Stocks and stock markets
Shares of stock represent ownership in a company. Stock markets let millions of investors buy and sell them every day.
What a stock is
A share of common stock is a unit of ownership in a corporation. Shareholders have a residual claim on the company's assets and profits after creditors are paid, usually vote on directors and major decisions, and benefit from dividends and rising share prices. Their liability is limited to what they invested.
Preferred stock
Preferred stock pays a fixed dividend that must be paid before any common dividend and has priority over common stock in liquidation, but usually carries no voting rights. It behaves partly like a bond and partly like equity. Cumulative preferred stock requires missed dividends to be paid before common shareholders receive anything.
Primary and secondary markets
In the primary market, companies sell new shares to investors, as in an initial public offering (IPO), raising capital. In the secondary market, investors trade existing shares among themselves on exchanges such as the New York Stock Exchange and Nasdaq; the company receives no money from these trades, but liquid markets make its shares more attractive.
How trading works
Investors place orders through brokers. A market order buys or sells immediately at the best available price; a limit order sets a maximum buying or minimum selling price. The bid is the highest price buyers offer; the ask is the lowest price sellers accept; the difference is the bid-ask spread, a trading cost.
Stock market indexes
Indexes track groups of stocks. The S&P 500 covers about 500 large US companies, weighted by market value. The Dow Jones Industrial Average tracks 30 large US companies, weighted by price. The Nasdaq Composite is heavy in technology stocks. Global indexes include the FTSE 100 (UK) and Nikkei 225 (Japan).
Returns from stocks
Total return combines dividends and price change: \(\text{return} = \frac{D_1 + (P_1 - P_0)}{P_0}\). If you buy a share for 50 dollars, receive a 2-dollar dividend, and sell at 55, your return is (2 + 5) / 50 = 14%. Over long periods, US stocks have averaged roughly 10% a year nominal, but with large swings.
Market efficiency
The efficient market hypothesis holds that prices quickly reflect available information, so consistently beating the market is very difficult. Evidence that most actively managed funds underperform low-cost index funds after fees supports a practical version of this view, though bubbles and crashes show markets are not perfectly rational.
Worked example
An investor buys 100 shares at 40 dollars (4,000 dollars). Over a year, the company pays dividends of 1.20 per share (120 dollars) and the price rises to 44 dollars (gain of 400). Total return = (120 + 400) / 4,000 = 13%. Dividend yield = 1.20 / 40 = 3%; capital gain yield = 4 / 40 = 10%.
Key takeaways
Common stock is ownership with voting rights, a residual claim, and limited liability. Preferred stock has dividend and liquidation priority but usually no vote. Primary markets raise new capital; secondary markets trade existing shares. Market and limit orders, bids, asks, and spreads describe trading. Indexes such as the S&P 500 track market performance. Total return = dividend yield + capital gain yield. Markets are largely efficient, making index funds hard to beat.
Flashcard
Ownership share with voting rights
Check your understanding
You buy a share for 80 dollars, receive a 4-dollar dividend, and sell it for 84 dollars. What is your total return?