A lot of people get intimidated talking about stocks, but I’ve found that most people fundamentally know what a stock is: a fractional ownership in a company.
Things start to get a little fuzzy from there, so I like to first talk about why stocks exist as we know them today. This won’t be a history lesson about joint-stock companies, but rather why you can even buy shares of McDonald’s or Nike in the first place.
Imagine you own a company that sells books. Hard to believe. Pretty soon you are selling a zillion books and making great money, and reinvesting all of that money back into your book selling company. But now, instead of just selling books, you’re selling everything. And people are buying it, and you’re making even more money.
Now, if you want to sell some or all of your company to someone else, you can. But you’ve gotta find a person and make a deal. Far better if you can just sell some to anyone that wants a piece.
Why would you want to sell? Maybe you want some cash now for yourself or your family. Maybe the selling business is great now, but who knows if it will last forever? Maybe you want to get some cash to reinvest in the selling business. It doesn’t matter: if you want to trade a piece (i.e., a share) of your company for cash, you need to sell stock.
Different countries have come up with standards that a company must meet in order to be able to trade shares on public exchanges. They are mostly built around transparency and reporting requirements. If you are going to be able to sell your shares to Joe Public, you have to at least open your books to him.
But I digress. You’ve sold some shares. What now?
Now the owners of all of the shares are entitled to their share (pro-rata) of the profits of the company. When you own stock, you own equity. However, that puts you last in line for those profits. Have people you borrowed money from? If the company stops making money, they have first dibs on the stuff it owns. Risky.
So you own something that might have some nice returns, but if it does poorly, the value could potentially evaporate. So why buy it? Well, at some point the price reaches a level where the future returns the investor expects are enough to compensate him for the risk. So he buys.
When you buy stock, you are literally purchasing a fractional interest in the company. If you buy all of the stock, you own the entire company. That’s actually how it works.
So to recap: stocks are part ownership in a company. They are risky. You buy them because you expect them to have good future returns.