So, you’ve got a friend who’s trading stocks and crushing it. Maybe they even doubled their money in a week. (Of course, they skipped telling you about the time they lost their shirt on a hot stock tip.) But still, with all the hype, you might feel like you’re missing out on easy money.
Okay, before you dive headfirst into the market, let’s take a look at what stock is and how it works. Because the first rule of investing is to never invest in something you don’t understand.
Most of the stocks bought and sold by slick stock brokers in three-piece suits or by twentysomethings constantly checking their phones are what’s known as common stock. Common stock is an investment that represents a share (or tiny piece) of a company that can be bought and sold. Common stocks are also known as common shares, ordinary shares or voting shares. But really, most people just call it stock.
Stock market investing is one of the best ways to build wealth for the future. But there’s a better way to use the power of the stock market than investing in single common stocks. We’ll get to that later. First, let’s dig into everything you need to know about common stock.
How Does Common Stock Work?
Companies issue common stock to raise money to pay for expansion projects or to cover the costs of running the business. When you buy stock in a company, you become a partial owner of that business. But before you shoot off an email requesting a corner office or reserving the company jet, just know that companies often issue millions—if not billions—of shares of stock.
For example, Apple has issued more than 16 billion shares of stock. So, if you own one share of Apple common stock (about $170 per share as of April 2022), you own 1/16,000,000,000 of the company. That’s like owning one grain of sand in a big ole sandbox. You won’t get executive perks when you own stock, but that grain of sand, as small as it is, does come with some rights.
When you own common stock, you get certain shareholder rights. These rights change from company to company, but some basic ones include:
- The right to vote for board members at the company’s annual meeting
- The right to share profits (in the form of dividends)
- The right to vote for major changes (like mergers and stock splits)
- The right to transfer ownership (by selling your stock)
Normally, each share of common stock equals one vote. So the largest shareholders still end up making the decisions. The votes of an average investor with a few hundred—or even a few thousand—shares of common stock don’t count for much in the grand scheme of things. Many small shareholders don’t even vote.
To make things even more complicated, some companies divide their stock into classes, usually labeled by letters—like Class A, Class B and Class C. Most of the time, stock classes are related to voting rights.
For example, a company might give Class A stock to executives or key investors and include multiple votes per share. This gives executives more voting power so they can keep control of the company.
Class B shares would be sold to the general public and include the normal one vote per share. Class C stock might have no voting rights at all.
While voting rights are different between the stock classes, if the company decides to pay a dividend on its profits, each class usually gets the same amount per share.
How Do You Make Money Investing in Common Stock?
So, all that stuff about voting and share classes sounds pretty boring. How do you actually make money on stocks? Well, there are basically two ways: collecting dividends or selling your stock for more than you paid for it.
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Dividends are payouts companies send to stockholders to share profits. Companies aren’t required to pay dividends—in fact, many pay low or no dividends and reinvest that money into growing the company. And seriously, many companies that do pay dividends might give you just a few cents per share.
Because of this, most investors who buy and sell common stock are looking to earn profits when the price of the stock increases. It all goes back to the old saying: Buy low, sell high.
Let’s say you buy 100 shares of Widgets R Us for $10 a share. The company posts a good quarterly profit report, and its share price goes up to $12. Your $1,000 investment is now worth $1,200. If you sell your stock, you’ll earn a $200 profit—not too shabby.
But the reverse could also be true, and you might just as quickly lose $200 if the value of the stock falls. That’s why investing in single stocks is risky.
Keep in mind, profits or losses aren’t set in stone until you sell your stock. So, if your stock goes down to $8 but you still own it, you have what investors call a 20% loss on paper. It isn’t an actual loss until you get rid of your stock.
What Causes Stock Prices to Go Up or Down?
At this point, you’re probably wondering, What makes stock prices go up and down?
