What are stocks and how do they work?

Across the world, stocks are an important asset class that offer individuals the potential for significant long-term returns. However, they are also associated with significantly higher risk than traditional banking and investment products.

With the rise of digital trading platforms, investing in stocks has become accessible to a many.

However, investors need to content with the dilemma between seeking inflation-beating return potential through stocks and capital stability through less risky avenues.

To help you navigate this and understand how to invest in stocks, this article offers an in-depth view of the basics of stocks including the stocks meaning, types of stocks, and essential factors to consider before investing in stocks in India.

• Table of contents

• What are stocks?
• What are the different types of stocks?
• What is the difference between stocks and bonds?
• Four reasons to invest in a company’s stock
• Factors to consider before investing in stocks
• Stocks vs mutual funds
• How to invest in stocks

What are stocks?

Stocks or equities represent ownership in a company. When you buy a stock, you are essentially purchasing a small portion of the company and have the potential to earn a share of the company’s profits in return for your investment.

In the context of investing, you may hear the term ‘stocks’ and ‘shares’ interchangeably. However, there are some differences between the two. ‘Stocks’ refer to ownership in one or more companies without specifying quantity, while ‘shares’ denote specific units of ownership in a particular company.

When a company needs to raise capital, it may decide to issue shares through an Initial Public Offering (IPO). Investors can buy these shares on stock exchanges. If a company grows and becomes more profitable, the value of its stock may rise, benefiting its shareholders. However, poor company performance, economic downturns and negative market sentiment can cause the company’s market value to decline, leading to a drop in stock prices.

What are the different types of stocks?

Stocks can be categorised in various ways based on different parameters. Here are some common ones:

• Common stocks: This is the most prevalent type of stock that retail investors purchase. Common stock represents ownership in a company, granting shareholders voting rights to influence corporate decisions. Dividends for common stockholders are not guaranteed and may vary based on the company's profitability. In the event of liquidation, common shareholders have rights to a company's assets only after bondholders and preferred shareholders have been paid. Additionally, common stockholders can realise capital gains or losses based on the appreciation or depreciation of the stock's market value, which are subject to capital gains taxes upon the sale of the stock.
• Preferred stocks: These offers shareholders fixed dividends and priority over common shareholders regarding dividends and asset liquidation. However, preferred shareholders typically do not possess voting rights. Also, they are relatively more stable than common stocks but offer lesser growth potential.
• Blue-chip stocks: These are stocks of well-established, financially stable companies with a long history of reliable performance. These stocks come with a relatively stable growth potential and lower volatility than mid cap or small cap stocks.
• Penny stocks: These are stocks of very small companies, sold at a minimal price. They can be highly volatile. These are companies with very small market capitalisation and these stocks are often not very liquid.
• Growth stocks: As the name suggests, these are stocks of companies that are expected to grow at an above-average rate compared to other companies in the market.
• Dividend stocks: These stocks belong to companies that have a track record of paying regular dividends to their shareholders. Dividend stocks are preferred by investors looking for the potential for regular income rather than capital appreciation.

What is the difference between stocks and bonds?

Both stocks and bonds can be issued by companies to raise capital. However, they are entirely different in their mechanisms.

• Ownership vs debt: As explained, stocks meaning represent ownership in a company. On the other hand, a bond represents a loan given by one entity (such as the investor) to another (such as the company issuing the bond). In return, the issuer agrees to pay periodic interest and repay the principal amount when the bond matures.
• Risk and return: Stocks are characterised by higher return potential and higher risk since their value fluctuates based on the company’s performance. Bonds are relatively stable since they come with fixed interest payments and principal repayment. However, for the same reason, they also offer lower return potential. Also, though they entail relatively lower risk, they are vulnerable to the risk of default by the bond issuer and are sensitive to interest rate movements in the market.
• Income source: Stocks have the potential to provide income through dividends, but these are paid out at the discretion of the company and are not assured. Moreover, not all companies pay high or regular dividends. Bonds aim to provide a regular income stream through interest payments (subject to default risk).

