A stock is a unit of ownership that a stockholder possesses in the organization. The percentage of ownership depends on the number of shares or stocks an individual owns out of the total capitalization of the organization. It is important to know about the basic concepts of stocks, types of stocks, advantages and limitations of investing in stocks, who should invest and so on. In this article, we have covered the basics of stocks meaning and investing in stocks.
What is a Stock?
Stock is security which represents ownership of a part of a company. It is also known as equity. The stockholder is entitled to the profits of the company. In other words, a stockholder is eligible for the company’s assets and profits to the proportion of stock they own.
Companies issue shares for multiple business reasons. Often most companies raise funds to operate the business. The two types of stocks are preferred and common. Companies issue stocks through an Initial Public Offering (IPO). After the IPO, the stocks are listed on the stock exchange. Interested investors can buy and sell stocks on the stock exchange.
Here are 6 Different Categories of Stocks Based on
- Market Capitalization
- Dividend Payout
- Price Trend
|Stocks Based on Ownership||Common Stocks|
Embedded Derivative Option Stocks
|Stock Based on Market Capitalization||Large-Cap Stocks|
|Stock Based on Risk||Blue-chip stocks|
|Stock Based on Dividend Payout||Income Stocks|
|Stock Based on Price Trends||Cyclical Stocks|
|Stock Based on Fundamentals||Undervalued Stocks|
Explore: Stock Market Basics
Different Types of Stocks
The stocks are also classified on the basis of their market capitalisation, ownership, risk, dividend payout, fundamentals, price trends.
1. Common Stocks
Common stocks are the type of shares that provide ownership to its holders in the organization. The common stockholders have voting rights in matters such as election of chairman, election of board of directors, policies, and so on. In the event of liquidation, the common stockholders have a right over the assets of the company after the creditors, lenders, preference shareholders are paid off.
2. Preference Stocks
Just like common stocks, preference shareholders have voting rights and rights over the assets in the event of liquidation. However, the difference between common stockholders and preferred stockholders is that the preferred stockholders enjoy a preference or priority over common stockholders. In the event of liquidation, the preference stockholders will be paid off first and then common stockholders will have a right to receive the assets. Similarly, the preferred stockholders are paid a fixed dividend when the company distributes its surplus.
3. Hybrid Stocks
Hybrid stocks are also known as convertible preference stocks. As the name suggests, such types of stocks have an option to be convertible into a common stock on a specified date for a predetermined convert ratio. For example a ratio of 3:2 preference to common stocks would mean for every 3 preferred stock held the shareholder will receive 2 common shares. Such stockholders may or may not have the voting rights.
4. Embedded Derivative Option Stocks
The stocks with an embedded derivative option can be a callable option or a puttable option. Under a callable option the company has a right to buy back at a given time for a specified buy back price. Under a puttable option, the shareholders have an option to sell the sell at a specified time for a predetermined price.
5. Large-Cap Stocks
Large-cap stocks are the ones with the highest and largest market capitalization. The companies such as Infosys, Reliance Industries, TATA fall under this category. Such companies offer diversification to its investors as they operate their business in multiple industries and sectors. With a large cash reserve at disposal such companies have a wider and greater opportunity to exploit the market and business laterals. The large-cap companies are also known as blue-chip companies.
6. Mid-Cap Stocks
Mid-cap stocks are stocks with a medium capitalization ranging between Rs. 250 crore to Rs. 4,000 crore. Such mid-sized companies have the potential to become the next large-cap companies in the years to come. With high business potential and growth opportunities such companies tend to grow in the long-term.
7. Small-Cap Stocks
Usually companies with a market capitalization of less than Rs 250 crore are considered as small-cap companies. Such companies have the potential to rapidly in the future given the business or industry they belong to. Since such companies are new to the market with a small market capitalization these stocks are relatively more volatile than mid-cap and large-cap stocks.
8. Blue-Chip Stocks
The blue-chip stocks are also the large cap market stocks with a larger capitalization and operations. The blue-chip stocks belong to companies that have a proven record of stable earning, higher growth potential, higher reserves, and wider consumer base. The companies such as ICICI Bank, Reliance Industries, Infosys fall under this category. Such companies usually pay regular dividends to its investors.
9. Beta Stocks
Beta is a measurement of volatility in the price of the shares that trade on the stock market. The beta is a signal of whether the stock price will move in sync with the market conditions or the price will move against the market trend. It could be a positive or negative beta. A higher beta denotes a higher volatility and a higher risk potential. Similarly, a stock with a lower beta denotes a lower volatility and lower risk. Hence, an investor must consider the beta stocks in his or her investment basket carefully.
