What Are Stocks?

If you think about investing, one of the first words that can come to mind is stocks. Movies like Wall Street, Margin Call, or the Wolf of Wall Street dramatizes the stock market. With stocks, people have made fortunes and lost them just as quickly, but what exactly are stocks?

What is a stock?

A stock, simply put, is a part ownership of a company. Having one entitles you to a proportionate part of the company’s assets and its earnings. Stocks are often referred to as shares or as equity. If a company is making a profit, a stockholder (someone who owns stock) may receive part of the profit in what is called a dividend. There are two main types of stocks: common stock and preferred stock.

Common stock

Common stock is what most people are referring to when they talk about stocks or equities. Common stock usually gives the stockowner voting rights that enables them to have a say in company meetings and elections. Common stockholders vote on who is elected to sit on a company’s board which can influence the company’s trajectory.

Out of everyone who owns equity in a company, common stockholders are paid last in case the company faces bankruptcy and must liquidate its assets. However, with common stock, the most you can lose is the money you paid for the stock. If a company goes bankrupt, creditors can’t go after stockholders.

The main way that common stock provides value to an investor is through appreciation. As the value of a company grows, so does the value of a stock. As an example, if you bought Apple stock on December 12, 1980 when it first became public, you would have paid $22 per stock. If you sold the stock as of August 31, 2022, you would sell it for $157.22 per stock, making a gross profit of $135.22 per stock. Because stocks are directly related to the value of the company, if the company decreases in value, so does the value of the stock.

Preferred stock

Another main type of stock is a preferred stock. In general, preferred stocks don’t have voting rights. Because it is a stock, preferred stock appreciates and depreciates with the value of the company, but it is much less severe as a common stock. The main way that a preferred stock provides value is through fixed dividend payments from the company when it has profits. If the company pays out dividends, preferred stockholders will be paid before common stockholders.

Also, if a company must liquidate its assets, preferred stockholders will be paid before common stockholders. Preferred stocks function very similarly to bonds, but because they don’t have the same guarantees as bondholders, their yields tend to be higher than bonds from a company with a similar credit rating.

Selling a stock

Whenever you sell a stock, you will experience a capital gains tax. If you own a stock for less than a year and you sell it, you will have to pay a short-term capital gains tax on the gain, which is equal to your current income tax. If you own a stock for more than a year, you will pay a long-term capital gains tax on the profit when you sell the stock.

The long-term capital gains taxes are set each year and are currently lower than the income tax for most taxpayers. For example, if you buy a stock for $10 in January, and proceed to sell it in March of that year for $40, you will have to pay your current income tax on the $30 of profit. If you held the same stock for a year and sold it for $40, you would have to pay a long-term gains tax on the $30 profit.

Stock options

To incentivize employees, some companies offer the option to buy their stock. A stock option is exactly as it sounds: the option to buy a stock. Stock options are granted at a “strike price” which is the price you will pay to buy the stock if you exercise your option. Most stock options have a vesting schedule where you have to wait a specific amount of time before you can exercise your option. Two common types of stock options are as follows:

• Incentive stock options (ISO): profits from exercising an ISO are often taxed as capital gains rather than ordinary income. These are generally granted to highly compensated executives and key employees.
• Non-qualified stock options (NSO): profits from exercising an NSO are taxed as ordinary income and they are generally granted to all levels of employees

Takeaways

Stocks can be a great way to build wealth. Common stock can help you benefit from the appreciation of a company while preferred stock can provide fixed income through dividends. A great Advisor can help you understand how stocks can fit into your financial plan, understand how to minimize taxes when you sell your stocks, and how to exercise stock options.

Disclaimer: This post is for informational purposes only and is never to be taken as advice or a recommendation. Talk to a tax or legal professional to determine how this information best applies to your personal situation.