Stocks

Introduction

When you invest in stock, you buy ownership shares in a company—also known as equity shares. Your return on investment, or what you get back in relation to what you put in, depends on the success or failure of that company. If the company does well and makes money from the products or services it sells, you expect to benefit from that success.

There are two main ways to make money with stocks:

 

  1. Dividends. When publicly owned companies are profitable, they can choose to distribute some of those earnings to shareholders by paying a dividend. You can either take the dividends in cash or reinvest them to purchase more shares in the company. Many retired investors focus on stocks that generate regular dividend income to replace income they no longer receive from their jobs. Stocks that pay a higher than average dividend are sometimes referred to as "income stocks."
     
  2. Capital gains. Stocks are bought and sold constantly throughout each trading day, and their prices change all the time. When a stock price goes higher than what you paid to buy it, you can sell your shares at a profit. These profits are known as capital gains. In contrast, if you sell your stock for a lower price than you paid to buy it, you've incurred a capital loss.


Both dividends and capital gains depend on the fortunes of the company—dividends as a result of the company's earnings and capital gains based on investor demand for the stock. Demand normally reflects the prospects for the company's future performance. Strong demand—the result of many investors wanting to buy a particular stock—tends to result in an increase in the stock's share price. On the other hand, if the company isn't profitable or if investors are selling rather than buying its stock, your shares may be worth less than you paid for them.

The performance of an individual stock is also affected by what's happening in the stock market in general, which is in turn affected by the economy as a whole. For example, if interest rates go up and you think you can make more money with bonds than you can with stock, you might sell off stock and use that money to buy bonds. If many investors feel the same way, the stock market as a whole is likely to drop in value, which in turn may affect the value of the investments you hold. Other factors, such as political uncertainty at home or abroad, energy or weather problems, or soaring corporate profits, also influence market performance.

However—and this is an important element of investing—at a certain point, stock prices will be low enough to attract investors again. If you and others begin to buy, stock prices tend to rise, offering the potential for making a profit. That expectation may breathe new life into the stock market as more people invest.

This cyclical pattern—specifically, the pattern of strength and weakness in the stock market and the majority of stocks that trade in the stock market—recurs continually, though the schedule isn't predictable. Sometimes, the market moves from strength to weakness and back to strength in only a few months. Other times, this movement, which is known as a full market cycle, takes years.

At the same time that the stock market is experiencing ups and downs, the bond market is fluctuating as well. That's why asset allocation, or including different types of investments in your portfolio, is such an important strategy: In many cases, the bond market is up when the stock market is down and vice versa. Your goal as an investor is to be invested in several categories of investments at the same time, so that some of your money will be in the category that's doing well at any given time.


 

Common and Preferred Stock

You can buy two kinds of stock. All publicly traded companies issue common stock. Some companies also issue preferred stock, which exposes you to somewhat less risk of losing money, but also provides less potential for total return. Your total return includes any income you receive from an investment plus any change in its value.

If you hold common stock you're in a position to share in the company's success or feel the lack of it. The share price rises and falls all the time—sometimes by just a few cents and sometimes by several dollars—reflecting investor demand and the state of the markets. There are no price ceilings, so it's possible for shares to double or triple or more over time—though they could also lose value. The issuing company may pay dividends, but it isn't required to do so. If it does, the amount of the dividend isn't guaranteed, and it could be cut or eliminated altogether—though companies may be reluctant to do either if they believe it will send a bad message about the company's financial health.

Holders of preferred stock, on the other hand, are usually guaranteed a dividend payment and their dividends are always paid out before dividends on common stock. So if you're investing mostly for income—in this case, dividends—preferred stock may be attractive. But, unlike common stock dividends, which may increase if the company's profit rises, preferred dividends are fixed. In addition, the price of preferred stock doesn't move as much as common stock prices. This means that while preferred stock doesn't lose much value even during a downturn in the stock market, it doesn't increase much either, even if the price of the common stock soars. So if you're looking for capital gains, owning preferred stock may limit your potential profit.

Another point of difference between common stock and preferred stock has to do with what happens if the company fails. In that event, there's a priority list for a company's obligations, and obligations to preferred stockholders must be met before those to common stockholders. On the other hand, preferred stockholders are lower on the list of investors to be reimbursed than bondholders are.


 

Classes of Stock

In addition to the choice of common or preferred stock, certain companies may offer a choice of publicly traded share classes, typically designated by letters of the alphabet—often A and B. For example, a company may offer a separate class of stock for one of its divisions which itself was perhaps a well-known, formerly independent company that has been acquired. In other cases, a company may issue different share classes that trade at different prices and have different dividend policies.

