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Investing in Stocks
Why Stocks?
Ways to Invest in Stocks
It seems that everyone is recommending investing in the stock market. To maximize your potential return, you have to be in the stock market, the national financial magazines dictate. "You won't beat inflation unless you're investing in stocks," your financial advisor says. "The Dow Jones Industrial Average reaches yet another all-time high," the headlines read.
What's all the hubbub about? Maybe it's time to step back from the pundits pontificating about the stock market and look at exactly what is involved in investing in stocks.
Public Ownership of a Company
Stock represents ownership of a company. If a company is privately held, then its stock is owned by only a few individuals and is not available for purchase by the public. If a company is publicly held, then its stock can be purchased through stockbrokers by individual investors and institutions alike. Corporations can issue different types of stock, but the most typical is common stock.
By investing in stock, you stake a claim in the future of that company and all the potential investment return that it may bring. With potential reward, however, you also have all the risks associated with owning a company. If a company is forced to liquidate, it is first obligated to pay its creditors, bondholders and those who hold preferred stock (a limited issue stock that does not hold voting rights), before those who own common stock.
As a shareholder of common stock, you have voting rights on issues such as election of a board of directors and other important issues affecting the direction of the company. Shareholders may also receive dividends, which are paid to shareholders from the company's earnings. The amount of the dividend is decided by the board of directors, and is based on what portion of earnings needs to be reinvested in the growth of the company and what portion can be distributed to shareholders.
Consider how various stocks have performed versus other investments over the 20 years ended December 31, 1998.
Source: Standard & Poor's. Performance is based on the following returns: Standard & Poor's Composite Index of 500 Stocks for large-cap stocks, Lehman Brothers Long Term Government Bond Index for long-term government bonds, The Russell 2000 index for small-cap stocks, Morgan Stanley Capital International's Europe, Australasia, Far East Index for international stocks, and the yield on 3-month Treasury bills. Indexes are unmanaged and do not reflect the performance of any individual investment or include the fees and expenses associated with purchasing securities. Individuals cannot invest directly in any index. International investors are sometimes subject to somewhat higher taxation and higher currency risk, as well as less liquidity, compared with investors in domestic securities. Although money market funds strive to maintain a stable $1 share price, their yields will vary. The figures given include reinvestment of all distributions and capital gains. Past performance cannot guarantee future results.
Why Stocks?
Stocks carry higher investment risks than bonds or money market investments, but they also have historically realized higher rates of return over longer holding periods (see chart). While past performance doesn't guarantee future results, the higher return potential of stocks can make them ideal investments for long-term investors seeking to build the value of their portfolios or to stay ahead of inflation. Both of these objectives are critical to investors with specific long-term goals in mind, such as saving for retirement.
In deciding to invest in stocks, investors must weigh the potential risk of loss of principal against the risk of not meeting their investment goals or of losing purchasing power to inflation. Stock investors can also manage risk by:
* Diversifying among stocks of many different companies. Investing in just one or two stocks is generally much more risky than buying stocks of 15 or 20 companies -- by holding stocks of different companies in several industries, you reduce your exposure to a substantial loss due to a price decline in just one stock.
* Allocating assets appropriately. Asset allocation refers to how you spread your portfolio among different types of investments -- such as stocks, bonds, and money market investments. An aggressive investor with a long-term horizon might choose to keep 80% of his or her portfolio in stocks, for example, with the remaining 20% in bonds and money market funds. This adds yet another level of diversification to the portfolio and can further reduce investment risk. Your financial advisor can help you select an asset allocation that is appropriate for your goals and time frame.
* Staying invested through periods of market turbulence can also help reduce risk of loss as the variability of returns tends to decrease over time.
Ways to Invest in Stocks
Individuals can buy stocks directly or through mutual funds or annuities. An employee may also have an opportunity to buy stock in his or her company through a company stock purchase plan or retirement plan.
Many financial analysts believe that most people can best access the stock market by buying shares of mutual funds that invest in stocks. Currently, there are over 6,000 mutual funds investing within a variety of stock market categories and sectors (see table). Mutual funds offer the potential advantages of professional money management, diversification, and liquidity. These advantages are particularly apparent when investing in international and emerging market stocks, which are often less accessible to individual investors. Your financial advisor can help you assess which types of mutual funds may be suitable for your portfolio.
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Ways of Categorizing Stock Investments
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Size of company
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The market value (capitalization) of the company
determines whether it is considered a large-,
mid-, or small-cap stock.
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Growth
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Stocks of companies that are expected to increase
earnings by 15% or more per year.
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Value
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Stocks of companies that are priced near their
asset value (with no growth in earnings assumed)
are called value stocks. They may or may not
be bargains, however, depending on whether their
prices subsequently recover.
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International
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Stocks of companies headquartered outside the
United States in industrialized countries.
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Emerging market
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Stocks of companies headquartered in underdeveloped,
fast-growing countries.
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Industry sector
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Type of industry, such as technology, energy,
or cyclicals.
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Investors with, say, $20,000 or more to invest and who want to manage their own portfolio can build a diversified portfolio with just 15 to 30 stocks. Individuals can also join an investment club and pool their resources to buy stocks of companies club members monitor. Even though it may seem to be a daunting task to find companies in which to invest, basic information is available at many libraries on most publicly traded companies that can help you to understand their financial positions. This information includes:
Price Range -- The price of a stock is determined according to the rules of supply and demand. Tracking the price over time can give you a partial picture of the company and its recent performance. Daily information in national newspapers includes the high and low price for the stock in the previous 52 weeks.
Price to Earnings Ratio -- This number, which is derived by dividing the stock price by the company's earnings per share, is used to determine what an investor is paying for the earning power of the company. It is one figure that can be used in comparing the value of several companies even though their prices may be vastly different.
Dividend Yield -- The dividend yield, determined by dividing the amount of the dividend by the share price, simply indicates what percent return the company is paying its investors. National newspapers report the return on both the initial investment at the time of the first public offering and the return on the current value of the stock. This number can also be used in a comparison of companies.
Payout Ratio -- This figure represents the percentage of earnings a company is paying out to its investors. It is an indication of whether most of a company's earnings are being paid to its investors, or whether they are being reinvested in the growth of the company.
In addition, a fundamental approach to stock investing considers the following questions: How does the company compare to its competitors in earnings growth and profitability? Are there any outside factors such as government regulations that may affect the entire industry? What is the projected demand for the company's product? Is the industry a cyclical one, i.e., does it move up and down in cycles? What are management's goals and how are they going to achieve them?
Because of their long-term potential, stocks have a place in nearly every portfolio. And because these investments involve risks that can be managed by following investment principles, speak with your financial advisor about how you can include stocks in your portfolio.
Points to Remember
1. Stock represents the shares of ownership of a company.
2. By investing in stock, you stake a claim in the future of that company.
3. As a shareholder of common stock, you have voting rights.
4. Shareholders receive dividends, which are paid to shareholders from the company's earnings.
5. Even though investing in stocks seems a daunting task, it needn't be. Many libraries carry information on most publicly traded companies.
6. Your financial advisor can help you decide which stocks are right for you.
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