What is a stock? Everything you need to know
Companies need money to grow but how do they gain access to this money? There are two main ways companies raise money (otherwise known as capital), either through loans (debt) or by selling stock (equity). In this article we’ll be covering how companies raise capital with stocks, as well as how stock prices work.
What is a stock?
We must start by understanding what a stock actually is. Put simply, a stock represents a small ownership in a company that can be bought and sold. Companies issue stocks to raise capital to launch and grow their businesses.
For companies whose stocks trade on the stock market, you can usually buy and sell stocks through brokerage platforms. These platforms may allow you to buy individual stocks, or a basket of stocks, such as “mutual funds” and “exchange traded funds” (ETFs).
Until recently, you had to buy an entire unit of a stock in order to be part owner of a company, which could cost you thousands of dollars. Today, with fractional stocks and new technology, you can buy “a fraction” of one stock for as little as $1, making investing in stocks accessible for all.
How do companies use stocks to raise capital?
Imagine you own a small apple orchard that sells apples to local markets. Each year you sell all your apples making a healthy profit.
The apple orchard next door goes up for sale for $1m. You want to buy this apple orchard to grow your company but you don’t have enough money to do so. You decide to sell shares in your company to raise capital.
You create 100,000 shares and sell them for $10 each ($100,000 x $10 = $1,000,000) and you now have the money to grow your business. What do the new shareholders get in return? Each one of those shares, or stocks, gives the new shareholders a percentage ownership in the company and potential share of profits via dividends.
How do stock prices work?
The price of a stock is based on multiple factors including supply and demand of the stock and the expected profits of the company. Profit expectations are extremely sensitive to competitive, economic and social conditions. This characteristic can make stock prices quite volatile.
For example, if investors collectively think profits of a company will rise in the future, the demand for its stock will increase, thus increasing the price of the stock. Similarly, if investors collectively think profits of a company will decline in the future, demand for the stock will decrease, thus decreasing the price of the stock.
Should you invest in stocks?
Investing in stocks has the potential to generate higher returns for your portfolio. When deciding whether to invest in stocks, there are a couple of things to keep in mind.
Firstly, picking a single stock ‘winner’ is difficult as there are many factors to consider. However, by increasing the number of companies you invest in, you can reduce the overall risk of your portfolio. This concept is known as diversification, and can be achieved by investing in ETFs or Mutual Funds.
Secondly, it is important to remember that a balanced portfolio is one that combines both stocks and bonds. Since bonds typically have an inverse relationship with stocks, they are a great way to keep your portfolio diversified. Stocks can be considered the growth engine of your portfolio while bonds assist with counterbalancing the overall risks of your portfolio.
Your investment strategy should always be based on your specific circumstances. A balanced portfolio can allow for complete diversification at a risk level that’s right for you. Finch’s recommended portfolio helps you achieve a balanced portfolio via stock and bond ETFs, which we customize to match your unique risk profile.