Investing in stocks is a popular way to make money. But it is not without risk. The potential for long-term investment success, as well as near-term volatility, makes stocks a staple of nearly every portfolio.
A stock is an ownership share in a company. When you buy a stock, you own a piece of the company, but this does not mean that you have any voting rights or can rub shoulders with the corporate bigwigs. What it does mean is that, if the company does well, you can make money from your shares either through increased price appreciation or dividend payments.
Companies typically list their stock in a public marketplace, called a stock exchange. This allows investors to purchase and sell shares in the company, thus allowing the company to raise funds to grow its business.
Over the long term, successful companies generally experience significant growth in their stocks. However, over shorter periods, the value of a stock can fluctuate dramatically on a number of factors, including market conditions, new developments in the company, and other news and events that have little to do with the performance of the underlying business.
The most common method to determine the intrinsic value of a stock is by using a ratio like the price-to-earnings (P/E) ratio. However, there are many other metrics that may be used. For example, a relative valuation method compares the stock with the competition to determine whether it is cheap compared to the industry average. A price-to-book ratio is another useful metric to gauge the value of a stock.
Some companies offer direct stock plans, which allow you to purchase or sell their shares directly through them rather than through a broker. These plans are usually open to employees of the company and some other parties, such as existing shareholders. However, they often come with high fees and minimum purchase amounts.
Most stocks are classified by a system of market capitalization, which groups them into categories of large-cap, mid-cap, small-cap, and micro-cap stocks. In addition, many stocks are also grouped by sector, which is a system of grouping industries that tend to react in similar ways to economic conditions. For example, technology and consumer discretionary stocks may be more sensitive to changes in consumer spending than utilities and health care stocks.
While it is not possible to eliminate the risks of investing in stocks, prudent investors should attempt to achieve a high level of diversification within their stock holdings, as this has been shown to strengthen overall returns and minimize risk. In addition, prudent investors should avoid establishing highly concentrated positions in individual stocks, unless they are doing so intentionally as part of their investment plan.