What are stocks and how to earn on them
Let’s delve into the details of what stocks are, the rights they provide, and how their owners generate profits.
What is a stock? A stock is a type of security issued by a company, also known as a corporation. When investors buy stocks, they become partial owners of the company. The stock itself serves as proof that its owner holds a stake in the company, even if it’s a small one.
What do stocks provide to their owners? You may have heard the term “controlling stake in stocks” – in movies, villains often cunningly acquire a company by obtaining 50% plus one share. Although the villain is not the sole owner, they still gain control over the company because they hold the majority of its shares.
However, even if you purchase a small fraction of a company instead of a controlling stake, you become a shareholder and enjoy certain rights. The main rights include:
- Voting rights at shareholder meetings, allowing you to participate in the company’s governance (if the stock is a voting share).
- Entitlement to dividends – a portion of the company’s profits (if dividends are paid).
- Right to claim a portion of the company’s assets in the event of its liquidation.
Why is the right to vote important? It’s because crucial decisions are made at general shareholder meetings, including those regarding the company’s liquidation or restructuring. The shareholder meeting determines how to allocate the year-end profits, whether to reinvest them entirely in the business or distribute a portion as dividends.
What are the types of stocks?
Stocks of companies can be classified into two main types: common stock and preferred stock. The differences lie in the two primary rights associated with stocks: voting rights and dividend entitlement.
Common stock: This is the most common type of stock. It grants shareholders the right to vote at shareholder meetings but does not guarantee dividend payments.
Preferred stock: Preferred stockholders have a predetermined dividend rate, such as a percentage of the company’s profits. Their ability to participate in voting is usually conditional on not receiving dividends for the previous year.
There are also special types of preferred stock that are occasionally encountered:
Non-voting preferred stock: It has a fixed dividend and priority in receiving payments but does not grant voting rights.
Preferred stock with special rights: The terms of dividend payment and participation in voting are outlined in the company’s bylaws. For example, holders of such stock may have the ability to vote, receive priority in dividend payments, and have the right of first refusal for purchasing new stock issuances. The bylaws can specify any other rights that the company wishes to provide to the stockholders.
The type of stock determines whether and to what extent dividends will be paid to its owners. If a shareholder meeting decides to allocate a portion of the company’s profits to dividend payments, it is first distributed among the holders of non-voting preferred stock. They are entitled to a fixed dividend amount, either as a specific sum or a percentage of the nominal value of the shares. Owners of non-voting preferred stock participate in voting only in cases involving the liquidation of the corporation.
Next in line for dividend payments are the owners of regular preferred stock. The dividend amount for these stocks can be a specific sum or a percentage of the stock’s nominal value. More commonly, it is determined as a percentage of the company’s net profit for the year, divided by the number of preferred shares. The dividend calculation method is typically outlined in the company’s bylaws. Owners of such stock cannot vote when dividends are being paid out. However, if dividends were not accrued, they regain the right to vote on all matters at the next meeting.
A single corporation can have multiple types of preferred stock, including those with special rights. The bylaws of the company should clearly define the dividend payment priority for stockholders. Therefore, it is important to carefully review the bylaws of the corporation before purchasing preferred stocks.
Owners of common stock may receive dividends only if the company fulfills all obligations to preferred stockholders.
After dividend distributions, payments are made simultaneously to all categories of shareholders in the company.
What do stocks look like?
Strictly speaking, stocks have no physical appearance. Due to cinematic and literary stereotypes, the word “stocks” is usually associated with a beautiful heraldic certificate. However, today stocks are not luxurious pieces of paper, and they are not printed at all. In official terms, they are non-documentary, meaning they exist solely in electronic form.
How are securities accounted for?
The accounting of securities depends on who is responsible for it. If your securities are held by a depository, your ownership rights are confirmed by a statement from your depository account. This account is personal to you and indicates the securities you own.
If the accounting is done by a registrar, to confirm your ownership rights, you would need to request a statement from your individual account with the registrar. This statement would specify the number of shares you hold in a particular company.
