What Are Common Stocks and How Do They Work?
Understand common stocks: grasp their fundamental nature as company ownership and the various ways they can generate financial returns.
Common stock is an investment security, representing a share of ownership in a company. It plays a significant role in corporate finance, allowing businesses to raise capital for operations and expansion. For individuals, common stock offers a direct path to participate in the growth and profitability of publicly traded companies. It forms a core component of many diversified investment portfolios, helping investors build wealth.
Defining Common Stock and Its Core Features
Common stock is a security signifying ownership in a corporation. As owners, common stockholders have a residual claim on company assets and earnings. In liquidation, common stockholders are paid only after creditors, bondholders, and preferred stockholders.
A key feature is voting rights, typically one vote per share. These rights allow shareholders to influence corporate governance, including electing directors and approving major decisions. Capital appreciation is another characteristic, where the stock’s market value can increase. This increase ties to the company’s financial health, operational success, and future prospects.
How Common Stock Generates Returns
Investors generate returns from common stock through dividends and capital gains. Dividends are distributions of a company’s profits to its shareholders, typically paid on a quarterly basis, though some companies may distribute them monthly, semi-annually, or annually. Dividends are not guaranteed; companies can reduce or suspend payments based on financial performance or strategic needs. Dividends are subject to taxation, with the specific tax treatment depending on whether they are classified as qualified or ordinary.
Capital gains occur when an investor sells shares for a higher price than the purchase price. This gain results from increased market value due to company growth, market sentiment, or improved financial performance. Capital gains are also taxed, with the rate depending on the holding period. Short-term gains (assets held one year or less) are taxed at ordinary income rates. Long-term gains (assets held over one year) generally receive more favorable tax treatment.
Common Stock Compared to Other Securities
Understanding common stock is enhanced by contrasting it with other common investment securities, such as preferred stock. Preferred stockholders typically do not possess voting rights, which differentiates them from common stockholders who actively participate in corporate governance. While preferred stock often offers fixed dividend payments, common stock dividends are variable and dependent on company performance and board decisions. In the event of liquidation, preferred stockholders have a higher claim on a company’s assets than common stockholders, meaning they are paid before common shareholders.
Bonds represent another distinct type of security, fundamentally differing from common stock as they signify debt, not ownership. Bondholders are essentially lenders to the company or government, receiving regular, fixed interest payments over a specified period. Bondholders hold the highest priority claim in liquidation events, being paid before both preferred and common stockholders. This inherent difference means bonds offer more predictable income and lower risk compared to common stock, but typically without the same potential for capital appreciation or ownership influence.
Buying and Selling Common Stock
Common stocks are primarily bought and sold on major stock exchanges, such as the New York Stock Exchange (NYSE) and the Nasdaq Stock Market. These exchanges provide organized marketplaces where investors can trade securities efficiently. To participate in these markets, individual investors typically need to open a brokerage account.
A brokerage account acts as an intermediary, holding an investor’s cash and securities, and executing buy and sell orders on their behalf. These accounts can be opened with various financial institutions, including online discount brokers. The process involves depositing funds into the account and then placing orders for specific stocks through the brokerage’s platform. When an investor decides to sell shares, the brokerage facilitates the transaction on the exchange, with the proceeds, minus any applicable fees or commissions, deposited back into the account.