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What they Are
Securities representing an equity interest or an ownership share in a company, and generally providing voting rights to the holder. Common shareholders may receive dividends only after distributions have been made to the preferred shareholders. In the event of liquidation, common shareholders are the last to receive part of the company's asset and ranks behind creditors, lenders and preferred shareholders.
How they Work
Companies have two basic choices when they want to raise money. They can borrow or they can sell ownership or equity in the business to investors. In general, companies sell shares to investors in what's called an initial public offering (IPO). If the company needs to sell more shares later to raise cash, it's called a secondary offering.
After a company has sold shares to investors the shares may be listed on a secondary market such as a stock exchange. Trading of shares on a stock exchange is between investors and the company doesn't see any of the money.
The price you pay for shares is essentially set by supply and demand forces. The greater the number of buyers, the higher the price. Ideally, you want to buy a stock that is going to be in high demand after you buy it.
There are many reasons why a stock might be in high demand. The most important is the company's ability to make bigger profits. As a shareholder, you have the right to share in the company's profits. In general, the more money the company has left after it has paid all its debts, the more your share of the company will be worth.
The Risks
Stocks are generally risky investments because if the company you invest in fails, you could lose all of your investment. When a bankrupt business is wound up, shareholders are last in line to get money out of what is left.
Some stocks, however, are riskier than others. Smaller companies that don't have track records of consistent profit growth and paying dividends are often the riskiest. Big companies that are established in their industries and which have consistently improved profits and paid dividends are usually less risky.
Many stocks are prone to rise and fall in value in the short term. If you invest in stocks and then find you need your money a year later, chances are higher that the share price will have fallen and you'll realize a loss.
The Rewards
Over the long haul, stocks as a whole can give investors higher returns than most other investments. |
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