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What Is a Stock?
Similar to a
bond, shares of stock are typically issued by corporations to raise needed funds to undertake projects or to expand their business. Often, businesses will initially be financed either by the founders themselves or other private investors. However, as they reach a certain size and need yet more funds, they may participate in an
Initial Public Offering (IPO) in which shares of the company are sold to the general public, and the stock begins to trade on a stock exchange (such as the
New York Stock Exchange or
NASDAQ).
Characteristics Of a Stock
A share of stock represents an
ownership share in the company. As such, it is perhaps the purest way to participate in a company's ultimate success or failure.
In contrast to a bond, a stock does not contain any promise to pay. While many stocks pay
dividends, unlike coupon payments on a bond these are not contractually promised, and can be lowered or even suspended in times of difficulty. Further, while a bond promises repayment of a defined face value, there is no promise as to what price you may receive for a share of stock in the future. Finally, if the company runs into severe difficulties and runs very short on money, bondholders get paid back first because they do have a contractual "promise to pay" from the company. Therefore, stocks are generally considered to be riskier than bonds.
On the other hand, since shares of stock represent actual ownership in the company, the opportunity for substantial gains is far higher than bonds. No matter how large a company becomes, or how vast the profits it generates, bondholders simply receive the payments promised in the terms of the bond. In contrast, the value of shares of stock in the company can rise dramatically, and shareholders benefit proportionately.
Growth vs. Dividend Stocks
Since stocks represent shares of ownership in
companies, it should quickly become evident that some are riskier than others. For example, consider shares in a small biotech company. To-date, this company has only one product; a drug which appears to offer a potentially groundbreaking method of seeking out and destroying cancer cells. However, the drug is still in the clinical trial phase and has not yet been approved for sale. Shares of this company carry a higher level of
risk than shares in a established pharmaceutical company with an international distribution network and multiple approved, successful drugs in current production. On the other hand, the small biotech company may well offer greater potential for
reward should it's drug be approved and live up to its potential. Financial theory says that
risk and reward are tied together. In other words, investors may be willing to take on extra risk, but only if there is potential for greater reward. While an entire book could be written on just this topic, for investors simply seeking a basic understanding we will generalize levels of risk into just two categories;
growth and
dividend stocks.
Growth Stocks
In general, growth stocks tend to be either smaller, younger companies or companies in high-growth fields such as technology. Since they are growing quickly, they may judge that it is best to reinvest any profits they earn in expanding their business, as opposed to paying them to investors in the form of cash dividends. For example; consider a coffee retailer that currently has 50 outlets, but believes there is room in the marketplace for 500 outlets. They may choose to take this approach.
In general, if they believe in the company's story and business plan, investors in growth stocks hope to reap gains from increase in the share price as the company expands. On the other hand, since there is typically a higher chance of failure, growth stocks might be considered somewhat riskier.
Dividend Stocks
In contrast, stocks that pay dividends tend to be older, more established businesses in mature industries. They may not see potential for further explosive growth. Therefore, they may decide to retain a certain percentage of their profits to support their business and engage in needed research and development and distribute the rest to investors in the form of dividends.
In general, investors who are more conservative may favor these types of companies. While the chance for substantial gain in the price of the shares may be less, the steady stream of income from dividends combined with the potential for modest appreciation in the share price is desirable to such investors. Further, in the event of a severe downturn in the economy, shares in such companies may not lose as much value as those of a smaller company whose very existence may be at risk.
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Disclosure: I am not a registered investment advisor or broker/dealer. Readers are cautioned that the material contained herein should be used solely for informational purposes, and are encouraged to consult with their financial advisor respecting the applicability of this information to their personal circumstances. Investing involves risk, including the loss of principal. Readers are solely responsible for their own investment decisions.
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