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Overview When you purchase a share of stock, you are buying ownership or equity in a company. Once you own at least one share, you become a shareholder or stockholder. When you buy stock, your ownership interest entitles you to any dividends distributed. Plus, there is the possibility that your shares will appreciate in value. You also face the risk that your stock will go down in value. There are two types of stock:
Preferred stock appeals more to older investors who are looking for income, because each share usually pays a specific dividend. Preferred stockholders will usually receive their dividends, even if owners of common stock aren’t receiving theirs. If you own preferred stock, you also receive preferential treatment if the company becomes insolvent. Owners of common stock are allowed to vote on important matters affecting the corporation. Owners of preferred stock, however, usually aren’t entitled to voting rights.
Why Stocks Are Important Investing in stock is particularly important to young people. Historically, the return on investment for stocks has been much higher than other investments. Therefore, stock ownership gives you a better opportunity to become wealthy and stay ahead of inflation. The stock market isn’t right for everyone. It depends upon your risk tolerance which is somewhere between two extremes:
Not all investments in stock are volatile. You can find stocks that are less likely to drop precipitously in value. They might not soar in value either.
Evaluating Stock Large-cap, mid-cap, small-cap & micro-cap stocks When it comes to investing, the general consensus is that size matters and larger stocks are a safer bet than smaller ones. The flip side is that small companies usually have more room to grow and you might be getting in on the ground floor of a great investment. Companies are broken down into categories based on their capitalization. A company’s capitalization is calculated by multiplying the price of one share of stock times the number of shares there are. Here is the breakdown for each category:
P/E Ratios Size by itself doesn’t tell you much about a company’s stock. The price-to-earnings (P/E) ratio is a useful tool that is commonly called upon to evaluate a stock. The P/E ratio is calculated by taking the price of a stock and dividing it by the company’s yearly earnings. For example, if a stock is currently selling for $30 and it has yearly earnings of $1 per share, the P/E ratio is 30. Remember that a company’s dividend is different from its earnings. A company may choose to pay out only a portion of its earnings as a dividend or none at all. Here are some things you should know about the P/E ratio:
When a company has an unusually high P/E ratio as compared to years gone by, it may indicate that the company is overpriced and ready to fall in value. An unusually low P/E ratio may indicate the stock is cheap or it may be a sign that the company is weak and has a higher risk of filing for bankruptcy. You should also realize that some aggressive investors are willing to buy shares of new companies that haven’t earned any money yet. They are banking on the company’s ability to produce earnings in the future, not the current P/E ratio.
Value vs. Growth The value style of investing looks at whether the price of a company’s stock seems low in comparison to its intrinsic value. A company’s intrinsic value is what it would be worth if it were sold. Value investors try to find out-of-favor stocks whose share price seems low. A company’s value is determined by factors such as:
When more investors are selling a stock than buying it, the price per share goes down. Even though a stock may seem like a bargain, there may be many reasons why people are selling and not buying it. To find out, it is helpful to look online at the company’s quarterly and annual reports. They are available on the Securities and Exchange Commission’s Edgar database located at www.sec.gov. Value investors typically invest in companies in a troubled industry. The value investor hopes that the troubles with a particular company are temporary in nature or a product of economic conditions, such as high oil prices. The growth style of investing focuses on companies that might grow in stature and profitability each year. Even if earnings grow each year, however, growth stocks usually pay little or no dividends. Earnings are reinvested to accelerate future growth.
Tips & Common Mistakes Tip: Do your homework Just as you wouldn’t make a major purchase without researching the product, you shouldn’t buy and sell stocks without doing your homework. Here are mistakes to avoid:
Just because you love a company’s high-tech products doesn’t mean its stock is a good investment. You need to do much more research before investing in it. As another example, you might love a fast food chain, but that doesn’t mean the parent company is a good investment. The company could be terribly mismanaged and its other restaurants might be losers. Tip: Re-evaluate your investments If you’ve taken physics, you’re familiar with the principle of inertia. Investors are sometimes inert and won’t budge from the stocks they’ve chosen. You can’t just sit on a stock and assume it will do well forever. You need to monitor your portfolio periodically to determine which stocks are performing well and which aren’t. You should also research whether those companies have a bright or bleak future. You shouldn’t hang onto a stock if it is no longer the right investment for you. The principle of inertia also says that a body in motion will remain in motion. When stock prices start to rise, it triggers a reaction among investors. The result is that demand pushes the prices of stocks beyond what they are worth. At the end of the inertia, the value of stocks fall. Common mistake: Day trading Day-trading is engaged in by investors who invest online and hope to capitalize on short-term swings in the market. They hold stocks for hours, not years. Day-traders hope the shares they buy will go up enough for them to make a quick profit (after commissions) and sell before the end of the day. If you’re just now learning the fundamentals of investing, day-trading is not for you. Many knowledgeable and experienced investors shun day-trading, because they believe investing in the stock market is a long-term proposition. Trying to time the stock market is a difficult if not impossible task. The Securities and Exchange Commission warns that day-trading is extremely risky. Common mistake: Trusting stock tips Watch out for faxes and e-mails that promise spectacular returns on a particular stock. You may be the target of a pump-and-dump scheme. The sender of the fax or e-mail pumps up the value of the stock with SPAM and then dumps shares for a huge profit when the price goes up
Getting Started Stocks are bought and sold through a brokerage firm. A brokerage firm, or broker-dealer as it is also called, is a company that buys or sells securities for its own account or for its clients. You can open a brokerage account in person or online. Depending upon your needs, you must choose between a:
Full-service brokers provide advice on which stocks to buy and sell. If you plan to do your own research and make your own decisions, you might do better with a discount brokerage firm. To evaluate a brokerage firm, find out more about the following:
Trading Online When you buy or sell a share of stock, you pay a commission to the broker-dealer that executes your trade. Online trading usually enables you to buy and sell stocks on your own. Generally, you pay a lower commission than you would if assisted by a stockbroker.
FAQs What is dividend reinvestment? When you receive a small dividend check from a stock you own, you’re probably tempted to spend it on a latte. Dividend reinvestment plans enable you to automatically buy more shares of stock with those small amounts. Over the years, your dividends will buy many more shares than you have now. Each of those new shares pays dividends and will help you build a portfolio. Before signing up, ask about any fees the plan charges. You must own a share of a company’s stock to sign up for its dividend reinvestment plan, assuming it has one. There are even companies that permit you to buy your first share of stock directly, so you can get started with a dividend reinvestment plan. What is the difference between a bull and bear market? “Bull market” is the term used to describe the stock market when investors are optimistic and share prices in general are increasing. Even though the stock market may have days when it goes down, a bull market might last years. When a “bear market” is in progress, investors are pessimistic. Even though stocks might trade higher over the course of weeks or months, the trend is downward during a bear market. Even if you’re in the middle of a bull market, the price of the shares you own may go down and you might lose money. What is a blue chip stock? The term “blue chip” comes from poker. In poker, blue chips are the most valuable. Similarly, the most consistently profitable companies are referred to as blue chips. Even if you only invest in blue chip stocks, there is no guarantee that your investment portfolio will do well.
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