Beginner’s Guide to Understanding Stocks

Think for a moment about some of your favourite things. No, this article is not about raindrops on roses nor whiskers on kittens, but think more about the items around your home or city that you use on a daily basis. We’re talking about things that make your life easier, or maybe more enjoyable. Perhaps your favourite beverage, maybe your car or just the clothes that you wear are good examples. Chances are that some of these things are provided to you through publicly traded companies. Now imagine that you actually owned the company that provides these items and services to millions of other people around the world. That is the amazing thing about buying stock. You can actually own a piece of that company and although it may be a small piece, you are an owner nonetheless.

Through buying stock, not only are you taking ownership in a company that you like and use on a regular basis, but you are investing in your own financial future. Of course, you should not simply buy a stock because you like a certain product or company, but it is a great place to start looking. Our articles on Making Your First Stock Shares Purchase and How to Research Stocks are great resources on the actual selection process and are highly recommended for investors without a lot of experience.

When one buys a share of stock, they are in essence buying a share or a piece of a company. At one time, shares were traded with actual stock certificates. However, it is rare to see a physical stock certificate these days. Instead, shares are usually held in trust electronically and transactions are made over telephone and computer networks.

Stock Holders Have Certain Rights

Holding shares of stock gives the owner certain rights, usually including one vote for every share owned. The vote is counted at shareholder’s meetings, where the board of directors and officers of the company present the company’s annual report. The report includes financial statements from the past year as well as forecasts for future growth. During the meeting, votes are taken on items such as board members and other pre-determined issues. Most shareholders do not actually attend the meetings, although all shareholders have the right to attend. Instead, many vote their shares by proxy. This is usually done either by mail or electronically on the internet.

Being a shareholder also entitles the owner to a share in the company’s profits if regular dividends are paid. Not all companies pay dividends, though. See our chapter on Buying Stocks That Pay Dividends for more information. You are not, however, guaranteed any profit or capital appreciation at all. In fact, in the extreme case of a company going out of business or being liquidated, stock holders are among the last to be paid, after bondholders and other creditors as well as preferred stock holders, and most often will receive no compensation at all

Understanding Preferred Stock

Preferred stock is another form of share ownership. While common stock (usually just called stock or shares) offers rights such as voting to the owner, preferred stock shareholders forego voting rights in return for other benefits. The most important benefit of preferred shares is dividend rights. Preferred shareholders must be paid dividends before dividends can be paid to common stockholders and often, preferred shares will pay dividends even if common shares of a stock do not. Preferred shares may also increase in value but are often traded much less often than common shares and usually do not appreciate at the same rate as common stock.

Where Stocks Are Traded

Most stock is traded on an exchange, such as the London Stock Exchange or the New York Stock Exchange. There are several major exchanges around the world and not every stock is listed on each exchange. Some stocks, however, are listed on multiple exchanges. This is most common with large international companies. For instance British Petroleum is listed on the New York Stock Exchange as well as the London Stock Exchange. Only certified stockbrokers, also called traders, brokers, brokerage firms, etc., are allowed to initiate stock trades. For that reason, if you want to buy or sell shares of stock, you must do so through a certified broker. There are many different UK stockbrokers and brokerage firms available either through a local office or from the comfort of your own home on the internet.

Over the Counter Stocks

Stocks that are not listed on any of the major exchanges are traded over the counter, or OTC. Most companies desire to be listed on an exchange, however, because OTC trading is limited. Limited trading creates liquidity issues, meaning that it may be difficult for a seller to find a buyer or vice versa. Poor liquidity leads to fewer people wanting to deal shares of that company and thus the price lowers. Lower stock price equals lower market capitalization of a company, meaning the company is worth less (on paper at least).

How Are Stocks Priced

Liquidity is one of the many issues that affect the price of any given share. Other factors include the strength of the company, its profitability, financial reports, overall market conditions and much more. There are a wide variety of key financial ratios and formulas that are used in analysing a company’s financial strength. Our chapter on Investing Terms and Ratios has more specific information on these formulas, many of which are not often used (if ever used) by the average investor, although they should be.

The overall market conditions can be one of the most difficult aspects to gauge in terms of evaluating stock. When the markets are doing very well, some stocks tend to be overvalued. Long periods of over-valuation can eventually lead to what is commonly known as a “bubble burst.” When the bubble bursts, the market as a whole will fall sharply; this is usually led by the overvalued stocks or industry.

The Dot-Com Bubble

For example, in the mid to late 1990’s the so called dot-com craze was very hot. Companies that had never even turned a profit were seeing their stock prices rise at incredible rates, with no real reason other than all of the other dot-com stocks were also rising. Millionaires were being made in very short time. Eventually, though, in 2001 the bubble burst. The market as a whole fell with the technology stocks and many dot-com businesses closed their doors for good. Most recently, markets in the United States, the United Kingdom, and others around the world are still recovering from the real estate market bubble, which burst in 2007. Worldwide markets were immediately dragged down sharply and economies have yet to fully recover.

Stock shares can be a very solid investment for many people. Those who should avoid stocks include short term investors and those who are generally averse to risk. For everyone else, though, stocks can offer income in the form of dividends as well as capital appreciation for long term wealth building. While it is possible to make money in the short term, there is much more risk involved and most novice investors will be much better served to take a long term approach. Read more about that in Short Term vs Long Term Investing. You can also find some options for Ways to Lower Risk in our chapter on that subject. There we discuss investment vehicles such as mutual funds and exchange traded funds. Both of these are another form of stock ownership that each offer instant diversification, one of the keys to reducing risk in the market.