Basic characteristics

As one of the most discussed and widely known financial products, stocks dominate the financial news and are consistently tied to the economy’s overall performance. There are two types of stock: common stock and preferred stock. We’ll focus on common stock in this chapter.

So, what exactly is common stock? It’s a representation of ownership in a company (issuer). If you “go long” (buy) one share of stock in a company like Coca-Cola, you’re an owner (stockholder) of Coca-Cola. Granted, you own a tiny piece of the company. For context, Coca-Cola has over 4 billion shares outstanding. It’s common for companies to have millions or billions of outstanding shares that represent the company’s overall ownership. Because of this, common stock is referred to as an equity security.

Common stock prices rise and fall in the stock market depending on demand. Most of the time, demand is influenced by the company’s success. If Coca-Cola has a good business year, its shares will likely rise in value due to higher demand for its stock (and vice versa). Simply put, prices rise if more investors purchase stock, and prices fall if more investors sell stock. We’ll discuss more about the stock market in the secondary market chapter.

There are two general ways to make money on common stock. First, investors can obtain capital appreciation, also known as growth and realized as capital gains. When an investor purchases stock, it is purchased at a specific price per share.

For example, Stacy purchases Ford Motor Company stock at $10 per share. She invests in Ford because she believes in its products and business model. Over the next few years, the company sells more cars and trucks than expected and demand for Ford stock increases. With more demand in the stock market, its stock price rises to $25. Stacy sells her shares and locks in a $15 per share profit. The increase in the value of her shares is an example of capital appreciation.

Issuers may also pay cash dividends to their stockholders. While Stacy holds her Ford shares and watches them rise in price, Ford could pay her a dividend. A cash dividend represents profit made by the company that is then distributed to its shareholders.

Not all publicly traded companies pay cash dividends. When companies grow, it’s essential to retain and reinvest profits back into the business. For example, Amazon has never paid a dividend to its shareholders. With every dollar the company makes, it reinvests those retained earnings back into the business and uses it to expand operations, hire employees, and pursue opportunities in new industries.

Companies like Amazon are known as growth companies, aiming to increase the size of their business operations and profitability. While Amazon is large and well-established, start-ups and small businesses also fall into this category. Investments in growth companies provide the opportunity for capital appreciation but generally do not pay income (dividends) to shareholders.

When a company is towards the end of its growth cycle (when there’s not much more room to expand its operations), it’s more likely to share its profits with shareholders through dividend payments. Companies won’t share all of their profits (they’ll need to pay for their current operations), but will typically share the “excess” it doesn’t need.

Ford Motor Company is an issuer with a long history of paying cash dividends. Referring to our previous example (above), Stacy could have made more than her $15 per share profit from capital appreciation. If Ford paid dividends amounting to $1 per share over the time Stacy held her shares, her overall profit is $16 per share ($15 per share from capital appreciation + $1 per share from dividends).

To receive a dividend payable by a company, investors must purchase their shares before the company pays the dividend. We’ll go further with dividend timelines later in this chapter.

This video should serve as a quick visual guide to the basic characteristics of common stock:

Cyclical stock

Cyclical stocks are shares that tend to follow the movements of the broader business cycle. These stocks generally perform well during periods of economic expansion, when consumer and business spending increases, and tend to decline during economic contractions or recessions, when spending slows down. Cyclical stocks are considered more volatile than non-cyclical (defensive) stocks because their performance is closely tied to the economy. They can offer strong growth during upswings but also carry higher risk during downturns.

Cyclical stocks are usually associated with industries that produce discretionary goods and services that consumers can delay purchasing in tough times. Common examples include automobiles, manufacturing, hotels, clothing, furniture, and restaurants. These sectors are sensitive to changes in consumer income and confidence. In contrast, defensive stocks (such as utilities, food, and healthcare) tend to be more stable because their goods and services are always in demand, regardless of economic conditions. Investors who expect the economy to grow may favor cyclical stocks to capitalize on potential gains.

Defensive stock

Unlike cyclical stocks, defensive stocks tend to hold their value through all business cycle phases. These companies typically operate in industries that provide essential goods and services that consumers continue to buy even during economic downturns. As a result, defensive stocks are known for being less volatile and are often favored for their reliable dividend payments.

Defensive stocks often underperform during economic expansions, when investors favor growth and cyclical opportunities. During economic contractions or recessions, defensive stocks tend to outperform because their revenues remain steady while other sectors experience losses. This stability makes them attractive for risk-averse investors or those looking for income through dividends. Common examples of defensive industries include healthcare, utilities, food and beverages, and tobacco. These sectors meet basic consumer needs, which means demand stays relatively constant regardless of economic conditions.