10. Income Stocks
Income stocks are also known as dividend yield stocks. This type of stocks belong to companies that distribute consistent and frequent dividends to its shareholders. These are highly stable companies. The share price does not fluctuate relatively higher than the market trend for such companies. Moreover, income stocks distribute a higher dividend in relation to their share price.
The preference shares are also a type of income shares as the dividend is promised and distributed at the predetermined ratio or rate. The income shares are a better option for conservative investors who are looking for a regular income and a relatively less risky type of stock.
11. Growth Stocks
Many companies prefer growth and reinvestment over distribution of surplus as dividends to its shareholders. Such companies reinvest their earnings to support its operations, increase their reserves for the future, expand its existing chain of business and scale. The stocks of such companies are known as growth stocks. With the growth of the company and its business, the company’s share price rises.
Such a rise in the share price is the return that an investor earns with growth stocks. The investors looking for growth and capital appreciation over time invest in such shares. Obviously such a return is at the cost of low or no dividend income. Such growth stocks are a better investment option for a long term.
12. Cyclical Stocks
The cyclical stocks are stocks or shares of companies that are majorly affected by the economic conditions. The performance of such companies is dependent or directly related to the existing economic considerations. When the economy booms the company performs well and shows a rising trend. While during an economic downturn the company’s performance and share price shows a downward trend.
13. Defensive Stocks
As the name suggests the defensive stocks are not directly affected by the economic conditions. Like all companies an economic condition such as inflation, recession, etc will affect this company as well just like it would affect other companies in the same industry. However, the defensive stocks are not directly affected or relatively unmoved by the fluctuations in the economic conditions.
Many investors believe that the share price of a company must be equal to the intrinsic value of the share. For such an analysis, arrive at the intrinsic value of the share by comparing the recent share price with the profit earned, earnings per share, and other financial ratios. Now, the share may be undervalued or overvalued in comparison to the intrinsic value of the share.
14. Undervalued Stocks
If the share price is less than the intrinsic value of the share then the share is an undervalued share. An undervalued share is also known as a ‘value share’ or a ‘value stock’. The value investors prefer undervalued shares as they believe that the share will correct its value and share price will rise in the future.
15. Overvalued Stocks
If the share price is more than the intrinsic value of the share then the share is an overvalued share
The following table will help you know the types of shares or stock.
Tax on Stock
Yes. Returns from stock market investments are taxable. The returns are known as capital gains. Capital gain is the increase in the value of the asset since the time of purchase. Investments in equity or equity-related instruments are taxable.
Investments with a holding period of less than 12 months attract short term capital gains tax. The gains are taxable at 15%.
On the other hand, investments with a holding period of more than 12 months attract long term capital gains tax. The gains above INR 1,00,000 in a year are taxable at 10%.
Risks of Investing in Stocks
The following are some of the common risks of investing in stocks –
- Market risk: This risk is faced by all investments due to the overall market performance and economic conditions. Because of this, the stock price fluctuates daily, determining the investor’s profit or loss from that stock investment.
- Company risk: When the company faces problems then, this impacts the stock price. Thus, it is essential to analyse the company’s financial strength before investing in any stock.
- Interest rate risk: The government changes the interest rates based on the direction in which the economy is heading. Hence, if the interest rates increase, companies get loans at higher rates, and they can cut their profits, affecting the stock price. In contrast, if the interest rates are low, it indicates an economic slowdown and businesses may suffer losses. Therefore, a balanced interest rate regime is healthy for stock markets.
- Inflation risk: Inflation means an overall increase in the price of commodities and products. When inflation increases, the companies spend more procuring the same amount of raw material, which can impact the company’s profitability, causing a drop in stock prices.
- Regulatory risk: The companies are spread among various sectors, and many sectors are governed by different regulatory bodies and involve government. Hence, any change made by the regulator or announced by the government can impact the companies in those sectors resulting in a stock price rise or fall.
- Liquidity risk: The solvency and liquidity position of the company are crucial while declaring dividends. Dividends form a good source of regular income for investors. Thus, a company with liquidity problems can cut dividends or, worse, find it difficult to repay its debts or clear outstanding bills. This will have an adverse effect on the stock price.
There are various other risks like political risks, currency risks, social risks, etc., which can impact the stock price.
What are the Advantages of Investing in Stocks?
- Return on investment: Stock market returns have historically outperformed most forms of other investments. Investing in the stock market provides the potential to grow money over time. Many well-established firms also offer dividends to shareholders, increasing the overall return on investment.
- Ownership in a company: One of the simplest methods to become a minority owner within a firm is to invest in their stock. When an investor acquires stock in a corporation, they are essentially owing a part stake in the business. Though the ownership percentage may not be significant, the investor will have the right to vote on certain business decisions and corporate leadership.