When a company has dual share classes, though, it's more common for one share class to be publicly traded and the other to be nontraded. Nontraded shares are generally reserved for company founders or current management. There are often restrictions on selling these shares, and they tend to have what's known as super voting power. This makes it possible for insiders to own less than half of the total shares of a company but control the outcome of issues that are put to a shareholder vote, such as a decision to sell the company.


 

Understanding Various Ways Stocks Are Described

In addition to the distinctions a company might establish for its shares—such as common or preferred—industry experts often group stocks generally into categories, sometimes called subclasses. Common subclasses, explained in greater detail below, focus on the company's size, type, performance during market cycles, and potential for short- and long-term growth.

Each subclass has its own characteristics and is subject to specific external pressures that affect the performance of the stocks within that subclass at any given time. Since each individual stock fits into one or more subclasses, its behavior is subject to a variety of factors.


 

Market Capitalization

You'll frequently hear companies referred to as large-cap, mid-cap, and small-cap. These descriptors refer to market capitalization, also known as market cap and sometimes shortened to just capitalization. Market cap is one measure of a company's size. More specifically, it's the dollar value of the company, calculated by multiplying the number of outstanding shares by the current market price.

There are no fixed cutoff points for large-, mid-, or small-cap companies, but you may see a small-cap company valued at less than $1 billion, mid-cap companies between $1 billion and $5 billion, and large-cap companies over $5 billion—or the numbers may be twice those amounts. You might also hear about micro-cap companies, which are even smaller than other small-cap companies.

Larger companies tend to be less vulnerable to the ups and downs of the economy than smaller ones—but even the most venerable company can fail. Larger companies typically have larger financial reserves, and can therefore absorb losses more easily and bounce back more quickly from a bad year. At the same time, smaller companies may have greater potential for fast growth in economic boom times than larger companies. Even so, this generalization is no guarantee that any particular large-cap company will weather a downturn well, or that any particular small-cap company will or won't thrive.


 

Industry and Sector

Companies are subdivided by industry or sector. A sector is a large section of the economy, such as industrial companies, utility companies, or financial companies. Industries, which are more numerous, are part of a specific sector. For example, banks are an industry within the financial sector.

Frequently, events in the economy or the business environment can affect an entire industry. For example, it's possible that high gas prices could lower the profits of transportation and delivery companies. A new rule changing the review process for prescription drugs could affect the profitability of all pharmaceutical companies.

Sometimes an entire industry might be in the midst of an exciting period of innovation and expansion, and becomes popular with investors. Other times that same industry could be stagnant and have little investor appeal. Like the stock market as a whole, sectors and industries tend to go through cycles, providing strong performance in some periods and disappointing performance in others.

Part of creating and maintaining a strong stock portfolio is evaluating which sectors and industries you should be invested in at any given time. Having made that decision, you should always evaluate individual companies within a sector or industry you've identified to focus on the ones that seem to be the best investment choices.


 

Defensive and Cyclical

Stocks can also be subdivided into defensive and cyclical stocks. The difference is in the way their profits, and therefore their stock prices, tend to respond to the relative strength or weakness of the economy as a whole.

Defensive stocks are in industries that offer products and services that people need, regardless of how well the overall economy is doing. For example, most people, even in hard times, will continue filling their medical prescriptions, using electricity, and buying groceries. The continuing demand for these necessities can keep certain industries strong even during a weak economic cycle.

In contrast, some industries, such as travel and luxury goods, are very sensitive to economic up-and-downs. The stock of companies in these industries, known as cyclicals, may suffer decreased profits and tend to lose market value in times of economic hardship, as people try to cut down on unnecessary expenses. But their share prices can rebound sharply when the economy gains strength, people have more discretionary income to spend, and their profits rise enough to create renewed investor interest.


 

Growth and Value

A common investment strategy for picking stocks is to focus on either growth or value stocks, or to seek a mixture of the two since their returns tend to follow a cycle of strength and weakness.

Growth stocks, as the name implies, are issued by companies that are expanding, sometimes quite quickly but in other cases over a longer period of time. Typically, these are young companies in fairly new industries that are rapidly expanding.

Growth stocks aren't always new companies, though. They can also be companies that have been around for some time but are poised for expansion, which could be due to any number of things, such as technological advances, a shift in strategy, movement into new markets, acquisitions, and so on.

