Stocks: What They Are, Common Types, Key Differences From Bonds

A stock is a broad term used to describe fractional ownership in a company. Owning “shares” or units of stock entitle the owner of such shares to a portion of the corporation’s profits and assets equal to the percentage of the shares they own. These are called shareholders. Additionally, shares may offer other benefits, such as voting rights for decision-making within the corporation.

For example:
If a corporation has 10,000 shares outstanding, and you own 500 of those shares – you own 5% of the shares and have an ownership interest in 5% of profits and assets.

Why Do Companies Issue & Sell Stocks?

Corporations issue stock to raise money from investors.

Why would corporations need to raise money?

The simple answer is to grow the company. Every company has it’s own plan that may include various needs for expansion.

These needs may include:

• Building new facilities
• Expanding the company into new regions or new markets
• Launching new products
• Researching unexplored technologies
• Or to pay off previous debts

The Legal Explanation of Corporations and Stock

Corporations and shareholders act as different entities for legal purposes. Shareholders hold an ownership interest in the corporation based on their percentage of shares, but they do not ‘own’ the corporation. The laws within the United States treat corporations as their legal person. Corporations file taxes, own property, borrow money and can be sued the same way an individual can.

The reason for these separations of shareholders and corporations is to limit the corporation’s and shareholders’ liability. For example, if a shareholder were to go bankrupt, a judge could not order the corporation to sell its assets to cover the bankruptcy; the same applies to the shareholders. Likewise, if the corporation were to go bankrupt, the courts cannot pursue the shareholder’s assets to pay the creditors.

The Two Common Types of Stock: Common & Preferred

The two primary types of stock are common and preferred stock. Preferred stock gets priority treatment in terms of dividend payments and asset distribution in the case of bankruptcy.

Each company will have different features for the preferred stock, making them more or less favorable than common stock, depending on your investment objectives. Preferred shares offer more protection than common shares but less protection than a bond in terms of a right to claim if bankruptcy occurs. The goal of preferred stock is to reduce the risk for the shareholder.

If you are using your online brokerage to purchase shares, these are likely common stock, but always be sure when buying shares.

Here are the underlying differences between common and preferred.

What Exactly Do You Own with Shares?

Owning common shares of a corporation provide you with the following:

• the right to cast your vote at shareholder meetings.
• to receive dividend payments if the management decides to distribute earnings.
• the right to sell your shares.

As a shareholder, you are not technically the ‘owner’ of the corporation. For example, if you own 25% of the shares of a corporation, you hold a 25% ownership interest. However, being a majority shareholder of a corporation increases your voting power, and with that voting power, you have more influence on the election of the board of directors.

The board of directors consists of elected persons that act in good faith on behalf of the shareholders. Its primary role is to oversee the direction of the company and the management team, including oversight of the CEO.

A stock’s value lies in the company’s ability to deliver value to its shareholders. The company could create value by improving cash flows, growing assets, or even reducing debt.

Some companies pay shareholders a portion of the profits continuously by distributing dividends. Dividends usually consist of cash, but sometimes additional shares are given instead. Paying dividends on an ongoing basis is a great way to add value and build trust with shareholders.

Most companies retain all of the cash earnings and invest it back into the company. Shareholders are okay with this idea as long as the company can grow at a moderate rate.

Providing value through dividends or continued growth are two great ways to build the long-term trust of shareholders. The market will continue to price in this value over longer time horizons.

Warren Buffett’s ‘look-through earnings’ method is a great way to measure how much you earn as a shareholder.

Corporate Bonds vs. Stocks – What’s the Difference?

Stocks provide ownership interest in the underlying corporation, whereas bonds are payable debts owed by the corporation. Investors purchase bonds for the fixed income feature of interest payments that include lower downside risk.

Bonds purchased from the corporation will be sold at a fixed amount, with fixed interest payments and a specified date to repay the debt in full. Bonds can also be bought and sold on the open secondary market. Prices of bonds don’t typically fluctuate as much as the stock of the same company.

Bonds are generally considered lower risk versus stocks due to the nature of the fixed interest payments that the bondholder receives. Additionally, bondholders are considered “creditors” and will be treated preferentially in the event of bankruptcy, with common stockholders reimbursed last.

Are Stocks Good Investments?

Stocks are the single best way to get started with investing. Opening a brokerage account and purchasing shares has never been easier. In fact, you can set up automatic recurring purchases making investing more manageable than ever.

