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