Because growth companies often receive intense media and investor attention, their stock prices may be higher than their current profits seem to warrant. That's because investors are buying the stock based on potential for future earnings, not on a history of past results. If the stock fulfills expectations, even investors who pay high prices may realize a profit. Since companies may take big risks to expand, however, growth stocks may be very volatile, or subject to rapid price swings. For example, a company's new products may not be a hit, there may be unforeseen difficulty doing business in new countries, or the company may find itself saddled with major debt in a period of rising interest rates. As always with investing, the greater the potential for an outstanding return, the higher the risk of loss.

When a growth stock investment provides a positive return, it's usually as a result of price improvement—the stock price moves up from where the investor originally bought it—not because of dividends. Indeed, a key feature of most growth stocks is an absence of dividend payments to investors. Instead, company managers tend to plow gains directly back into the company.

Value stocks, in contrast, are solid investments selling at what seem to be low prices given their history and market share. If you buy a value stock, it's because you believe that it's worth more than its current price. You might look for value in older, more established industries, which tend not to get as much press as newer industries. One of the big risks in buying value stocks, also known as undervalued stocks, is that it's possible that investors are avoiding a company and its stock for good reasons, and that the price is a fairer reflection of its value than you think.

On the other hand, if you deliberately buy stocks that are out of fashion and sell stocks that other investors are buying—in other words, you invest against the prevailing opinion—you're considered a contrarian investor. There can be rewards to this style of investing, since by definition a contrarian investor buys stocks at low prices and sells them at high ones. However, contrarian investing requires considerable experience and a strong tolerance for risk, since it may involve buying the stocks of companies that are in trouble and selling stocks of companies that other investors are favoring. Being a contrarian also takes patience, since the turnaround you expect may take a long time.


 

Volatility

If you've seen the jagged lines on charts tracking stock prices, you know that prices fluctuate throughout the day, week, month, and year, as demand goes up and down in the markets. You'll see short-term fluctuations as the stock's price moves within a certain price range, and longer-term trends over months and years, in which that short-term price range itself moves up or down. The size and frequency of these short-term fluctuations are known as the stock's volatility.

If a stock has a relatively large price range over a short time period, it is considered highly volatile and may expose you to increased risk of loss, especially if you sell for any reason when the price is down. Though there are exceptions, growth stocks tend to be more volatile than value stocks.

In contrast, if the range of prices is relatively narrow over a short time period, a stock is considered less volatile and normally exposes you to less investment risk. But reduced risk also means reduced potential for substantial short-term return since the stock price is unlikely to increase very much in that time frame.

Stocks may become more or less volatile over time. One example might be a newer stock that had formerly seen big price swings, but becomes less volatile as the company grows and establishes a track record. Another example might be a stock with a traditionally stable price that becomes extremely volatile following unfavorable or favorable news reports, which trigger a rash of buying and selling.


 

Stock Splits

When a stock price gets very high, companies may decide to split the stock to bring its price down. One reason to do this is that a very high stock price can intimidate investors who fear there is little room for growth, or what is known as price appreciation.

Here's how a stock split works: Suppose a stock trading at $150 a share is split 3-for-1. If you owned 100 shares worth $15,000 before the split, you would hold 300 shares valued at $50 each after the split, so that your investment would still worth $15,000. More investors may become interested in the stock at the lower price, so there's always the possibility that your newly split shares will rise again in price due to increased demand. In fact, it may move back toward the pre-split price—though, of course, there's no guarantee that it will.

You may also own stock that goes through a reverse split, though this type of split is less common especially among seasoned companies that trade on one of the major U.S. stock markets, including the NYSE, The NASDAQ Stock Market, or the Amex. In this case, a company with very low-priced stock reduces the total number of shares to increase the per-share price.

For example, in a reverse split you might receive one new share for every five old shares. If the price-per-share had been $1, each new share would be worth $5. Companies may do reverse splits to maintain their listing on a stock market that has a minimum per-share price, or to appeal to certain institutional investors who may not buy stock priced below a certain amount. In either of those cases—indeed if reverse splits are announced or actually occur—you'll want to proceed with caution. Reverse splits tend to go hand in hand with low priced, high risk stocks.


 

Evaluating a Stock

When you buy a stock, you're buying part ownership of a company, so the questions to ask as you select among the stocks you're considering are the same questions you'd ask if you were buying the whole company:

  • What are the company's products?
  • Are they in demand and of high quality?
  • Is the industry as a whole doing well?
  • How has the company performed in the past?
  • Are talented, experienced managers in charge?
  • Are operating costs low or too high?
  • Is the company in heavy debt?
  • What are the obstacles and challenges the company faces?
  • Is the stock worth the current price?