The two best things about owning shares of stock are (1) they are highly liquid, and (2) over the long term can provide a great return on investment.

Being highly liquid means you can easily convert your shares into cash when the stock market is open. (Monday – Friday, 6 am EST to 4 pm EST). Other investments, such as real estate, may require months to receive cash proceeds.

The broader stock market return has been 11.88% yearly (including reinvested dividends) using market data from 1957 through 2021. The market measuring tool used in this case is the Standard and Poor’s 500 (S&P 500)[1].

How Do You Buy Stocks?

All of us have seen a movie where someone calls their broker to make a stock purchase. Fortunately, it’s now more accessible and cheaper than ever to transact stocks. As a result, there is no need to ever speak with a broker about purchasing or selling stock.

Dozens of online brokerages offer free apps to buy, sell, and track your portfolio. With a quick search, you will find the top brokerages with various services, including stocks, bonds, and retirement accounts, to fulfill your investment needs. Choose only one to keep your investments organized. My recommendation would be Vanguard.

Opening an account is like opening a bank account. Of course, it will require some confidential information, but everything can be completed online.

Once you’ve completed the application and your account is open, you can deposit money and begin purchasing shares of stock.

What is an ETF (Exchange Traded Fund)?

An exchange-traded fund, or ETF, is a collection of individual stocks that can be bought or sold just like a stock. These funds are typically made up of hundreds or thousands of different stocks allowing investors an easy way to diversify their portfolio with one simple investment. ETFs are designed to mimic specific sectors or indexes such as the S&P 500, China, Europe, Real Estate, Bonds, Commodities, Gold, Energy, Oil, and many more.

Every major index, sector, and industry has an ETF for you to invest in. For most investors, this is a perfect investment option. ETFs provide a good amount of diversification with minimal research and planning.

Is it Better to Purchase Individual Stocks or Index Funds?

The simple answer for those needing to ask this question is to buy low-cost index funds. Purchasing individual stocks requires research of the company and understanding what a fair price for the stock is. If you are able and competent, then stock picking may be ideal.

Purchasing low-cost index funds gives you exposure to the best companies and provides you with the average market return. An average return is acceptable for an investment that requires very little research and time to manage.

Acquiring the knowledge to analyze individual companies requires an extensive amount of time. Portfolio construction can be another constraint. For most investors, the wiser decision would be a simple portfolio constructed of low-cost index funds.

The simple investment of purchasing an S&P 500 Index fund has outperformed more than 90% of the time. Warren Buffett made a $500K wager against any fund manager that wished to try to beat the S&P 500; one manager took that wager, and guess who won? Warren Buffett.

Starting small with stock picking might be the ideal choice for someone new to investing. But you must be willing to spend time learning and conducting company research before purchasing. It would be wise to start investing only a small portion of your portfolio in single stocks to begin. Doing so will provide you with minimal risk until you are proficient and confident in stock analysis.

What Are The Risks of Owning Stock?

As with any investment, there is a degree of risk. If market conditions are poor, the value of stocks, bonds, ETFs, mutual funds, real estate, and most assets will decline. The way to mitigate the risk is by having a diversified portfolio.

Investment values of individual stocks will vary much more than a market tracking fund such as an S&P 500 Index Fund. Individual stocks may rise or fall due to market conditions, management decisions, expansion into new markets, or even activist investors.

It’s important to remember that stocks have outperformed most other investable assets over the long run.

Costs of Investing with Stocks

The costs of buying and selling stocks, ETFs, bonds, mutual funds, and other securities have gone down tremendously with the advent of web-based brokerages.

Investing in a simple portfolio of ETFs or stocks can be done with nearly zero fees.

Traditional Full-Service Brokers

Avoid these like the plague. Most full-service brokers charge 1% – 2% of your total purchase price of each trade. On top of the trading fees, they charge a yearly management fee for your entire portfolio, typically ranging from 1%-3%. These costs are atrocious. Yet, brokers are paid well for something that you can easily manage on your own.

Commission-Free Trading*

Brokerages advertising to investors and traders have developed a new marketing gimmick –
“Commission-Free Trading.” While in most cases, the fees will be less than traditional brokers, there are built-in costs. Trading fees have been reduced substantially with the implementation of payment for order flow (PFOF). It’s a highly questionable way of ‘reducing trading fees’ by selling your trades to third parties and taking a cut of the fees.

