to a study from 2018 in the Journal of Financial Economics – since 1926, 4 out of every 7 individual stocks have experienced lifetime buy-and-hold returns less than one-month treasuries, which are generally one of the lowest risk, lowest return investments around.
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Investing involves risk. Your investments are subject to loss of principal and are not guaranteed. Investors should consider their ability to continue investing through periods of fluctuating market conditions. Diversification doesn’t guarantee a profit and can still result in losses in declining markets. The information does not represent a recommendation to buy or sell securities.
Published on November 18, 2019