If your assets are managed by a trustee, the shares are held in their depository account or individual account with the registrar. You cannot directly request a statement from the depository or registrar, but you have the right to demand a report of transactions from your trustee at any time.
Why buy stocks?
There are several reasons why people buy stocks:
- Participation in company management: By purchasing a package of shares, you can have a say in the company’s decision-making process and participate in its management. However, this is less common compared to other reasons.
- Dividend income: If a company generates profits and its shareholders approve the distribution of dividends, you will receive a portion of the profits for each share you own. However, there are no guarantees that you will receive dividends. If the company operates at a loss or the shareholders decide not to distribute profits, you may not receive any dividends. Investing in stocks involves risks.
- Capital appreciation: Investors buy stocks with the expectation that their value will increase over time. When you sell the stocks at a higher price than what you paid for them, you can make a profit. However, it’s important to consider transaction costs such as fees to the depository or registrar, brokerage commissions, and capital gains taxes when selling stocks. It’s also important to note that investing in stocks carries the risk of potential losses if the stock price declines. The stock market is inherently unpredictable and risks are always present.
It’s crucial to assess your risk tolerance, do thorough research, and diversify your investment portfolio to mitigate risks when investing in stocks.
Where can you buy stocks?
You can buy stocks either on an exchange or over-the-counter (OTC). Trading on an exchange is more transparent as you can easily track the stock prices and other market data. When you buy or sell stocks directly over-the-counter, there is a risk that the prices may be overvalued or undervalued compared to the market prices.
Moreover, exchanges thoroughly assess the issuing companies. You are unlikely to find stocks of blatant fraudsters listed on the exchange. For other securities, the exchange assigns an important attribute called listing level after conducting an evaluation.
The second quotation list has lower requirements compared to the first list. However, all companies whose stocks are eligible for inclusion in the first or second list must regularly report to the exchange about their performance, publish financial statements, and provide other important information about themselves on the internet.
The third level consists of the non-quotation part of the list with the lowest requirements. If you intend to buy securities of a company from the third level or a company that is not listed on the exchange at all, you will have to independently assess its reliability. This can be challenging even for experienced investors.
What risks can you face when buying stocks?
Investing always carries risks, and the level of risk is proportional to the potential return of the securities. There are three main risks that investors may face:
- Market risk: This means that the prices of securities can rise or fall. Market risk is determined solely by the market’s law of supply and demand. For example, if a company discovers a new oil, gas, gold, or palladium field, its stock prices are likely to increase. Conversely, if a financial company has its license suspended, its securities will sharply decline in value.
- Liquidity risk: This refers to the possibility that the securities you purchase may be difficult to sell. Either no one may be willing to buy them, or if they agree to buy, it may only be at a significant discount, i.e., a heavily discounted price. “Blue-chip” stocks of the largest and most reliable companies can be sold within minutes if desired. However, there may be little demand for stocks of lesser-known companies like “Pupkin & Co.”
- Credit risk: This is the risk that the issuing company may go bankrupt, leading to a sharp devaluation of your securities. However, after the bankruptcy procedure, you may still be entitled to a share of the company’s assets.
In addition, due to sanctions, there is a risk for investors of having their foreign stocks frozen abroad. In such a situation, you will be unable to sell your securities and receive dividends from them.
If circumstances unfold unfavorably and these risks materialize, you may lose your money. That is why investing in securities is suitable only for those who have already established a financial safety net and fully understand all the risks involved.
To conclude, here are some recommendations for novice investors:
- Don’t invest your last money in the securities market. First, establish a reliable financial cushion by depositing 3 to 6 months’ worth of income in a secure bank account.
- Remember the direct relationship between risk and return. If certain stocks are rapidly increasing in price (or you believe they should skyrocket), it also means that they can plummet just as rapidly (or not rise at all).
- Don’t put all your eggs in one basket. If you decide to invest in stocks, choose several companies, preferably from different industries.
- Stay informed about what is happening with the companies you have invested in and the prices of their securities.
- If monitoring the stock market on your own seems too complex or time-consuming, you can explore other options, such as entering into an agreement with a fund manager or buying shares in a mutual fund that invests in securities.