Stocks
As will be explained in this chapter, there is no investment that has
done as well as stocks over the long term. If you plan to invest in
stocks either directly or indirectly (through mutual funds) you need to
read this section.
When you invest in stocks, you are doing something quite different than
what you do when you invest in bonds. When you buy a share of stock, you
actually become a part owner of the company that issued the share. You
can now vote, along with thousands of other owners, at stockholder’s
meetings. You have a say (even if it is small) in the future direction
of the company through the election of the board of directors. More
importantly, you have a claim on the assets of the company and on its
future earnings. Most people own stock without ever going to a
stockholder’s meeting, but it is part of what it means to hold shares in
a company.
If ever there was a place to take dispassionate action, it is when you
invest in a company through the purchase of some of its shares of stock.
It doesn’t usually serve you well to make an emotional decision when it
comes to investing. While the press is full of stories about individuals
who invested early in a start up company and made a fortune in the
process, there are many more who tried the same thing with companies
that went out of business or never really get off the ground. Most
people will find it to be a better course to invest in successful
companies and maintain that investment as long as you feel the company
will be successful.
 Risk factors
Owning stock, either directly or through mutual funds, carries with
it a certain amount of risk. As stated earlier, every form of investing
carries with it some degree of risk. For stock investments, the risks
fall into three general categories. First, there is financial risk.
Financial risk is proportionate to the amount of debt that the company
is carrying. If they are not able to earn enough to service the debt,
they will not have net earnings and there will be no dividends paid. In
a worst-case scenario, they may even go bankrupt. If a company does not
have any debt, there is no financial risk. Before you invest in a
company directly, you need to make sure that it is not carrying more
debt than it can reasonably be expected to repay.
With stocks there is also business risk. This gets to the actual nature
of the business being conducted. Make sure that there is a market for
the products or services that they offer and that they are able to offer
them at competitive prices. They also need to stay on top of things with
research and development. They need to be constantly assessing what
consumers want and find ways to deliver it to them at prices that the
consumer can afford. We have all read about companies that were in
business for decades but failed to keep up with the changes and
eventually were sold off; the proceeds distributed to the investors,
often at far less than what they were worth when they were in business.
Finally, there is market risk. Even if a company has no debt and
therefore has no financial risk, and, even if it minimizes business risk
by staying on top of the demands of consumers with innovative product
lines, it is still subject to market risk. Sometimes, investors simply
feel that earnings on stocks are not going to be as good in the future
as they have been in the past. They sell their stocks and look for
investments that will provide them with better returns. When there are
enough people selling, stock prices begin to drop and it becomes harder
and harder to find buyers who are willing to accept the risk of lower
earnings and falling prices.
When the market reacts in this way it doesn’t make much difference if
the company that you are invested in has brighter prospects than the
market as a whole. Its price gets pulled down with the rest of the
market as large and small investors reposition their holdings to find
investments that hold more promise. Interest rates are a key indicator
of future prospects for the stock market because high interest rates
reduce earnings among companies that need to borrow funds. Falling
interest rates have the opposite effect and that is why you will see
action to lower interest rates when the stock market has declined.
It is an over simplification to say that stocks can be divided into two
or three categories but for our purposes we will do that in order to
highlight some of the differences that exist in stocks and how they can
be selected. The first category we will look at is growth stocks.
Growth Stocks
A growth stock generally defined as stock in a company whose earnings
are growing faster than they are for the market as a whole. Normally,
while growth stocks may have good earnings, they may not be paying any
dividends. Rather they are choosing to reinvest their earnings to make
the company grow faster by opening new markets and developing new
products. When looking at a growth stock, you will need to assure
yourself that the stream of earnings that is being generated is growing
faster than for the market as a whole.
Growth stocks tend to fluctuate more than other types of stocks. That is
to say that they will increase more in good markets and decrease more in
bad markets than other types of stocks highlighted below that seem to
trade in a somewhat narrower range.
Value Stocks
Value stocks represent another broad category of investment
possibility. There are some who would suggest that by looking at the
current value of the company and the current stream of earnings, it is
possible to arrive at an exact value of a share of stock and when you
compare that value to the value of other investments, your choice
becomes obvious, almost scientific. However, you are investing and
regardless of how much research you may do before you commit money,
there is no guarantee that your investment will pay off. There are so
many variables that come into play that there is no way to know
everything that could happen or come into play.
