Stocks rule: What they are and how they make money

Before you start investing, understand how stocks work.

What is a share of stock?

A stock is a piece of a company. Even if you own just one share of stock, you are a shareholder and you own part of that company. 

Of all investment types, stocks carry some of the best potential for long-term returns. Since Nasdaq's inception in 1971, stocks have returned more than 10 percent annually, on average. The chart below compares that return to bonds over that period, as well as the current earnings on high-yield bank savings accounts. 

The bad news? Stocks are also riskier than other investments, which means investors can lose money, especially in the short term. 

A stock's value is always changing

There are many reasons why a stock's value can go up and down. For starters, company performance. When a business is successful, the value of its stock typically rises. 

But another factor affecting a stock's value is supply and demand. 

When more investors like a company, demand drives the price of its shares up. On the other hand, when more shareholders want to sell, the price falls. This is the law of supply and demand in action.  

Sometimes demand is rational. For example, a company could invent a faster and cheaper way to stream video, or a top stock analyst might recommend the company. The demand of this stock would then likely increase. Conversely, demand for a stock could drop if the company reveals unexpectedly low earnings in their quarterly report. 

Supply can change when a company buys back some of its own stock, or splits the stock. Analysts also look at inflows and outflows, which refers to how much money confident investors are pouring into a company by buying stock—or whether frightened investors are selling. 

Of particular interest for analysts are something known as 13F filings, which are reports filed by institutional investors (think hedge funds) with at least $100 million with equity assets under management. Stocks can drop when institutional investors are reporting having sold their holdings in that company (for example, if a major hedge fund reports that they sold all of their shares in General Electric, that could have an impact on the stock's price). 

But sometimes investor sentiment is based on intangibles, like fear. If there's bad news for an industry—say, an industrial oil spill at sea, threats of a trade war or other geopolitical events—the stocks of even slightly related companies might take a hit. 

In the worst case, intangibles can lead to a herd mentality that transcends logic. As economist John Maynard Keynes once said, "The market can remain irrational longer than you can remain solvent." When you add in the rise of algorithmic trading, in which huge blocks of shares trade within nanoseconds, you can see how even small market shifts can quickly turn into major events. 

What are dividends?

While there is risk involved, the ultimate goal of investing is to make money. When you invest in stocks, your profits typically come in two forms: 

1. You get cash dividends. A company can choose to pay shareholders some or all of its profits through dividends. You can take your cash and buy new sneakers, or you can reinvest your dividends by buying more shares. This may not sound as fun as new sneakers, but over time you could buy a house with a walk-in shoe closet. 

2. Share prices go up. Lots of companies don't pay dividends, but shareholders' money can still grow exponentially if the value of the stock rises. 

Of course, there's no guarantee that the stock price will rise or the company will offer dividends. Just as the fine print always says, past performance is not indicative of future results.