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A majority of Americans own stocks, mostly via mutual funds in retirement accounts. Unfortunately, not everyone understands precisely what that means.
For instance, a 2022 FINRA Foundation study found that only 73% of investors correctly identified that buying a stock means you’re purchasing a piece of a company.
Stock trading works by generating profits over the long term in the form of income and capital gains. Let’s take a closer look at how you benefit from owning shares of a public company.
What Is Stock? How Does It Work?
When you buy shares of stock, you own a small piece of a public company. As a shareholder, you get the ability to potentially vote on company decisions, receive dividend payments and benefit from the company’s growth.
Shares of stock are traded on a stock exchange. The price of a stock is determined by a company’s financial performance, supply and demand in the stock market and the performance of the overall economy.
When a company performs well and its earnings grow, its stock price tends to increase. Shareholders can benefit from capital gains if they decide to sell their shares. But if a company’s earnings are weak or there is trouble in the wider economy, its stock price may decline.
Different Types of Stock
There are two main types of stock: common stock and preferred stock.
- Common stock. If you own just one share of stock in a company, you can attend its shareholder meetings and earn dividends. A company’s dividends may distribute profits to its shareholders in the form of cash or stock.
- Preferred stock. Preferred stockholders typically can’t vote on corporate matters that shareholders are asked to decide. But they get dividends before common stockholders. In addition, they’re in line ahead of common stockholders if the company files for bankruptcy and its assets are liquidated.
Beyond these two categories, there are types of stock that depend on the nature of the company:
- Growth stocks are companies that are growing their sales and earnings at an above-average rate.
- Value stocks are companies that are undervalued compared to their real, underlying value.
- Dividend stocks are companies that reliably pay dividends to shareholders.
- Blue-chip stocks are big, well-established companies like Apple, IBM, McDonald’s, Microsoft and Walmart.
Stocks Are Traded on Stock Exchanges
In the U.S., stocks are traded on the New York Stock Exchange and the Nasdaq, which are stock markets where shares of publicly traded companies are listed so they can be bought and sold.
Among the largest, best-known publicly traded companies in the U.S. are Walmart, Amazon and Apple. The NYSE lists more than 2,400 stocks, while Nasdaq lists more than 4,200 stocks.
“Public companies are a key part of the American economy,” states the U.S. Securities and Exchange Commission (SEC), an independent federal agency that regulates stock trading.
You might own a company’s stock through a retirement plan or mutual fund, for instance, or you might buy the stock directly through your own investment account.
How Does Stock Trading Work?
Investment firms, financial professionals and regular people all engage in stock trading. Their overarching goal is to buy stock at a low price and later sell it at a higher price.
When you want to buy and sell stocks, you can opt to use the services of a financial advisor or handle it on your own via an online brokerage or a trading app. No matter who places a stock order, trades on a stock exchange are handled electronically.
Among the types of stock orders that a trader can place are:
- Market order. This type of order aims to buy or sell shares at the price when the order is placed.
- Limit order. The trader specifies a price the stock needs to reach before buying or selling.
- Stop-loss order. Designed to prevent losses, this order sells a stock when it falls a certain price.
- Day-only order. This type of order is in effect solely on the day that it is placed.
- Good-til-canceled order. This type of order is in effect unless it’s carried out or canceled.
Day traders aggressively buy and sell stocks over the course of a single day, with the intent of reaping gains from short-term price changes. As you might imagine, day trading carries a lot of risk.
Meanwhile, buy-and-hold investors purchase stocks and hold them for an extended period of time, typically several years or more. The idea is to avoid the short-term fluctuations in the market and instead focus on the long-term growth potential of the investment.
Why Trade Stocks?
- Earn profits when stock prices rise. A long-term investor might buy a stock and hold onto it in order to build up their retirement savings. Meanwhile, a day trader typically buys and sells stock in a short amount of time for a quick financial gain.
- Generate a regular stream of income. Income investors buy stocks in order to generate a recurring stream of income from dividend payments. Retirees, for instance, might rely on these dividends to help cover their expenses.
- Influencing a company’s operations. Activist investors might purchase a large chunk of a company’s stock to pressure the company to make changes, such as selling poorly performing assets or getting rid of the CEO.
Where Can You Buy and Sell Stock?
These days, you’ve got plenty of options for buying and selling stock. They include:
Online Brokerages
An online brokerage account enables you to buy or sell stock through a website or app without assistance from a stockbroker or other investment professional.
To achieve the best results, you should do your homework to make sure a stock purchase or sale aligns with your short-term and long-term financial goals.
Robo-advisors
A robo-advisor is a digital platform that automates investment decisions based on your preferences and goals. Some folks may enjoy the lack of a human connection with a robo-advisor, while others may be turned off by it.
Full-Service Brokerages
A full-service brokerage can handle your trades in person or over the phone. A professional at one of these firms can also buy and sell stocks on your behalf and can offer advice about such matters as retirement planning and tax planning.
Full-service brokerages tend to charge higher trading fees than online brokerages or robo-advisors.
Should You Be Trading Stocks?
Trading stocks is one of the best ways to grow your wealth over the long term.
BetterInvesting, a nonprofit founded as the National Association of Investment Clubs, recommends a strategy of diversifying your stock holdings and regularly buying stock regardless of the forecasts for stock market performance.
“Trying to guess the stock market’s direction so that you’re investing in stocks when share prices are low and selling stocks when prices are high has never worked,” BetterInvesting says.
“Despite the stock market’s gyrations, stock prices over the long term have continued to increase—about 10% a year, historically. So investors are better off taking the long view and investing a set amount regularly, no matter what the market is doing and Wall Street analysts are saying.”
This strategy is known as dollar-cost averaging, which involves automatically buying more shares of a stock when the price is lower and fewer when the price is higher, according to BetterInvesting. As a result, you should end up with a lower average purchase price and a higher overall return.
Of course, some strategies have historically worked better than others, but it’s always worth keeping in mind that when it comes to investing, past performance is no guarantee of future results.