Income Stocks
The final category that we will look at is income stock. The classic
example of an income stock is a share of stock in a utility company.
Even though it is a regulated industry, utility companies generally pay
regular dividends that may not grow very much over time but are very
reliable. Income stocks are thought to carry less risk than growth
stocks and often do better in an economic downturn than growth stocks.
Investors who are interested in a steady stream of dividends but who do
not want to rule out any chance of growth often choose to invest some of
their money in income stocks.
Stock Indexes
In order to report the direction of the stock market on any given day
and track it over time, indexes have been developed that are designed to
measure the direction of certain segments of the market. The three that
we hear the most about are the Dow-Jones Industrial Average, the S & P
500 and the NASDAQ. By following these three averages you will get a
sense of how the stock market is doing and, by implication, how your
portfolio is probably doing. Later on, we will present a way that you
can essentially invest in one of the averages and pretty well match its
performance.
International Stocks
Not every company is headquartered in the United States. A growing
number of very successful companies are headquartered in other parts of
the world. There was a time when international stocks and stocks
primarily at work in the United States moved in opposition to one
another. However, recent corrections in the financial markets are
normally experienced around the world and so investing in international
stocks does not have the moderating impact that it once had.
However, it is still a good idea to invest at least some of your money
internationally. Many countries that were once characterized by nothing
but poverty are experiencing real growth in excess of what is normally
found in the United States and this is expected to continue. There will
be periods of decline as with any investment but you should give
consideration to investing at least some of your money in other markets.
Socially Conscience Stocks
In recent years, investors have given attention not only to the
potential return of an investment but also to the core business and
practices of the corporations that they invest in. If you are concerned
about the environment and the impact that industrialization has on it,
then you would want to invest in companies that have a good
environmental records. It goes beyond just looking at the products that
are produced and distributed and gets to employee benefits and
practices. There are various ways to judge the non-financial activities
of a company and you need to know how determinations about a company are
being made. Not every person who judges a company to be socially
conscience will be applying the same criteria that you may want to
apply.
It is possible to do well financially while doing good socially but you
will need to make sure that the criteria being applied are close to your
value system, not just the value system of the persons making the
judgment.
Diversification
If you decide to invest directly in common stock, you will need to
work to make sure that you are adequately diversified. This will mean
owning several different stocks and stocks from different industries.
Good diversification means lower risk because you do not have all your
“eggs in one basket”.
Every discipline has its own vocabulary and investing is no different.
Rather than go through a long (and probably still inadequate) listing of
financial terms, I would encourage you to use the internet resources
found at the end of each chapter to learn what is meant by terms like PE
ratio and Book Value.
A word about volatility…
The media needs to report something each day and so they sometimes
make it look like there is a story in the day-to-day changes in the
financial markets. When the stock market drops and pundits declare that
investors are panicking and selling, who do they think is buying? The
answer is: Other investors! (Who are not panicking.) Over time, the
results on any given day are not all that significant. Over the short
term, there will be volatility. Over the long term (10 years plus) the
direction is almost always up.
Fundamental Analysis and Technical Analysis
These represent two different approaches to stock selection. There
are people who are convinced that stock prices are best understood by
technical analysis that uses charts and graphs to determine the future
direction of a particular stock price independent, in many ways, of the
financial strength of the underlying company. Most of what has been
presented in this resource deals with fundamental analysis. Further,
virtually all of the mutual funds that you will encounter use some form
of fundamental analysis in their buy and sell decisions. If you decide
that you would like to invest in individual stocks, you need to become
skilled in fundamental analysis. If all of this gives you a headache and
makes you want to swear off investing forever, you need to go
immediately to the chapter on mutual funds. You will probably not reach
your financial goals without investing in stocks but investing in stocks
through good mutual funds is an excellent way to build for the future.
IMPORTANT POINTS:
WEB SITES:
http://stocks.about.com/
http://www.usaaedfoundation.org/financial/bi07.asp
http://www.investorguide.com/igustockintro.html
http://www.fool.com/school/basics/basics03.htm
http://www.aaii.com/stocks/index.shtml
|
