Once the province of the rich, stock ownership today is widespread, with over half of American households invested in stocks through pension plans, retirement funds or direct ownership. But just what is the stock market and 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 may be 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 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.
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. Remember, diversification does not eliminate risk.
- 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.1 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.
|Average Rates of Return
Consider how various stocks have performed versus other investments over the 30 years ended December 31, 2012.
Large-cap stocks are represented by the S&P 500 index. Midcap stocks are represented the S&P MidCap 400 index. Small-cap stocks are represented by a composite of the CRSP 6th-10th decile portfolios and the S&P Small Cap 600 index. Foreign stocks are represented by the MSCI EAFE Index. Bonds are represented by the Barclays U.S. Aggregate index. Cash is represented by a composite of yields of 3-month Treasury bills and the Barclays 3-Month Treasury Bills index. Based on average 12-month total returns from 1983-2012. Different investments offer different levels of potential return and market risk. International investors are subject to higher taxation and currency risk, as well as less liquidity, compared with domestic investors. Midcap stocks and small-cap stocks are generally subject to greater price fluctuations than large-cap stocks. Bonds are generally guaranteed as to the timely payment of principal and interest. Past performance does not guarantee future results. Investors cannot invest directly in an index. (CS000168)
|Ways of Categorizing Stock Investments
||The market value (capitalization) of a company determines whether it is considered a large-cap, midcap, or small-cap stock.
||Stocks of fast-growing companies (in general, companied expected to increase earnings by 15% or more per year).
||Stocks of companies that are priced near or below their intrinsic value (with little growth in earnings assumed) are called value stocks. They may or may not be bargains, however, depending on whether their prices subsequently recover.
||Stocks of companies headquartered outside the United States in industrialized countries.
||Stocks of companies headquartered in underdeveloped, fast-growing countries.
||Type of industry, such as technology, energy, or cyclicals.
Investing in Stocks
Individuals can buy stocks directly or through mutual funds and other pooled investment products. 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. There are thousands of mutual funds available today that invest in a variety of stock market categories and sectors. 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.
When it comes to investing in stocks, there's a variety of information available on public companies that may help you 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. Speak with your financial advisor about how you can use equity investing to help meet your financial goals.
Points to Remember
1This allocation is presented only as an example and is not intended as investment advice. Your own allocation will depend on your specific circumstances.
- Stock represents the shares of ownership in a company
- By investing in stock, you stake a claim in the future of that company.
- As a shareholder of common stock, you have voting rights.
- Shareholders may receive dividends, which may be paid to shareholders from the company's earnings.
- Your financial advisor can help you decide which stocks are right for you.
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Growth vs. Value: Two Approaches to Stock Investing - Article
Diversifying Your Investments - Interactive Chart