Because each company is a different size and has issued a different number of shares, you need a way to compare the value of different stocks. A common and quick way to do this is to look at the stock's earnings. All publicly traded companies report earnings to the Securities and Exchange Commission on a quarterly basis in an unaudited filing known as the 10-Q, and annually in an audited filing known as the 10-K.

If you check those reports, the company's annual report, or its Web site, you'll find its current earnings-per-share, or EPS. That ratio is calculated by dividing the company's total earnings by the number of shares. You can then use this per-share number to compare the results of companies of different sizes. EPS is one indication of a company's current strength.

You can divide the current price of a stock by its EPS to get the price-to-earnings ratio, or P/E multiple, the most commonly quoted measure of stock value. In a nutshell, P/E tells you how much investors are paying for a dollar of a company's earnings. For example, if Company A has a P/E of 25, and Company B has a P/E of 20, investors are paying more for each dollar earned by Company A than for each dollar earned by Company B.

There's no perfect P/E, though there is a market average at any given time. Over the long term that number has been about 15, though higher in some periods and lower in others. Value investors tend look for stocks with relatively low P/E ratios—below the current average—while growth investors often buy stocks with higher than average P/E ratios.

While P/E can be a revealing indicator, it shouldn't be your only measure for evaluating a stock. For example, there are times you might consider a stock with a P/E that's higher than average for its industry if you have reason to be optimistic about its future prospects. Remember, though, that when a stock has an unusually high P/E, the company will have to generate substantially higher earnings in the future to make it worth the price. At the other end of the scale, a low P/E may be a sign that significant price appreciation is possible or that a company is in serious financial trouble. That's one of the determinations you'll want to make before you buy.

A P/E ratio can only be as useful as the earnings numbers it's based on. While there are standards for reporting earnings, and a company's financial reports are audited, there may still be a lack of consistency across earnings reports. You've probably seen stories in the financial press about companies restating earnings. This happens when an accounting error or other discrepancy comes to light, and a company must reissue reports for past periods. Inaccurate or inconsistent earnings statements may make P/E a less reliable measure of stock value.

Even though P/E is the most widely quoted measure of stock value, it's not the only one. You'll also see stock analysts discussing measures such as ROA (return on assets), ROE (return on equity), and so on. While all of these acronyms may seem confusing at first, you may find, as you get to know them, that they can help answer some of your questions about a company, such as how efficient it is, how much debt it's carrying, and so on.

One way to learn more about individual stocks is through professional stock research. The brokerage firm where you have your account may provide research from its own analysts and perhaps from outside sources. You can also find independent research from analysts who aren't affiliated with a brokerage firm, as well as consensus reports that bring together opinions from a variety of analysts. Some of this research is free, while other research comes with a price tag.

In the past, there have been conflicts of interest at brokerage firms that provide investment banking services to public companies, since analysts may sometimes have felt pressure to review those stocks positively. However, brokerage firms are required to establish strict separations between their investment banking and stock analysis departments to comply with regulations designed to minimize any such potential conflicts of interests.


 

Buying and Selling Stock

To buy and sell stock, you usually need to have an account at a brokerage firm, also known as a broker-dealer, and give orders to a stockbroker at the firm who will execute those instructions on your behalf, or online, where the firm's technology systems route your order to the appropriate market or system for execution. The kind of firm you use will determine how you convey your orders, what types of services you have access to, and what fees you pay to trade your stocks. In general, the more services the firm offers, the more you'll pay for each transaction. Brokerage firms may also charge fees to maintain your account.

Full-service brokerage firms provide research as well as trade executions and may offer customized portfolio management, investment advice, financial planning, banking privileges, and other services. Discount firms offer fewer services but, as their name implies, generally charge less to execute the orders you place. The trick is to find the balance that's right for you. On the one hand, you don't want fees to cut into your returns, but on the other hand, you may benefit from more guidance. You'll want to check what effect the amount you have to invest—or what are known as your investable assets—will have on the level of service you receive and the prices you pay.

You can place buy and sell orders over the phone with your broker or you can trade stocks online. Many firms offer full account access and trading through their Web sites at lower prices than they charge for phone orders. If you do trade online, it's important to be wary of trading too much, simply because it's so easy to place the trade. You should consider your decisions carefully, taking into account the fees and taxes as well as the impact on the balance of assets in your portfolio, before you place an order.

There are ways to buy stock directly through certain companies without using a broker. For example, if you used a broker to purchase a share of stock in a company that offers a dividend reinvestment plan, or DRIP, you can choose to buy additional shares through that plan. DRIPs allow you to automatically reinvest your dividends and periodically write checks to buy more stock. Some companies also offer direct purchase plans, or DPPs, that allow you to buy shares directly from the issuer at any time.

