What are stocks?

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One part of investing in stocks and other financial markets is the use of many, many terms that all refer to the same thing. This is very confusing for a starting investor. Many websites and other sources use the wrong terms in the wrong context. To get things clear right from the beginning:

While we're at it, you will also encounter the word “security” a lot when reading about stocks or bonds. A security is a general term used for financial instruments that have ownership or debt in a company that has value and can be bought or sold. A stock represents ownership so a stock can be called a security. A bond represents debt, so a bond is also called a security. There are three types of securities:

You’ll learn more about bonds and derivatives in later chapters. For now you just need to know that a stock is a type of security.

3.1 Why do companies sell stocks?

3.2 Ownership

It’s important to understand that you do not actually own everything the company possesses when you buy their shares. You own the shares of that company. You do have a stake in the company's equity but the real corporate property is legally separated.

For example, all the computers used in the company are owned by the “company” and not by the shareholders. This is important to know because of the liability. For example, if you go bankrupt for whatever reason, you can’t sell the computers of the company to pay creditors just because you are a shareholder. And the same applies for the company if they go bankrupt. They can’t quickly sell your shares because they need money.

3.3 Two types of stocks

There are two types of stocks:

The main difference between common and preferred stocks are certain rights and features. For example, preferred stockholders hold an advantage over dividend payments. They receive dividends before common stockholders do. Preferred shareholders also get a predetermined amount of dividend at a predetermined interval. The dividend payment might be lower than common stocks but is more steady. In some cases, preferred stock holders get dividend payments and common stocks holders get none.

Preferred stockholders are eligible for payback of leftovers before common stockholders when a company gets liquidated (the company goes bankrupt / stops existing). While on the other hand common stockholders have voting rights where preferred stockholders do not. Preferred stocks act more like a hybrid combination of stocks and bonds (equity and debt). You’ll learn more about bonds, equity and debt in the next chapters.

Preferred stocks have a call option. A call option gives the issuer (the company) the right to redeem or reclaim the shares at a certain price on a certain date. Basically meaning you have to sell back the shares to the company. Common stocks don't have a call option. 

An overview of differences:

Issueing preferred stock is often the last resort for a company to raise additional money due to taxes. They will issue common stocks and bonds first. Dividends paid to preferred stockholders are paid with profits after tax. These expenses are not deductible while bonds are deductible. Most of the time preferred stocks are bought by institutional investors. Institutional investors are large institutions with hundreds of millions or billions of cash like banks and hedge funds. As a traditional investor you will most likely always buy common stocks. But preferred shares are getting more attraction by investors over the last few years.

An overview of historical returns and volatility over the years between preferred stocks and common stocks (equity):

Source: Bloomberg, RBC Dominion Securities, Inc.