Investing in Stocks

The stock market has its ups and downs, but it can be worth the ride.

When you invest in a stock, you’re buying part of a publicly traded company. That piece, also known as your equity or ownership share in the company, means you’re in a position to profit from the company’s success—or lose money if its share price drops and you sell.

Despite the potential risk involved, stocks are one of the most popular types of investments, especially for long-term goals. It’s for good reason: They’ve historically provided better returns than any other kind of investment—almost twice as much as long-term government bonds and about two and a half times as much as cash since year-end 1925, according to Morningstar, Inc.

UPS AND DOWNS

A stock doesn’t have a fixed value and its market price changes in response to supply and demand. It can go as high as you and other investors are willing to pay to own it—usually because you expect it to be worth even more in the future. But it can also drop in value, sometimes to almost nothing, if the company that issued it isn’t meeting investor expectations, or is part of an industry that’s out of favor with investors, or if the market as a whole tumbles.

Some people hesitate to invest in stocks or stock mutual funds and ETFs because they think it’s too risky. So they stick with investments they consider safe. The problem is that by skipping equity investments, you’re missing out on a reliable source of long-term investment gains. While you can lose money in some years, investors who’ve held a portfolio of stocks or stock funds in any 15-year period since 1926 have always come out ahead. But it doesn’t work if you sell every time prices drop.

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CREATING A PORTFOLIO

Suppose, for example, that price were no object and you could create an instant portfolio of six stocks. There are some basic principles you’d want to keep in mind to be sure that your porfolio turned out to be diversified.

Be sure that each of the stocks is from a different sector of the economy. You may want to avoid the sector your employer is in, or limit yourself to one company in that sector, so that you aren’t depending on one industry for investment gains and your paycheck.

If you concentrate on companies that show promise of future growth, be sure to include at least one or two well-established companies, even if their growth rate is likely to be slower.

If the stocks that interest you have P/Es that are higher than the current average, you might look for one or two undervalued companies that show promise of long-term growth. You can find P/E figures on the websites of the companies that interest you.

Consider dividing your portfolio evenly among large-cap stocks (with market caps over $10 billion), mid-cap stocks (with market caps between $2 and $10 billion) and small-cap stocks (with market caps below $2 billion).

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FINDING YOUR STYLE

Investing in stocks is a matter of style. If you’re a buy and hold investor, you’re in for the long haul. You buy stocks you think will increase in value over time, and you hold onto them—even through price drops in down markets.

You may even buy more shares when the stock loses value, since you’ll pay less per share than when the price is high. And if, from time to time, the price goes high enough and the stock splits, you end up with even more shares.

If you trade, you buy stocks you expect to increase enough in value in the short term so that you can sell them for a profit. With this approach, you may want to set some guidelines for when you should sell. For example, you might decide you’ll sell any stock whose price has increased 20% and reinvest in another promising stock.

Remember, though, that long-term gains on stocks you own more than a year are taxed at a much lower rate than short-term gains.

SIZING UP STOCKS

If you’re investing in stocks, it’s a good idea to diversify your portfolio. That means building a portfolio of stocks that tend to react differently to changes in the economy, to grow in value at different rates, and to carry different levels of risk.

To evaluate how diversified your portfolio is, and to identify the kind of stock you might buy next, you can classify stocks and the companies that issue them in several ways:

• By sector, or industry
• By growth potential, which is a stock’s apparent capacity to increase in price
• By valuation, to assess whether a stock’s current price is higher or lower than the company’s financial standing and growth potential seem to deserve
• By market capitalization, or market cap for short, which is the price of one share of stock multiplied by the total number of existing shares

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P/E RATIOS

Investors often use a stock’s price-to-earnings ratio (P/E) to get a sense of its value in relation to other stocks in the same sector or in the market at large.

A P/E—which you find by dividing the current price per share by the company’s earnings per share—that’s much higher than the market average may be a warning that investors expect a higher return from the stock than it may be able to deliver. And a lower-than-average P/E may indicate either a company in trouble or one poised to produce a good return on investment.