Here’s how it works:

You submit an order for $100. Your broker sends out that order to other market participants (market makers).

The market maker finds someone selling it for $99 and purchase it for $99.

Then sell it to you for $100 – pocketing the $1.

Your broker will then get a kickback from the market maker. This happens in a matter of milliseconds, so you wouldn’t know it. The issue is that they are front-running your purchase and then selling it to you.

Brokers are required by law to report if they are making revenue through this process so you can identify the brokers you want to work with.

Keep this in mind when deciding which brokerage you want to open an account with. Fees across most platforms are low so there’s no need to spend a lot of time researching which one to use. Choose one that suits your specific needs.

Exchange Traded Fund (ETF) & Mutual Fund Fees

ETFs and mutual funds come with a fee, typically a small one, for the services of a team and company to manage the fund. This fee is called an expense ratio. The average expense ratio is around 0.50%, and low-cost ETFs are less than 0.05%.

Here are a few low-cost ETFs:

Vanguard S&P 500 ETF (VOO) has a cost of 0.03%
Schwab US Broad Market ETF (SCHB) has a cost of 0.03%
Vanguard Total Bond Market ETF (BND) has a cost of 0.03%

You don’t need to worry about paying this fee each year as it’s automatically deducted from the fund and is reflected in the price per share.

How Are Stocks Taxed?

Stocks are a tax-efficient way of investing. In most cases, you will pay less tax on your capital gains (profits) than on ordinary income. The tax benefits favor those wishing to invest and hold a particular stock for at least one year. Taxes are only imposed when the stock is sold for a profit, and only the profits earned will be subject to tax.

Here are the three primary rules for understanding taxes for stocks.

1. Short-term capital gains tax – stocks held for less than one year. You will pay taxes on profits on any of the stock gains you bought and sold in less than one year. These profits are taxed at the same level as your income tax bracket. Avoid this if you can.
   
2. Long-term capital gains tax – stocks held for longer than one year, hence the word long-term. Long-term capital gains are taxed at a considerably lower rate. These rates range from 0% to 15% to 20%, depending on your taxable income and filing status. Take advantage of this!
   
3. Dividends – There are two types of dividends that you can receive as a shareholder: qualified and non-qualified. Non-qualified dividends are subject to the same taxation as ordinary income. In contrast, qualified dividends are taxed at long-term capital gains rates of 0%, 15%, or 20%, depending on your income level.

The benefits here are very straightforward. You can pay minimal taxes on your investments by holding onto your investments for at least one year.

How Can I Analyze a Stock?

There are two primary ways of analyzing stocks: fundamental analysis and technical analysis.

Fundamental analysis involves evaluating the company’s performance through various data sources. The company’s annual and quarterly filings with the SEC provide nearly all relevant information. These filings include all of the company’s financial statements, risks, management notes, and other material information. Other sources may include comparisons to companies within the sector or economic reports. With this information, investors can determine what they think is fair to pay for a company.

Technical analysis uses historical market data such as charts and price history to decide when to purchase or sell stocks. ‘Technicians’ believe that by studying past trends, price actions, and other various data, they can predict the future price action of the stock. This analysis is somewhat controversial by some, but it is very apparent that it does hold some merit. Although, basing your trading behavior simply on technical analysis would require a skill that very few have been able to master.

The most common approach to stock analysis is using a company’s fundamentals to make decisions about the company and the fair price to pay for the stock. Some traders use a combination of the two approaches to validate one another. The reality is that you need to decide what works best for you.

What Factors Should I Consider When Investing in Stocks?

When selecting stocks to invest in, there are two critical factors.

Time Horizon & Investment Strategy

Time horizon refers to the period you plan to hold the investment. This is most known as short-term or long-term, but these terms are too vague. The question you should ask yourself is, “when do I plan on needing this money?”. Once you can make this decision, then you can move on to the next topic.

Investment Strategy

Every person has their own unique financial needs and expectations. Designing an investment strategy is not very difficult, but it does take a little thinking and planning for the future. The questions you need to answer are:

How will I pay for my investments? You need to know how frequently and how much money you plan to invest in your portfolio. Having a plan and goals will lead to a higher chance of success.

How much time will I spend on maintaining my portfolio? Some investors may want to set it and forget it, and others may want to observe and research stocks. Either chosen strategy can work; it’s merely a decision that you must make.