Each day, millions of shares of stock change hands through the stock market. And all that buying and selling causes prices to rise and fall. If lots of investors are buying a certain stock, that’ll cause the price to rise. But if more investors are trying to sell instead of lining up to buy, then the price of that stock will drop.
So, what makes investors want to buy one stock instead of another? Demand for a stock is driven by things like a company’s earnings and profitability. But there are hundreds of other reasons why people do or don’t invest in companies, and that all affects price. If the U.S. economy is going through a downturn, stock prices could fall across the board.
Stock prices often go up and down based on guesses about how companies are performing or how they’ll perform in the future. Maybe they’re in an up-and-coming industry or in an industry that seems to be on the decline.
In other words, prices are unpredictable, and that’s another reason why investing in single stocks is risky.
Alternatives to Investing in Common Stock
When it comes to your retirement investments, investing in single shares of common stock is just too risky because stock prices fluctuate from second to second. Today’s hottest company could be tomorrow’s Enron (a giant energy company that went belly-up in 2001).
When you invest in single stocks, you’re putting all your eggs (your hard-earned money) in one basket (a single investment). If that basket breaks, you’re left with a mess on your hands—and no money saved for retirement.
And that guy who told you he hit it big in the stock market? That’s just a fishing story. He’ll tell you about the huge one he caught, but he won’t mention the times he lost big.
So, how do you avoid getting stuck holding stocks from companies that have ended up in the toilet? The answer is to diversify. Diversification just means spreading out your money into different investments, which lowers your risk while still allowing your money to grow.
The best way to diversify (and still use the power of the stock market to build wealth) is to invest in mutual funds.
What Are Mutual Funds?
Mutual funds are professionally managed investment portfolios that allow investors to pool their money together to invest in something. A typical mutual fund has stocks from dozens, sometimes hundreds, of different companies—so when you put money in a mutual fund, you’re basically buying bits and pieces of all those companies.
Some of those company stocks may go up while others go down, but the overall value of the fund should increase over time. Even if one company in the fund totally tanks (like Enron), the other companies your fund is invested in will help balance it out. And as the value of the overall fund goes up, so do your returns!
No matter what’s happening with the stock market, our advice is the same: Invest in the right mix of good growth stock mutual funds with a history of strong performance, and stick with them over time. Diligently investing your money, little by little over time, is where real, lasting wealth comes from. Simply put, the best way to get rich quick is to get rich slow.
Common Stock vs. Preferred Stock
There’s one more type of stock you might hear about—preferred stock. Preferred stock is kind of like a mix between a stock and a bond. It normally has no voting rights, but it pays regular dividends similar to bond interest payments.
People normally buy preferred stock when they’re looking for an investment with stable returns. Preferred stock prices don’t change as quickly or dramatically as common stock prices, so it’s seen as a safer investment. It usually doesn’t grow much and stays close to the issue price.
Another feature of preferred stock is that it’s often callable. This means a company can buy the stock back from you (whether you want to sell or not) when they decide to change its dividend terms.
On the surface, preferred stock has some benefits that might seem more appealing than common stock or bonds. But when you dig a little deeper, you can see that preferred stock is really the worst of both worlds—it doesn’t have the potential for growth that common stock has . . . and it doesn’t have the security that makes bonds appealing to some investors.
Your best bet is to steer clear of preferred stock entirely. It’s just not worth the time or effort.
Work With a Financial Advisor
You don’t have to camp out on the trading floor of the New York Stock Exchange to get smarter about your investments. Mutual funds are a straightforward, affordable way to begin investing for the long haul.
If you’re ready to take control of your financial future, then it’s time to sit down with a SmartVestor Pro. You can work with your SmartVestor Pro to select your funds, create a long-term investing strategy, and stick with that strategy whether the stock market is swinging up or down. Your pro will help make sense of your investing options and walk you through the process so you can set real goals.
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This article provides general guidelines about investing topics. Your situation may be unique. If you have questions, connect with a SmartVestor Pro. Ramsey Solutions is a paid, non-client promoter of participating Pros.