Stock

A stock is a security that represents part ownership of a company. The Securities and Exchange Commission's own investor education describes stocks as securities that give stockholders "a share of ownership in a company," and notes that they are also called equities. Three words get used almost interchangeably with slightly different emphasis: the stock is the security, a share is one unit of it, and equity is the ownership interest itself. What the owner actually holds is a residual claim. Everything the company owes to lenders, suppliers, employees and bondholders is settled ahead of the stockholders, who receive whatever is left rather than a promised amount.

The residual claim is the single most important fact about the instrument, and the SEC states the consequence plainly: if a company goes bankrupt and its assets are liquidated, bondholders are paid first, then preferred stockholders, and common stockholders "get whatever is left, which may be nothing." That ranking cuts both ways. Because no one has promised the stockholder a fixed payment, there is no ceiling on what the claim can become if the company grows, and no floor either. The SEC characterises stocks as offering "the greatest potential for growth (capital appreciation) over the long haul," while also recording that large-company stocks as a group "have lost money on average about one out of every three years."

Ownership carries two kinds of right. The economic right is a claim on earnings, which reaches the owner either as dividends the board declares or as a higher price another buyer will pay for the same claim later. The governance right is a vote, ordinarily at the annual shareholder meeting, on directors and certain corporate questions. Common stock normally carries both. Preferred stock usually trades the vote away in exchange for priority, receiving its dividends before common stockholders do and ranking ahead of them in a liquidation. Beyond that one sentence the two are different instruments with their own mechanics.

Where your money goes when you buy is widely misunderstood, and a pair of SEC definitions settles it. A primary market is one "in which newly issued securities are sold to investors and the issuer receives the proceeds." A secondary market is one of the "markets where existing securities are bought and sold," between investors. So a company receives cash when it issues shares, which it may use to pay off debt, launch products, or expand. Buying 100 shares of a large public company today happens on the secondary market and pays the investor who sold them, leaving the company's balance sheet unaffected. This is also why a single company's stock is the riskiest common way to own equity. One issuer can fail for reasons that have nothing to do with the wider market, whereas a fund holding hundreds of issuers cannot lose everything to a single bankruptcy. Diversification addresses that specific risk and does nothing about the risk that the whole market falls.

A company divides its ownership into a fixed number of shares outstanding. Buy some and you own that fraction of the company, with a proportional claim on its earnings and, for common stock, a proportional vote. Returns arrive in two forms, price change and dividends, and neither is promised. Nothing about the arrangement obliges the company to pay you, buy your shares back, or return your money on any date.

A hypothetical example. A company has 10,000,000 shares outstanding, and Marcus buys 500 of them at $30, investing $15,000 for 0.005% of the company. During the year the board declares a dividend of $0.60 per share, paying him $300. The shares end the year at $34, so his stake is worth $17,000. His total return is $2,000 of appreciation plus $300 of dividends, or $2,300 on $15,000, about 15.3%. Two details in that example matter more than the number. His $15,000 went to the investor who sold him the shares, not to the company. And if the company had instead been liquidated during the year, its lenders and any preferred stockholders would have been paid from the proceeds before Marcus received anything.

Pros

• Ownership of a productive business, with a claim on earnings that can grow for as long as the company does and no fixed upper limit.
• Two independent sources of return, price appreciation and dividends, one of which can arrive as cash without selling anything.
• Shares in public companies are generally easy to buy and sell while the market is open, at a price anyone can look up.
• Common stock carries a vote, so ownership includes a say in who runs the company.

Cons

• The claim is residual. In a liquidation, common stockholders are paid last and can receive nothing at all.
• Prices move for reasons inside the company and for reasons entirely outside it, and there is no guarantee of a positive result over any period.
• Nothing is promised. A company can cut or eliminate a dividend, and can do so without warning.
• A single company's stock concentrates risk that a diversified fund spreads, which is why one holding growing into a large share of a portfolio is a problem worth noticing.