DRIPs and DPPs are usually administered for the company by a third party known as a shareholder services company or stock transfer agent that can also handle the sale of your shares. Transaction fees for DRIP and DPP orders tend to be substantially less than brokerage fees.


 

Trading vs. Buy-and-Hold

The goal of most investors generally is to buy low and sell high. This can result in two quite different approaches to equity investing.

One approach is described as "trading." Trading involves following the short-term price fluctuations of different stocks closely and then trying to buy low and sell high. Traders usually decide ahead of time the percentage increase they're looking for before you sell (or decrease before they buy).

While trading has tremendous potential for immediate rewards, it also involves a fair share of risk because a stock may not recover from a downswing within the time frame you'd like—and may in fact drop further in price. In addition, frequent trading can be expensive, since every time you buy and sell, you may pay broker's fees for the transaction. Also, if you sell a stock that you haven't held for a year or more, any profits you make are taxed at the same rate as your regular income, not at your lower tax rate for long-term capital gains.

Be aware that trading should not be confused with "day trading," which is the rapid buying and selling of stock to capitalize on small price changes. Day trading can be extremely risky, especially if you attempt to day trade using borrowed money. Individual investors frequently lose money by trying to use this approach.

A very different investing strategy—called buy-and-hold—involves keeping an investment over an extended period, anticipating that the price will rise over time. While buy-and-hold reduces the money you pay in transaction fees and short-term capital gains taxes, it requires patience and careful decision-making. As a buy-and-hold investor, you generally choose stocks based on a company's long-term business prospects. Increases in the stock price over years tend to be based less on the volatile nature of the market's changing demands and more on what's known as the company's fundamentals, such as its earnings and sales, the expertise and vision of its management, the fortunes of its industry, and its position in that industry.

Buy-and-hold investors still need to take price fluctuations into account, and they must pay attention to the stock's ongoing performance. Naturally, the price at which you buy a stock directly affects the potential profits you'll make from its sale. So it makes sense to buy the stock at a price you believe is reasonable. While you hold the stock, it's also important to watch for signs that your investment isn't going the direction you planned—for example, if the company regularly misses its earnings targets, or if developments in the industry turn bleaker.

Sometimes you'll decide, after reviewing the company's fundamentals, that it's worthwhile to ride out a slump in price and wait for a stock to recover. Other times, you may decide you'll have better returns if you sell your holding and invest elsewhere. Either way, it's important to stay on top of the stocks you own by paying attention to news that could affect their value.


 

Advanced Short-Term Trading

There are a number of ways that some experienced investors seek increased returns by taking on more risk.


 

Buying on Margin

When you buy stocks on margin, you borrow part of the cost of the investment from your broker, in the hopes of increasing your potential returns. To use this approach, you set up what's known as a margin account, which typically requires you to deposit cash or qualified investments worth at least $2,000. Then when you invest, you borrow up to half the cost of the stock from your broker and you pay for the rest. In this way, you can buy and sell more stock than you could without borrowing, which is a way to leverage your investment.

If the price goes up and you sell the stock, you pay your broker back, plus interest, and you get to keep the profits. However, if the price drops, you may have to wait to sell the stock at the price you want, and in the meantime, you're paying interest on the amount you've borrowed. If the price drops far enough, your broker will require you to add money or securities to your margin account to bring it up to the required level. The required level is based on the ratio of your cash and qualified investments to the amount you borrowed from your broker in your account. If you can't add enough money, your broker can sell off the investments in that account to repay what you've borrowed, which invariably means that you'll lose money on the deal.


 

Short Selling

Short selling is a way to profit from a price drop in a company's stock. However, it involves more risk than just buying a stock, which is sometimes described as having a long position, or owning the stock long. To sell a stock short, you borrow shares from your broker and sell them at their current market price. If that price falls, as you expect it to, you buy an equal number of shares at a new, lower price to return to your broker. If the price has dropped enough to offset transaction fees and the interest you paid on the borrowed shares, you may pocket a profit. This is a risky strategy, however, because you must still re-buy the shares and return them to your broker. If you must re-buy the shares at a price that's the same as or higher than the price at which you sold the borrowed shares, after accounting for transaction costs and interest, you will lose money.

Because short selling is in essence the sale of stocks you don't own, there are strict margin requirements associated with this strategy, and you must set up a margin account to conduct these transactions. The margin money is used as collateral for the short sale, helping to insure that the borrowed shares will be returned to the lender down the road.