- Liquidity: Stock investments are the most liquid investment options available to investors. Buying and selling stocks can be done within seconds. In case of immediate requirement for liquidity, one can always sell their share easily and have access to cash.
- Regulated by SEBI: The Securities and Exchange Board of India (SEBI) regulates and governs the stock market. SEBI has the responsibility of overseeing any development and protecting the interests of its stakeholders.
What are the Disadvantages of Investing in Stocks?
Following are the disadvantages of investing in stocks:
- Significant Risk: Stock market investments are high-risk investments. During unfavourable market scenarios, an investor could lose their entire investment. Stocks are highly volatile investments. Therefore, it is advisable to invest with caution.
- Timing: It is almost next to impossible to time the market. The volatile nature of the stocks makes it difficult to hit the bull’s eye. Buying low, selling high is a good strategy. However, buying them at the lowest and selling at the highest is not very easy.
- Knowledge: Stock investing requires in-depth research about the company and the market as well. Studying the financial statements, annual reports, comparing the historical performance, sector analysis, etc. is a tedious job. Therefore, unless one can do all the research before investing, stock investing is a gamble.
- Emotions: Seeing the stock movements, investors often buy at high prices with an anticipation that the prices would go up (out of greed). Also, they end up selling at low and making losses with an expectation that the price may fall further (out of fear). Price fluctuations are frequent. However, it is essential not to get carried away by them.
- Stockholders are paid last: In a scenario where the company goes out of business, first, the preference stockholder and bondholders or creditors are paid. And in the last, the common stockholders are paid.
|Basis of Difference||Shares||Stocks|
|Nominal Value||Shares have a nominal value.||No nominal value for stocks.|
|Original Issue||Shares are part of the original issue by the company.||Not part of the original issue. Once the shares are issued, they are converted to stocks.|
|Paid-Up Value||Fully paid up or partially paid up||Fully paid up.|
|Transfer||Transferred in lots but not fractions.||Can be transferred in fractions.|
|Maximum Number||Offered in limited quantity, thus there is a limit on holding.||No limit.|
|Scope||Narrower than stocks.||Wider scope than shares.|
|Types||Equity Shares and Preference Shares||Common Stock and Preferred Stock|
What Moves A Stock Price?
Once the shares are trading in the secondary market, the stock prices are determined by the forces of demand and supply. The three basic scenarios that occur for stock price movement are –
- Stock price will appreciate: There are a large number of buyers and only a few sellers. It means there is high demand and low supply.
- Stock price will decline: When there are a large number of sellers and only a few buyers. It means the supply is high, but demand is low.
- Stock price remain the same or fluctuate slightly: The number of buyers and sellers are the same.
Besides this, several other factors affect the demand and supply of stocks, influencing stock prices. Some of the common factors are –
- Company performance: If the company’s earnings have exceeded expectations, the demand for a stock is expected to rise. As a result, the stock price will increase. On the other hand, if the company’s performance declines, then stockholders may want to sell their shares where there are only a few buyers. As a result, stock prices tend to fall.
- Sector performance: The stock prices of companies in the same sector tend to move in a similar way. If the entire sector is experiencing a bullish trend, then the stock prices of companies within the sector are likely to increase. On the contrary, if the sector is in a bearish trend, the stock prices of the company will fall.
- News events: Any economic announcement will affect the stock price of the company. For instance, a change in repo rate could affect the debt cost for a company. Similarly, any political event, like a change in the governance of a country, can affect stock price movements.
Frequently Asked Questions
Stock investment comes with significant risk that an investor should be aware of. Especially in the short term, stocks are prone to high volatility due to dynamic market conditions. In the long term, historically, stocks have given significant returns. However, they do not guarantee returns.
Over the years, there were many highs and lows in the stock market. Therefore, investors need to be cautious while investing in stocks. Only investors with high-risk tolerance can consider investing in stocks.
There are other investment avenues where one can invest based on their investment horizon and risk levels. For example, mutual funds offer good diversification. Mutual funds invest in multiple stocks and professionals manage them. Therefore, these eliminate the risk of exposure to just one stock. However, these are not risk-free investments and also do not guarantee returns.
Yes, stocks are assets. However, they are financial assets rather than real assets. Financial assets are those assets that are easily convertible to cash. Financial assets do not have a physical existence. One cannot see or touch them. Real assets are tangible assets with a physical existence—for example, a piece of land, commodities, buildings, factories and trucks.
Financial assets have higher liquidity than real tangible assets. One can purchase a stock easily at lower costs than any other real assets.
There are some instances where financial assets invest in real assets. The underlying asset of a financial asset sometimes can be a real asset. However, this doesn’t make the financial asset a real asset. Some examples of financial assets investing in real assets are gold ETFs, REITs or commodity ETFs.