What is a Common Stock?

What's a common stock?

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The answer to this question isn't particularly difficult, yet a surprisingly small number of people seem to know it.

What's even more amazing is that the majority of people who own common stock don't know the answer either...

Or, at the very least, their actions seem to indicate that they don't.

But if you ever want to invest in the stock market successfully, you need to know the answer to this question.

You need to drive it into your brain.

You need to never forget it.

Why?

Because just knowing the correct answer gives you a sizeable advantage over 95% of those who purchase stocks.

What's this elusive secret?

What is a Common Stock?

I'll tell you what the answer is, and it's so simple, you might not realize the significance at first.

But, trust me, it's a 9.0 on the Richter scale of stock market importance.

Here it is...

A common stock is a fractional ownership interest in a real and ongoing business enterprise.

"So what?" you ask. "Everybody knows that."

And you're right. At first glance, this seems self-evident.

But be honest with yourself. If I had asked you this question yesterday, how would you have answered?

Yes, everyone knows a common stock is a fractional ownership interest in a real business. But do they act that way?

Actions speak louder than words, and judging by actions alone, most common stock owners have absolutely no clue what a common stock is.

Let me give you an example based on firsthand experience...

It's late 1999, and I'm finishing up my degree at James Madison University.

As an honors graduate with distinction in the College of Business, I know that a common stock is a fractional ownership interest in a real business.

But my actions don't reflect that knowledge.

Almost every stock on the major exchanges trades at a new high on a daily basis. In many cases, you can literally sit at your computer and watch a stock price ascend $1, $2, $5 - in just a few minutes!

Against this backdrop, I speculate that an earlier than expected mapping of the human genome will cause biotechnology stocks to explode just like Internet stocks. So I buy shares in a biotechnology company, Ariad Pharmaceuticals (ARIA).

I even convince several friends to join me in buying Ariad shares.

I buy the shares for $2. I even purchase Ariad warrants (which give me the rights to buy Ariad shares for $8 when it only trades at $2) for about fifty cents.

What happens next is an experience I'll never forget...

Between early January 2000 and March 3, shares in Ariad Pharamceuticals rise from approximately $2 per share to a little over $40!

The warrants perform even better, rising from fifty cents to upwards of $32!

I join my friends at our favorite hangout, the local Buffalo Wild Wings (BWLD), where we celebrate our good fortune well into the night.

Sounds good so far, right?

Only one problem.

I didn't sell.

Why would I?

This was a hot stock heading higher!

The following day, March 3, is the day Ariad reaches its all time high.

From there, it proceeds to move downward just as quickly as it rose...

Ten years later, I still own those shares of Ariad Pharmaceuticals (ARIA), holding out a ray of hope they'll one day pay off again.

So what's my purpose in telling this story?

It isn't to disparage Ariad Pharmaceuticals, but rather to teach an important lesson about investing in the stock market.

I treated shares of Ariad Pharamceuticals like a random number on a roulette wheel.

I was gambling.

I was NOT investing.

Why do I say this?

Because, at the time, Ariad Pharmaceuticals didn't have a product. They didn't have revenues. They didn't have much of anything but some promising research and a ticker symbol.

So why did I buy Ariad?

Because I hoped and believed their research would soon translate into a flood of revenues and profits, or at the very least, a much higher stock price...

Ultimately, this was my goal - to watch the stock price rise 100-fold and then sell.

I had no interest in, or knowledge of, Ariad's business operations beyond that point.

While I knew common stocks were fractional ownership interests in real business enterprises, I acted like common stocks were lottery tickets offering a quick chance to score big.

95% of common stock owners act the same way...

Don't be like those 95%.

A Lesson Learned

Some people will say the lesson from my Ariad story is to sell while you're ahead.

But when should I have sold? $10? $20? 30?

And what if I had never been ahead?

That's the problem with speculating instead of investing.

The real lesson is to treat common stocks for what they are - fractional ownership interests in real businesses.

When you do that, you don't need to worry about a stock's peak price...

As long as the business fundamentals remain strong, the peak price will always be in the future.

By 2003, this principle was thoroughly ingrained in my head.

So...

When our favorite hangout, Buffalo Wild Wings (BWLD), went public, I once again told my friends and family to purchase a company's common stock.

But this time, my recommendation was based completely on the underlying business ownership the stock represented.

I knew Buffalo Wild Wings. I loved to eat and drink there. I loved to celebrate there. I loved to watch sports there.

The business was easy to understand. The earnings were real. The company was well-run. It was conservatively financed. Growth targets were realistic and easy to predict...

Today, Buffalo Wild Wings remains a thriving business, and those who took my recommendation to buy and hold in 2003 are very happy.

Just look at a chart of company's stock.

Through early 2009, that's an approximate gain of 200% while the S&P 500 is down 31% over the same time period.

Now, how many of the thousands of people who ate in a Buffalo Wild Wings in the two decades prior to its market listing ignored its stock while speculating on the latest investment fad?

The Key to Successful Stock Market Investing

The stories above illustrate the fundamental key to successful stock market investing...

Common stocks are fractional ownership interests in real-life businessess.

Remember that definition.

It's that simple.

Does that mean it's easy to pick stock market winners and losers?

No.

I said it's simple, not easy.

But it will be within your grasp - once you learn to make investment decisions the same way you make business decisions.

Don't believe me?

Check out my stock picks in The Motley Fool CAPS Community.

My picks not only outperform the market, they outperform 95%+ of the other CAPS community members.

Remember when I said not to be like 95% of common stock owners?

Well, I practice what I preach. I view common stocks as businesses, and in the CAPS community, I rate each stock solely on the basis of its future business prospects relative to its current price. In aggregate, and over time, I'll always win by doing this.

This is the path to wealth in the stock market, and I'm willing to lead you down that path so you don't make the same mistakes I made.

If you want to avoid repeating my mistakes and enjoy long-term success in the stock market, you need to know the lessons that follow. You need to commit them to memory. So don't quit now. Stay on the path and keep reading?

Learn The Road to Roth IRA Retirement Riches >>>

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