What is Common Stock?

Common stocks just might reign in your portfolio. That’s because they’re the investment most likely to pull in the greatest return over the long run, thereby leading the way in helping many investors achieve their financial goals.

Definition of common stock

A stock is a fraction of a public company’s assets and earnings. So when an investor buys shares of a stock, they essentially become a part-owner of the company and gain a vested interest in its business. If the company does well, the value of your shares typically go up, and you get that much closer to reaching your financial goals. If the company does not-so-well, your shares are likely to lose value, and your goals may seem to get further away. 

Common shares are the investment class most people are referring to when they’re talking about investing in stocks.

Common vs. preferred stock

Though not as, well, common, there is another share class for stocks: preferred. But don’t let the name fool you: Preferred stocks actually may not be the class you’d pick over common stocks. They do pay set dividends—a definite draw, especially for investors looking for the security of regular payments. Common stocks might pay dividends, too, but they typically pay less than preferreds. And if a company offers dividends with both preferred and common shares, the former get paid first.

Preferred stocks also get preferential treatment if a company declares bankruptcy. In such cases, bondholders get repaid first. If there’s anything left after that, preferred shareholders get paid. Common shareholders are last in line.

Still, common stock tends to perform better than its preferred brethren. Preferred stock functions a little like a bond in that you get the original investment back if you hold the shares for a set period of time (“to maturity”)—typically 30 years of more. But while the payback for preferreds is largely defined by whatever its dividend pays, the value of common stocks can soar—and sink—with the company’s success (or lack thereof). 

And the big advantage over preferred stock: Common shareholders get voting rights. That means you get to elect the company’s board members and have a small say—typically one vote per share owned—in what the company is doing.

Why invest in stocks?

Whichever class you opt for, stocks are a smart choice for any investor looking to generate the largest potential returns. Consider the numbers: Between 1926 and 2018, a portfolio built of 100 percent bonds offered a tidy return of 5.3 percent a year, on average, according to data from financial firm Vanguard. But an all-stock portfolio nearly doubled those gains over the same time period, returning an average 10.1 percent a year.

Of course, that higher reward only came after enduring a very bumpy ride: The stocks-only portfolio had 26 losing years over the 93-year period, dropping as much as 43.1 percent in 1931. The all-bond portfolio, on the other hand, posted losses in only 14 of the 93 years with its worst year losing just 8.1 percent in 1969.

The risks of investing in stocks

Why are stocks so risky? Because every business can face a host of headwinds that threaten their profitability: political strife, new competition, bad weather, changing trends, or, as we’re witnessing now, a global pandemic. 

Even if management is able to successfully navigate the unpredictable and generate solid profits, it doesn’t necessarily mean the company’s stock will do well throughout that process. That’s because investor sentiment is what really drives stock price. Investors push prices up and down with each buy and sell order. And why investors decide to trade can be just as unpredictable as the business landscape, as evidenced by the constant ups and downs of the market.

But you also face risks by not investing in stocks. Inflation eats away at the value of your money, whether you keep it in an investment portfolio, savings account, or even stuffed under your mattress. And with the current inflation rate at 2.33 percent, as of February 2020, according to InflationData.com, money in a savings account, where it’s likely to be earning far less than 1 percent these days, simply can’t keep up. That means money in savings is actually losing purchasing power. Your best bet for beating inflation over the long run is investing in stocks.

Building a well-diversified stock portfolio

The good news is that while you can’t control the market, you can control your own investments and actions to mitigate potential risks. Diversification is your key to doing this, even within just the stock portion of your portfolio. For example, you should have a nice mix of small-company, midsize-company and large-company stocks, international and domestic stocks, growth and value stocks, and much, much more. In normal market cycles, some of those types of stocks should go up while others go down, which should protect your portfolio from overwhelming losses. (A fully diversified portfolio might also include other types of investments, such as bonds, real estate, commodities and other alternatives, as well as cash.)

If investing in all those different kinds of stocks sounds like a lot of work, you’re not wrong. You’d need to do a ton of research and possibly pay a lot in trading costs and taxes to build and maintain a well-diversified portfolio using individual stocks. 

Luckily, there is a better way. Mutual funds and exchange-traded funds, or ETFs, allow you to invest in possibly hundreds of companies in one fell swoop. (Acorns portfolios include a mix of ETFs that give investors exposure to thousands of stocks and bonds.) Plus, funds—particularly ETFs and index funds—provide that broad diversification at relatively low costs. That helps make investing and achieving your financial goals as easy as possible.

The stock market can go down, as we’re witnessing now, so it’s important to factor that into your equation and make sure the money you’re investing has time to recover from any bumps. It has taken several months for the market to fully recover from some downturns. Still, throughout history, every market downturn has ended in an upturn and stocks have eventually gone on to new highs.