Understanding Stocks and the Stock Market

Understanding Stocks and the Stock Market

You can gain financial freedom by investing in stocks, but first you need to understand what shares are and how the stock market functions. Find out right here.
Updated: Jan 20, 2022
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7 min read

The investment tools available for people to retire earlier are more abundant today than ever before. One of the most popular ways people do this is through investing in stocks. This first guide from Invezz answers the most basic questions around stocks and the stock market.

I. Understanding stocks – what is a stock?

A stock represents the ownership interests of an investor in a public company. Investors can trade stocks over an exchange to cash in on the price growth of the public company. A stockholder is an entity or individual with ownership interests in a company. Stockholders often have limited powers in terms of controlling the company, unless they own a significant volume of stocks.

One of the most popular ways for a company to raise more money is by going public, which is essentially offering the general public the opportunity to buy a part of that company.

Companies go public through what is known as an initial public offering, commonly referred to as an IPO. An IPO entails the process that a company follows to offer a share of its ownership to the public. Often, just a few individuals and/or entities own a typical private company. In an effort to raise more capital, the private corporation can opt for an IPO, where investors and the general public buy into the firm.

Investors who participate in the IPO acquire a stake in the company. After acquiring ownership, investors become termed as stockholders/shareholders of the company. Once the private corporation completes the IPO process, it becomes known as a public company.

II. The different types of stock

There are two primary types of stocks. Each type of stock provides certain rights to the stockholder.

On the one hand, common stock allows the stockholder the right to influence the general direction of the company through voting. For instance, common stockholders can choose the directors for the company’s Board of Directors. In addition, common stock investors can sometimes receive dividends. In the UK and across some commonwealth jurisdictions, the common stock goes by the name ordinary shares/stock. Indexes like the Dow Jones, the FTSE, and the S&P 500 track the performance of common stocks.

However, there is a catch for common stockholders. Part of the pitfalls of holding common stock is the capital risk. This means that holders of common stock face losses if the company loses value. Further, in the rare instance of company failure, holders of common stock are considered last when sharing whatever assets of the company left. In addition, common stockholders might not receive any dividend if the company performs below expectations.

On the other hand, you have preferred stock. Unlike common stock, preferred stock does not confer voting rights to stockholders. Instead, these stockholders have access to a non-fluctuating dividend at a given time interval. Particularly, holders of preferred stock enjoy a higher priority in case the company becomes insolvent.

Preferred stock can be cumulative, where stockholders can receive their dividends after a period of missed payouts. On the contrary, non-cumulative preferred stock does not pay its owners missed dividends. In addition, participating preferred shares confer their owners the right to receive dividend payments that are higher than normal in case the company outperforms profit projections. Lastly, convertible preferred shares are those whose owners can convert to common stock.

Bottom line

Stocks help companies stay liquid and finance major groundbreaking projects. In addition, stocks help investors and other market participants compute the market capitalization of public companies. The total value of a company’s stock is the company’s market cap. Investors can thus distinguish small-cap stocks from mid-cap and large-cap stocks.

III. Stock market explained – what is a stock market?

A stock market consists of a collection of investors who buy and sell shares of publicly listed companies. Stock markets offer the framework for companies to issue a share of their company (stocks) and for investors to buy these stocks with the hope that their value will rise over time.

The stock market is the general term for the whole collection of stock exchanges, covered in this guide later. However, the stock market and stock exchange are sometimes used interchangeably, which adds another layer of complexity for those getting to grips with it for the first time.

Usually, the stock market is categorised as either primary or secondary. A primary stock market is a place where companies float their shares. This is the platform where companies offer to go public. Once investors take up the shares, they can trade them among fellow investors based on the prevailing market price. The secondary stock market constitutes the platform where investors trade shares amongst themselves.

IV. Different classifications of stock markets

Given the complexity of the stock markets, it’s can be hard at first to understand how they work. To make it simpler, stock markets are generally classified by a few standard groups. Each classification aims to make it easy to value the markets and to track their performance. Some features by which stock markets are classified include:

1. Organisation of a trade

The stock market is huge, and trades are organized differently. Normally, there are strict rules and regulations that govern the trading process. However, there is a section of the market where traders can determine the conditions of trade amongst themselves. This is what is popularly known as the over-the-counter (OTC) market. Such a platform is available for private companies that are privately held.

2. Circulation of stocks

A stock market is classified as primary if the investor is buying stock from a company that has just issued shares for the first time. The stock market is primary at the IPO stage. Investors can then resell the stock to other investors through the secondary stock market.

3. Issuers

If government entities are the issuers of securities, the accompanying stock market is termed as a government securities market. On the other hand, the market is termed the corporate securities market if the issuers are private corporations.

4. By geography

A stock market can be national, regional, or international. This classification depends on the area in which the distribution of financial resources takes place. If the market operates within sovereign boundaries, then it is a national stock market. Some stock markets serve international investors, and as such, they are international stock markets.

As explained earlier, stock markets are comprised of a network of stock exchanges. Some of the most popular stock exchanges include the New York Stock Exchange (NYSE), Euronext N.V., the Hong Kong Stock Exchange, and the OTC Markets Group, among others.

Sources & references
Risk disclaimer
Harry Atkins
Financial Writer
Harry was a Financial Writer for Invezz, drawing on more than a decade writing, editing and managing high-profile content for blue chip companies, Harry’s considerable experience… read more.

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