What are the end goals for my investments? (this ties into time horizon) Most people naturally think about investments as a source of retirement. This is completely acceptable. Others may be using an investment as a springboard into another investment opportunity. Knowing when you expect to need the money can dramatically change your portfolio allocations.

Once you can answer all the above questions, you’re ready to start designing and planning your diversified portfolio.

Is There a Relationship Between Stock Price and Company Performance?

The simple answer is, Yes. Over the long term, a company’s performance will impact the price of the stock. Don’t get this confused with the day-to-day markets pricing stocks efficiently. At any point in time, a stock could be way undervalued or way overvalued, depending on how you analyze the price. The market is very inefficient at times, and this is where opportunities exist to purchase stock at a discount. The question is whether you have done the research to know this. Most average investors do not do the necessary research to know if a stock is priced fairly.

How To Determine the Value of a Stock?

The price-to-earnings ratio (P/E) is the most commonly used method for determining the value of a stock. This number is calculated by taking the current share price and dividing it by the most recent earnings per share (EPS).

Example: a stock selling for $100 recently reported earnings of $3.50 per share. This would equate to a P/E ratio of 28.6.

To provide a little context to this. The S&P 500 Index of 500 of the best companies has an average P/E of 21.52. High speculative growth companies may be P/E ratios in the 100’s or even 1,000’s. In comparison, other well-established companies with consistent earnings may have a P/E in the single digits.

There are many other ways to evaluate the value of a stock. Understanding where the company is now, where it plans to go in the future, how it’s going to get here, and WHO is managing it are among the most important questions.

Stock Market Sectors

The United States stock market is divided into 11 sectors. Within these 11 sectors, there are 24 industry groups, 69 industries, and 158 sub-industries. Every company that is traded on US exchanges has been classified into these categories. These are the 11 sectors:

Category Terminology of Stocks

Investors have created several names or terms for categories of stocks.

Blue-chip stocks are a well-recognized company that has stood the test of time. Typically looked at as the ‘safest’ stocks to purchase.

Value stocks are mature businesses that have continued rates of growth and reliable revenues. Many of them are dividend-paying. The valuations (P/E Ratios) are typically lower than that of a company that has longer-term growth potential. These are Warren Buffett’s favorites.

Income stocks are well-established businesses that provide a steady income paying dividend. These are usually considered lower risk and are less volatile.

Growth stocks are companies that are growing rapidly, typically outpacing competitors and the market in general. They sell at higher P/E ratios and carry more risk.

Mega-cap refers to a company with a market capitalization value of more than $200 billion.

Large-cap refers to a company with a market capitalization value of more than $10 billion.

Mid-cap refers to a company with a market capitalization value between $2 billion and $10 billion.

Small-cap refers to a company with a market capitalization value between $250 million and $2 billion.

Micro-cap refers to a company with a market capitalization value under $250 million.

Penny stock is a term used to describe a stock that trades for less than $5. Most of these stocks are traded OTC (over-the-counter OR not through regular brokerages). These are considered the highest-risk stocks.

Pink Sheets are companies that are not listed on any exchange. They fall into the category of penny stocks. As a result, many of them fall through the cracks of government oversight. This does not mean they are bad companies, but average investors should not be buying these.

Conclusion

Corporations issue and sell stock to raise money to facilitate the company’s ongoing needs. Shares of stock represent fractional ownership of the company’s profits and voting rights.

Stocks are different from bonds. Bonds act as a company loan, with continuous interest payments and a date when the loan is paid in full.

There are two types of stock, common and preferred. Each offers shareholders different rights and benefits of ownership.

Investing in stocks provides tax benefits for those that buy and hold shares for longer than one year. Taxes are owed after the stock has been sold and only on the profit earned.

Stocks are one of the best-performing investments over long periods of time and are the best option for new investors to get started or for those that want to invest with limited research and maintenance. Purchasing stocks has become more accessible and easier over time. Most transactions take place online without the need for brokers to execute trades.

Determining how and what to invest in is different for every person. It does not need to be difficult or overly complicated. Answering a few basic questions can ultimately set the direction for building an investment strategy with stocks.

[1] Aswath Damodaran, New York School of Business. “Historical Returns on Stocks, Bonds and Bills: 1928-2021. https://pages.stern.nyu.edu/~adamodar/New_Home_Page/datafile/histretSP.html”