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Investing in Stocks

Stocks have a long history of strong investment performance, but they also have a reputation for being volatile. In about 70% of the years since 1926, the return on stocks as an asset class has been positive, sometimes very positive. In the other 30%, stock prices fell, sometimes for several years in a row.

You might feel conflicted about investing a big part of your portfolio to these equity investments. The potential for strong returns over the long term can be attractive, and strong returns may help you meet your investing goals. On the other hand, the possibility of losing even some of your principal may make you hesitate.

As with everything, investing comes with tradeoffs. If you want the higher potential returns, you may have to take on more risk. No matter which way you go, you should make sure that you understand the risks of investing while you're dreaming about returns.

A Stock Market Overview

When you buy a stock, you pay the market price per share times the number of shares, plus commission. As a group, stock prices move up and down all the time, and that is from the balance between supply and demand. If lots of investors are buying stocks, the prices tend to head higher (though not in a straight line). If investors are selling more shares than they're buying, demand is lower and the prices tend to fall.

The price movement of an individual stock also depends on what's happening with the company that issued it. If the company's products or services are in demand, the stock price can be more-or-less stable or increase. But if there are management problems, or its sales and earnings fall, the stock price is more likely to drop. Those issues and others, such as the amount of debt a company has, are factors you may want to consider before you invest in a particular stock.

You might also want to consider a stock's market capitalization before you invest, since companies of different sizes tend to behave, as a group, in different ways. Market capitalization is a stock's share price multiplied by the number of outstanding shares, and will fluctuate as the stock price moves. There are three major categories:

  • Big companies, called large caps (short for large-capitalization), are the most likely to pay dividends, have higher prices per share, and have the most reserves to help protect them against a downturn in the market (but no guarantees, of course).
  • Mid-caps, or middle-sized companies, tend to have somewhat lower-price stocks and more growth potential than large caps. But compared to the large caps, they are less likely to pay dividends and may be more volatile.
  • Small companies, or small-cap stocks, may offer the greatest chance for big price increases, along with the greatest risk of your losing money. There may also be much less information available about the performance of small-cap stocks, which can make them harder to evaluate.

Buying What You Know

One approach to investing in stocks is to select companies whose products and services you know. The logic is that if you like (and buy) what a company offers, other people may be, too. Think of this approach as simply a first step.

It's a good idea to analyze each stock you're considering before you decide to invest. Your broker's website can be a valuable resource in doing your research.

Similarly, you may think about buying stock in your employer's company to share in its potential profits. But be cautious about investing more than just a small percentage. You might find yourself too dependent on just one source for both salary and investment return.

Looking for Bargains

Are stocks ever on sale? While stock discounts aren't advertised the way that furniture sales are, there are often some stocks that are cheaper than others.

Sometimes stocks are cheap because the issuing company is in financial trouble. Some companies never recover from that. But if the situation or the management changes, some companies can make a dramatic recovery.

In fact, one potentially successful investment strategy is to concentrate on value stocks. Value stocks are selling at a lower price than the company's reputation or financial situation seems to deserve. If you buy the stock when the price is low, planning to sell when the price goes up, you may make a profit if there is a rebound (but there's no guarantee there will be). Or, you may decide to keep the stock in your portfolio.

The hard part, of course, is figuring out why certain stock prices are low. It can be difficult, especially if the company doesn't get lots of press or analyst coverage. But if value investing appeals to you, it may be worth some effort. It's a strategy that can provide substantial rewards when you make a wise choice.

Contrarian Investing

If you're interested in stocks that other investors are ignoring, you're known as a contrarian. For this approach to work, however, you have to be willing to hold a stock that you've identified as a good investment even if takes a long time to gain value (if it ever does). You have to be comfortable with the fact that some stocks may never realize their potential or recover after a period of losses, and you could lose your entire investment.