Stock basics

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A stock share (also known as an equity share) represents ownership in a corporation.

The two familiar types of stock shares are "common stock" and "preferred stock." Owners of common stock typically have voting rights to elect board members of the corporation. In some cases, such as Ford Motors, there are two (or more) types of common stock. One class has the right to vote and the other does not. The Ford family created this dual-share class in such a way that they were able to maintain control of the company without being fully exposed to its risk as an actual majority shareholder.

Preferred stock typically has no voting rights but is legally entitled to dividends before other shareholders. Holding common stock in a corporation allows a shareholder the right to receive dividends from the company, and gives the shareholder a right to the company's assets during bankruptcy liquidation, though not before all creditors have been paid first. Holding stock may result in capital appreciation, as the demand for the stock goes up as the company grows its profits.

Note: Those looking for a "very basic" introduction to stocks should start with the tutorial at the bottom of this page.

Buying and selling

You can purchase individual stock through either direct investment with the company (through a dividend reinvestment plan, for example), or through a brokerage account. Buying and selling through a brokerage account usually involves a commission paid to the broker. Many discount brokerages offer commissions under $20, and some even offer free commissions for certain situations. Full service brokerages can charge anywhere from $50 to $200 a trade depending on their rates, the number of shares purchased, and how often you trade a stock.

When you place an order to buy or sell stock, you might not think about where or how your broker will execute the trade. But where and how your order is executed can impact the overall costs of the transaction, including the price you pay for the stock.[1]

While trade execution is usually seamless and quick, it does take time. And prices can change quickly, especially in fast-moving markets. Because price quotes are only for a specific number of shares, investors may not always receive the quoted price. By the time your order reaches the market, the price of the stock could be slightly – or very – different. No SEC regulations require a trade to be executed within a set period of time.

Just as you have a choice of brokers, your broker generally has a choice of markets to execute your trade such as: a specific stock exchange, a regional exchange, or a market maker.[note 1] When deciding how to execute orders, your broker has a duty to seek the best execution that is reasonably available for its customers' orders.

Classification of common stocks

Country

One classification of stocks is the country where the corporation is headquartered. Knowing where a stock trades is important because international investments can provide a diversification benefit to a portfolio invested solely in the domestic market.

All else being equal, you should see a diversification benefit from investing internationally because the equity markets in other economies are less-than-perfectly correlated with your own domestic equity market. However, investing in foreign markets also exposes you to fluctuations in foreign exchange rates. In the long term, currency movements should have no impact on the returns of a foreign portfolio, but in the short term these fluctuations can significantly impact both your portfolio volatility and your returns.

Stocks trade on stock exchanges all over the world, and trading stocks on an exchange in a different country from your own usually results in higher costs to buy and sell. This expense is greater if the company is located in a smaller or more underdeveloped country where the stock may not get traded frequently, resulting in even higher transaction costs.

In the U.S., an American Depository Receipt (more commonly known as ADR) is a type of stock traded on U.S. exchanges that represents ownership of a non U.S. corporation. ADRs allow U.S. investors the ability to more easily and cheaply buy stock in corporations from many countries.

A representative global index such as the S&P Global Broad Market Index illustrates the breakdown of the global equity market by country.

Sector

Stocks may also be classified by the sector of business or industry where the corporation makes its revenue and profits. MSCI and S&P have created the widely used GICS global system of business sectors. This divides companies into four levels: 11 sectors, 24 industry groups, 69 industries, and 158 sub-industries. The eleven sectors are:

 Global Industry Classification Standard (GICS) 
Communication Services
Consumer Discretionary
Consumer Staples
Energy
Financials
Health Care
Industrials
Information Technology
Materials
Real Estate
Utilities

For a detailed description of the GICS sectors, see: Global Industry Classification Standard (GICS®), from MSCI.

Size

Stocks may classified by the size of the corporation. This is most commonly done by market capitalization. This is simply a value calculated by taking a stock's current share price and multiplying it by the number of stock shares outstanding.

Exact market cap ranges will vary among different financial and rating institutions, but there are three different terms commonly used to describe stocks by their general size:

  • Large capitalization stocks: Large cap stocks have a market cap over $10 billion dollars.
  • Mid capitalization stocks: Mid cap stocks have a market cap between $2 billion and $10 billion dollars.
  • Small capitalization stocks: Small cap stocks have a market cap between $300 million and $2 billion dollars.

While these are the most common market cap references, there are also some less commonly used: mega cap, micro cap, and nano cap. Market cap terms are relative and change constantly as companies get bigger and smaller.

Style

Stocks may also be classified by "style," either value, blend, or growth. Growth stocks are companies that are growing their profits at a very fast rate and are expected to continue to grow at an increasing rate. Value stocks are stocks that tend to trade at deep discount relative to their intrinsic value (as defined by profits, book value, and so on). Investors commonly perceive growth stocks as "high flying companies" and value stocks as "distressed companies."

