Primer on Stocks
What are stocks?
Stocks have been around for hundreds of years—the first stock ever issued was by the Dutch East India Company in 1602. Although the stock market has obviously changed a bit since then, the basic principle underlying stock remains the same: A stock entitles the holder to a fraction of ownership in a company. By owning the stock, the holder can participate in the firm’s earnings or growth through dividends and/or stock appreciation.
Every corporation issues shares of stock when it comes into being, and each owner of shares has what is called an equity ownership interest in the issuing company. Each share represents an ownership interest equal to the share divided by the number of shares outstanding in the company. Corporations issue, or sell, stocks to raise money for business operations. The purchaser of the stock, or shareholder, buys a share in the corporation. Businesses raise capital by selling shares to either a small number of other investors in a private offering or placement, which is typically the first step, or to the public at large in what is called an initial public offering (IPO).
Stock holders don’t own the corporation itself; they own the shares issued by the corporation or purchase them from other shareholders on the stock market. For example, owning shares in Apple doesn’t mean you can walk into an Apple store and waltz off with an iMac.
How do I buy stocks?
Once shares are available to the public, you can buy them through one of the larger stock exchanges like the New York Stock Exchange (NYSE), the NASDAQ, one of the smaller regional exchanges, or on the over-the-counter (OTC) market.
How much do stocks cost?
As a general rule, and as with most things in economics, for stocks traded on public exchanges (such as the New York Stock Exchange or Nasdaq) prices are determined by supply and demand. A company issues a fixed number of shares in an initial public offering. The initial share price is determined by a third party (often an investment bank), which uses a complicated series of formulas to determine the company’s overall value divided by the number of shares issued at the time of the IPO. If the demand for those shares is high, the price of the shares will go up. If demand is low, the price goes down.
Individual share prices vary enormously—from a few cents per share (you might hear these shares referred to as “penny stocks”) to hundreds of thousands of dollars per share (although stocks this costly are not common). Fractional shares are a relatively new offering and are exactly what they sound like: a fraction of a single share. Fractional shares allow you to invest in a company whose shares you wouldn’t otherwise be able to purchase, or without committing all of your investment funds to a single company’s stock. Fractional shares are handled differently from broker to broker, so if you’re interested in purchasing them, be sure to check out the fees particular to the broker you are working with.
When you buy stock, your cost basis is the total purchase price of the stock plus brokerage commissions and fees. If you received the shares from someone else as a gift, your cost basis is that of the person who gave you the shares. If you inherited the shares, your cost basis is likely the value as of the date of death of the decedent, or the person who left you the stock, which is “stepped up” from the original cost basis of the decedent.
If you buy or sell individual stocks there may be commission charges paid to the transacting broker for each transaction. Usually, the transacting broker is also the custodian firm where you hold your shares, but it doesn’t have to be. If you buy or sell stocks at an online or discount brokerage firm, the commission will probably be $0–10. In the event that you use a full-service broker, the commission will be close to some number of cents per share for most types of accounts. They will have a published schedule online, so you can look up your costs before you commit to the purchase. The commissions may be less if you do frequent trading, or if you have a big account.
Online investment apps are another brokerage option for investors. These apps are relatively recent—RobinHood, one of the first and probably still best-known, was founded in 2013, and the app itself wasn’t launched until 2015. Most online investing apps don’t charge brokerage fees; this means you can buy the stock through the app without paying a commission. They make money in other ways—usually payment for order flow—that don’t necessarily show up as direct costs to the investor but may give some people pause.
There are no costs ordinarily associated with holding stocks, though some firms will charge account fees or low balance fees if you are below a minimum amount, typically a few thousand dollars for taxable accounts and $1,000 for IRAs. If you are opening an account without much money, you should inquire into these fees beforehand. However, owning individual stocks doesn’t make much sense if you have that little money, because the costs are prohibitive. You’re better off investing in a fund.
If you have an investment advisor, it is likely that you will pay a small commission at a discount brokerage firm or mutual fund company. In addition to those commission costs, you will pay fees to the advisor for the advice. The advisor’s fees will not be related to the specific purchase, and you will not likely owe them due to a specific transaction. They usually cover a specified time period, like a calendar quarter.
You don’t have to pay any taxes for just owning stocks. However, if you sell the stocks at a profit, you’ll pay taxes on those gains. Some investors choose to offset those gains by selling other securities at a loss—what’s called tax-loss harvesting— reducing their overall capital gains tax liability (“robo-advisors” will usually do this for you automatically). You can hold stocks indefinitely without owing federal taxes on them if they don’t pay a dividend and you don’t sell them.
How do I make money with stocks?
It’s important to remember here that you might not! Stocks are inherently risky, although some are much less risky than others. It’s always possible that you will lose money with stocks. That said, in the simplest possible terms, the way you make money with stocks is to wait for the value to increase from your purchase price, and then to sell them.
The key to making money with stocks is longevity and a diverse portfolio (or a hot-ticket stock and extraordinary short-term luck, which is not a reliable investment strategy). An investor’s length of time in the market is the best overall predictor of the return on their investments. More time in the market also allows you to collect dividends (if the company pays them), in addition to building wealth as your shares increase in value.
Again, however, your shares in an individual company might also decrease in value. For this reason, it’s best to have a diversified portfolio rather than put all your money into a single company’s stock. The better-performing stocks in your portfolio are likely to offset any losses from more poorly-performing stocks over time.
Your profits from the sale of stock are simply the total amount you sold the stock for, less any brokerage commissions and fees.
Your stock holding period begins when you purchase the shares and ends on the date you sell them. Gains or losses attributed to holding periods of one year or less are characterized as “short-term”; those for holding periods of longer than one year are “long-term.” Shares that you have inherited are always considered long-term. Short-term gains are taxed at their marginal income tax rate; long-term gains are taxed at the applicable long-term capital gains tax rate.