Four reasons to invest in a company’s stock

Before you find out how to invest in stocks, it is important to know why investing in stocks can be a suitable investment strategy:

• Capital appreciation potential: One of the primary reasons for investing in stocks is the potential for capital appreciation. If the company performs well, the stock value may increase. This gives you the opportunity to sell your shares for gains. Over time, this can offer better return potential than most other conventional investment avenues and asset classes.
• Dividends: Some companies may also choose to distribute a portion of their profits to shareholders in the form of dividends. For investors seeking the potential for regular income from the investment, dividend-paying stocks can be suitable. However, dividends are not guaranteed and are released at the company’s discretion.
• Portfolio diversification: Investing in stocks allows you to diversify your investment portfolio. By holding stocks in different companies across various sectors, you can spread the risk and reduce the impact of any one stock’s poor performance.
• Ownership and voting rights: After reading about the basics of stocks, you know that buying stocks gives you ownership of a part of the company and gives you the potential for financial benefits. It also gives you the right to vote on important corporate matters such as electing the board of directors or approving major company decisions.

Factors to consider before investing in stocks

• Investment goals and horizon: No investment should be made without properly defining your investment goals and identifying a suitable investment horizon.
• Risk tolerance: High-growth stocks may offer a high return potential, but they come with higher volatility. Assess your ability to handle losses and choose investments accordingly.
• Company fundamentals: Research the company before buying its stocks. Companies with strong fundamentals tend to perform better in the long run.
• Diversify: Avoid putting all your money into one or a handful of stocks. Diversify your investment in stocks.

Stocks vs mutual funds

Another way for investors to participate and potentially benefit from the equity market is through mutual funds. Mutual funds pool money from many investors to buy a variety of stocks and other assets. This diversification helps spread risk, as the performance of one company has less impact on the overall fund. Moreover, mutual funds are managed by professionals, so investors do not need to have in-depth knowledge of the stock market to participate in it. However, when investing in mutual funds, individuals do not directly own stocks but own a mutual fund unit. Investors earn returns if the price of underlying stocks in the portfolio appreciates.

How to invest in stocks

Investing in stocks involves the following steps:

• Step 1: Open a demat and trading account with a stockbroker or an online trading platform. You need a demat account to hold shares electronically and a trading account to execute buy/sell orders.
• Step 2: Study the stock market and individual companies. Use fundamental and technical analysis to find stocks with a good potential for growth.
• Step 3: Start with small amounts, if you are new, and gradually increase your exposure as you become more comfortable with the market.

Conclusion

Understanding the basics of stocks is important for investors who want to participate in the financial markets. Investing in stocks offers significant potential for wealth-building. However, it is crucial to understand the risks involved, keep track of market trends, and have a clear investment strategy in place. With the right approach and proper knowledge, investing in stocks can potentially a rewarding way to build your financial future. Investors who do not have the time or inclination to trade independently can also participate in the stock market through mutual funds, which mitigate risk through diversification and professional management.

FAQs:

How do I buy and sell stocks in India?

The first step is to open a demat and trading account with a broker. Then, you must deposit funds in the account and use the platform to place orders. You can then monitor trades for buying and selling.

What are small, mid, and large cap stocks?

Companies are ranked based on their market capitalisation in India and categorised into small, mid and large cap companies. Large cap companies are the top 100 companies on the stock exchange in terms of market capitalisation, mid cap companies are listed from 101 to 250 and small cap companies are listed 251 and beyond. Their stocks are called large, mid and small cap stocks respectively.

What is a stock index?

A stock index is a benchmark that tracks the performance of a group of stocks. Popular indices include Nifty 50 (National Stock Exchange) and the BSE Sensex.

What is a stock dividend?

A payment made by companies to shareholders in the form of additional shares, rather than cash, based on the number of shares they already own, is known as a stock dividend.

Mutual Fund investments are subject to market risks, read all scheme related documents carefully. This document should not be treated as endorsement of the views/opinions or as investment advice. This document should not be construed as a research report or a recommendation to buy or sell any security. This document is for information purpose only and should not be construed as a promise on minimum returns or safeguard of capital. This document alone is not sufficient and should not be used for the development or implementation of an investment strategy. The recipient should note and understand that the information provided above may not contain all the material aspects relevant for making an investment decision. Investors are advised to consult their own investment advisor before making any investment decision in light of their risk appetite, investment goals and horizon. This information is subject to change without any prior notice.