Both growth and value stocks have taken turns leading and lagging one another during different markets and economic conditions.[note 2]

Dividends

Dividends are payments a corporation makes to its shareholders. It is the portion of corporate profits paid out to stockholders. When a corporation earns a profit or surplus, it can put that money to two uses: the business can either re-invest it (called retained earnings), or it can pay it to shareholders as a dividend. Many corporations retain a portion of their earnings and pay the remainder as a dividend.[2] In other words, dividend payments are based on many factors, and decided by the corporation issuing the stock.

Risks

Figure 1. Risk vs. return[3]

Stocks are subject to the following risks:

  • Business risk -- A measure of risk associated with a particular security. It is also known as unsystematic risk and refers to the risk associated with a specific issuer of a security. A common way to avoid unsystematic risk is to diversify - that is, to buy mutual funds, which hold the securities of many different companies.
  • Financial risk -- Risk due to the capital structure of a firm. Corporate debt magnifies financial risk.
  • Liquidity risk -- The risk that an asset cannot be sold when desired due to a thin market.
  • Market risk -- Systematic risk faced by all equity investors due to market volatility. This risk can not be diversified away. This is the type of risk most people are referring to when they casually use the term "risk" with respect to investments, without qualification.
  • Political risk -- Risk to an investment due to changes in the law or political regime. Potential changes in tax law or changes in a country's structure of governance are sources of political risk.

In addition to these risks, international stocks are subject to currency risk.

As Figure 1 illustrates, these risks result in considerable volatility of returns.

Role in a portfolio

An investment in stocks gives you an ownership stake in the profitability of corporate business enterprise. By receiving the dividends and potential long term appreciation of equity value, you participate in the growth potential of capitalism. A diversified portfolio of stocks, invested for the long term, can provide a portfolio with an asset that has the potential to grow over time.

Figure 2 shows the long term global equity market returns over the past 100+ years. Over this period, equities have produced returns that exceeded those from bonds and cash. However, equity returns have large variations, and can trail bond and cash returns for extended periods (see Figure 3).[4]

Style boxes

Style boxes are based on the Fama and French three-factor model. They are 3 x 3 grids that categorize securities. Different investment styles have various levels of risk which leads to differences in returns. This visualization allows investors to compare securities using an easy-to-understand standardized format.

For equities (stocks and stock funds), securities are classified by market capitalization ("market cap") on the vertical axis, and value and growth factors on the horizontal axis.

Stock and stock fund style box
Investment style Market capitalization
Value Blend Growth
      Large
      Mid
      Small

Morningstar introduced the Style Box™ in 1992 to help investors determine the investment style of a fund.[6] Other fund providers, such as Vanguard, also use style boxes.[7][note 3]

Equity style boxes (stock funds) and fixed income style boxes (bond funds) represent two-dimensional (horizontal and vertical axis) views of risk versus return. However, the background behind these boxes is based on very different concepts. Only compare stocks-to-stocks and bonds-to-bonds.

Both equity and fixed income style boxes are a way to visualize how diversified your portfolio is with respect to the main characteristic of each asset class - size and value for equities; credit risk and term risk for fixed income.[8]

For example, you are interested in Vanguard's balanced funds, which contain both stock and bond funds. The style boxes show you a simple collection of colored boxes, and this can make asset allocation decisions easier.

Notes

  1. A "market maker" is a firm that stands ready to buy and sell a particular stock on a regular and continuous basis at a publicly quoted price. For more, see: Market Maker, from Investor.gov.
  2. The Callan periodic table of investment returns that visualises the performance of the different asset classes. In it, you can see the alternating performance of the growth and value stocks.
  3. Do not compare Vanguard's style box to Morningstar, as they have very different criteria for box style composition. See Bogleheads forum topic: "9-style box - Vanguard vs M*"

See also

References

  1. "Trade Execution". SEC. January 16, 2013. Retrieved August 13, 2023.
  2. See also: Dividend, from Wikipedia
  3. "Historical Behavior of Asset Returns". Duke University. Retrieved August 13, 2023.
  4. Larry Swedroe (February 21, 2012). "Embrace risk, but only over the long haul". CBS Market Watch. Archived from the original on February 29, 2012.
  5. Aswath Damodaran (February 23, 2011). "Equity Risk Premiums (ERP): Determinants, Estimation and Implications – The 2011 Edition". doi:10.2139/ssrn.1769064.. Available at SSRN.
  6. "Fact Sheet: The New Morningstar Style Box™ Methodology" (PDF). Morningstar. Archived from the original (PDF) on August 22, 2022.
  7. "Vanguard Funds by Style Box". Vanguard. Retrieved August 13, 2023.
  8. Bogleheads forum post: "Style boxes - Why the differences? Some questions"

External links

Tutorial

Easy to understand, fundamental information about stocks. From Investopedia: