1.3 Stocks

Stocks, also known as equities, are one of the most fundamental and widely traded financial instruments in global markets. They represent ownership in a corporation, providing investors with claims to part of the company's assets and earnings. Stocks are a cornerstone of capital markets and play a critical role in both raising capital for businesses and offering investment opportunities for individuals and institutions.

1.3.1. Definition and Basic Concepts of Stocks

A stock is a type of security that signifies ownership in a corporation and represents a claim on part of the corporation’s assets and earnings. Stocks are issued by companies to raise funds for expansion, development, and other business needs. By buying a stock, investors become part-owners of the company, also known as shareholders.

• Shares: The basic unit of stock is a share. When investors buy shares, they purchase a portion of ownership in the company.
• Stockholder Rights: Ownership of stock entitles shareholders to certain rights, such as voting rights in corporate matters and a share of the company's profits through dividends.
• Stock Markets: Stocks are traded in stock markets, which facilitate the buying and selling of shares. The two main types of stock markets are primary markets (where stocks are issued) and secondary markets (where stocks are traded among investors).

1.3.2. Types of Stocks

There are two primary types of stocks: common stock and preferred stock. Both provide ownership in a company, but they differ in terms of rights and claims.

1.3.2.1. Common Stock

Common stock is the most widely issued and traded type of equity. It represents ownership in a corporation and usually provides voting rights on corporate decisions.

• Voting Rights: Common stockholders typically have voting rights, which allow them to vote on important corporate issues such as electing the board of directors and approving mergers or acquisitions. Each share generally represents one vote.
• Dividends: Common shareholders may receive dividends, but these payments are not guaranteed and are typically paid only if the company has sufficient profits. Dividends can fluctuate based on the company’s performance and profitability.
• Residual Claim: In the event of a company’s liquidation, common shareholders have a residual claim on the company’s assets, meaning they are paid only after bondholders, creditors, and preferred shareholders have been compensated. As a result, common stockholders bear more risk.

1.3.2.2. Preferred Stock

Preferred stock combines characteristics of both equity and debt. Preferred shareholders typically do not have voting rights, but they enjoy a higher claim on the company’s assets and earnings than common stockholders.

• Fixed Dividends: Preferred stock usually pays a fixed dividend, making it more similar to a bond. These dividends are paid before any dividends are distributed to common shareholders, and the payment is often more predictable.
• Priority in Liquidation: In the event of liquidation, preferred shareholders are paid before common shareholders but after bondholders and other creditors. This priority provides an additional layer of security compared to common stock.
• No Voting Rights: Most preferred shares do not carry voting rights, which limits the holder’s influence over corporate decisions.

1.3.3. Stock Ownership and Benefits

Owning stocks provides several benefits to investors, primarily in the form of potential financial gains and influence over corporate governance.

1.3.3.1. Dividends

Dividends are payments made by a corporation to its shareholders, usually from its profits. Companies that are financially stable and profitable often distribute a portion of their earnings as dividends to reward shareholders.

• Regular Income: Dividends provide shareholders with a steady stream of income, especially in the case of mature companies with stable earnings.
• Dividend Yield: The dividend yield is a financial ratio that shows the annual dividend payment as a percentage of the stock’s current price. It is a key indicator for income-focused investors.

1.3.3.2. Capital Gains

Investors can earn profits by selling their shares for more than they paid for them, generating capital gains.

• Appreciation: Capital appreciation refers to the increase in the price of a stock over time, which can provide investors with significant returns.
• Market Value: The market price of a stock fluctuates based on supply and demand, market sentiment, and the company’s financial performance.

1.3.3.3. Voting Power and Corporate Governance

Common stockholders often have voting rights, allowing them to participate in key corporate decisions.

• Electing the Board of Directors: Shareholders vote to elect the board of directors, who oversee management and represent shareholder interests.
• Major Corporate Decisions: Shareholders may vote on mergers, acquisitions, and other significant corporate actions that impact the future of the company.

1.3.4. Risks Associated with Stocks

While stocks can provide significant rewards, they also come with inherent risks. The value of stocks can be highly volatile and influenced by various factors.

1.3.4.1. Market Risk

Market risk refers to the risk of stock prices declining due to changes in market conditions. This risk is driven by factors such as economic downturns, changes in interest rates, geopolitical events, and fluctuations in investor sentiment.

• Volatility: Stock prices can experience significant swings in value, which may result in substantial losses for investors in the short term.
• Economic Factors: Recessions, inflation, changes in consumer behavior, and government policies can all impact stock prices.

1.3.4.2. Company-Specific Risk

Company-specific risk, also known as unsystematic risk, refers to risks that are unique to a particular company or industry.

• Business Performance: A company’s profitability, management decisions, and competitive position directly impact its stock price. Poor earnings reports, management changes, or negative news can result in sharp declines in the company’s stock.
• Bankruptcy: In extreme cases, a company may go bankrupt, causing its stock to become worthless. In such cases, common shareholders are the last to be compensated, if at all.

1.3.4.3. Liquidity Risk

Liquidity risk occurs when an investor is unable to sell their stock at a reasonable price due to a lack of buyers in the market.

• Thinly Traded Stocks: Stocks with low trading volume may be difficult to sell quickly without significantly impacting the market price.
• Small-Cap Stocks: Smaller companies often have lower liquidity, increasing the risk for investors.

1.3.4.4. Dividend Risk

Dividends are not guaranteed, and companies may reduce or suspend dividend payments, especially during times of financial difficulty or economic downturn.

• Dividend Cuts: If a company’s profitability declines or it needs to conserve cash, it may cut or eliminate dividend payments, reducing the income that investors expected to receive.

1.3.5. How Stocks are Traded

Stocks are bought and sold through stock markets, which provide a platform for buyers and sellers to trade shares. These transactions take place either on exchanges or in over-the-counter (OTC) markets.

1.3.5.1. Stock Exchanges

Stock exchanges are centralized platforms where stocks of publicly listed companies are traded. Examples of major stock exchanges include the New York Stock Exchange (NYSE), NASDAQ, and the London Stock Exchange (LSE).

• Transparency: Stock exchanges provide a regulated environment that ensures transparency and fairness in trading.
• Liquidity: Exchanges facilitate the continuous buying and selling of shares, providing liquidity for investors to easily enter and exit positions.

1.3.5.2. Over-the-Counter (OTC) Markets

In over-the-counter markets, stocks are traded directly between parties without using a centralized exchange. OTC stocks are typically less liquid and riskier than those traded on major exchanges.

• Smaller Companies: OTC markets often include smaller companies that do not meet the listing requirements of major exchanges.
• Price Negotiation: Unlike exchanges, where prices are publicly available, prices in OTC markets are often negotiated between buyers and sellers.

1.3.5.3. Electronic Trading and Algorithms

With advancements in technology, electronic trading platforms have become the dominant method of buying and selling stocks.

• High-Frequency Trading (HFT): HFT refers to automated trading systems that execute thousands of trades per second based on pre-programmed algorithms. This type of trading has increased liquidity but can also contribute to short-term volatility.

Summary

Stocks, as essential financial instruments, provide investors with ownership in companies and the potential for financial gains through dividends and capital appreciation. There are different types of stocks, including common and preferred shares, each offering distinct rights and privileges. While stocks offer attractive returns, they also carry various risks, including market risk, company-specific risk, and liquidity risk. Understanding how stocks are traded on exchanges or over-the-counter markets, and the associated risks, is crucial for anyone participating in equity markets. Through careful analysis and strategic decision-making, investors can leverage stocks to build wealth and achieve financial objectives.