The stock market has its ups and downs, in recurring cycles.
When you invest in a stock, you’re buying part of a publicly traded company. That piece, also known as your equity or ownership share in the company, means you’re in a position to profit from the company’s success—or lose money if its share price drops and you sell.
Despite the potential risk involved, stocks are one of the most widely held investments, especially for long-term goals. It’s for good reason: They’ve historically provided stronger returns than any other kind of investment, though there’s no guarantee that will be true in the future. Some of that increase has been the result of dividend payments and some the result of increased share value.
UPS AND DOWNS
A stock doesn’t have a fixed value the way some other investments do. What it’s worth can go as high as you and other investors are willing to pay to own it—usually because you expect it to be worth even more in the future. But it can also drop in value, sometimes to almost nothing, if the company that issued it isn’t meeting investor expectations, or is part of an industry that’s out of favor with investors, or if the market as a whole tumbles.
Historically, investors have picked companies based on how strong their earnings were and how consistently those earnings increased. But in the late 1990s, many technology and internet stocks increased rapidly in value even though those companies weren’t making money. Some commentators speculated that a new era in investing had arrived. But that phase was soon being described as a bubble doomed to burst, and investors went back to looking at earnings.
CREATING A PORTFOLIO
Suppose, for example, that price were no object and you could create an instant portfolio of six stocks.There are some basic principles you’d want to keep in mind to be sure that your porfolio turned out to be diversified.
Be sure that each of the stocks is from a different sector of the economy. You may want to avoid the sector your employer is in, or limit yourself to one company in that sector, so that you aren’t depending on one industry for investment gains and your paycheck.
If you concentrate on companies that show promise of future growth, be sure to include at least one or two well-established companies, even if their growth rate is likely to be slower.
If the stocks that interest you have P/Es that are higher than the current average, you might look for one or two undervalued companies that show promise of long-term growth. You can find P/E figures on financial or company websites.
Consider dividing your portfolio evenly among large-cap stocks (with market caps over $10 billion), mid-cap stocks (with market caps between $2 and $10 billion) and small-cap stocks (with market caps below $2 billion).
FINDING YOUR STYLE
Investing in stocks is a matter of style. If you’re a buy and hold investor, you’re in for the long haul. You buy stocks you think will increase in value over time, and you hold onto them—even through price drops and down markets.
You may even buy more shares when the stock loses value, since you’ll pay less per share than when the price is high. And if, from time to time, the price goes high enough and the stock splits, you end up with even more shares.
If you trade, you buy stocks you expect to increase enough in value in the short term so that you can sell them for a profit. With this approach, you may want to set some guidelines for when you should sell. For example, you might decide you’ll sell any stock whose price has increased 15% to 20% and reinvest in another promising stock.
SIZING UP STOCKS
If you’re investing in stocks, it’s a good idea to diversify your portfolio. That means building a portfolio of stocks that tend to react differently to changes in the economy, to grow in value at different rates, and to carry different levels of risk.
To evaluate how diversified your portfolio is, and to identify the kind of stock you might buy next, you can classify stocks and the companies that issue them in several ways:
- By sector, or industry
- By growth potential, which is a stock’s apparent capacity to increase in price
- By valuation, to assess whether a stock’s current price is higher or lower than the company’s financial standing and growth potential seem to deserve
- By market capitalization, or market cap for short, which is the price of one share of stock multiplied by the total number of existing shares
As helpful as diversification can be in helping to manage risk, it doesn’t guarantee you’ll make money or ensure you won’t lose money in a falling market.
Investors often use a stock’s price-to-earnings ratio (P/E) to get a sense of its value in relation
to other stocks in the same sector or in the market at large. A P/E—which you find by dividing the current price per share by the company’s earnings per share—that’s much higher than the market average may be a warning that investors expect a higher return from the stock than it may be able to deliver. And a lower than average P/E may indicate either a company in trouble or one poised to produce a good return on investment.