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Historically (1926 through1997), stocks have averaged acompound
total return of 11 per-cent, far better than governmentbonds (5.2
percent) or cash invest-ments (3.3 percent). This is themost
persuasive argument forinvesting in stocks. When you pur-chase
shares of stock in a compa-ny, you share in the future successor
failure of the business. Over thelast century, stock prices have
con-sistently risen or fallen with corpo-rate earnings, or profits.
Whilestock prices may temporarily over-shoot or undershoot the
stock’strue value, eventually, prices fol-low earnings.
The potential profit from a stockinvestment is unlimited,
whilepotential loss is limited to theamount of the investment.
Stockprices (and thus the value of yourinvestment) are dynamic and
canfluctuate wildly. Sometimes themarket settles into a period of
littleor no growth and lower values forstocks. This is called a
“bear mar-ket.” By contrast, a “bull market”is a period when stock
values areincreasing. An investor must beemotionally prepared for
bad timesas well as good. The easiest wayto ensure peace of mind is
to
assess your risk tolerance andmake stocks part of a welldesigned
investment plan.
Financial advisors often use thisgeneral guideline to
determinehow much of a person’s long-terminvestments should be in
stocks:Subtract your age from 100 (forconservative investors) or
120 (formore aggressive investors). Theresulting number is a
reasonablepercentage of long-term invest-ment money to allocate to
stocks.As your age increases, the less youshould be invested in
stocksbecause the less time you have towithstand the volatility of
thestock market.
Benefits of OwningStocks
There are many benefits toowning stocks, whether you pur-chase
them individually or collec-tively through mutual funds. Asidefrom
their historical appreciationin value, stocks also can
produceincome from dividends. From 1926to 1997, the dividend income
ofstocks in the Standard & Poor’s500 Stock Index averaged 4.6
per-cent annually. Thus, 42 percent ofthe 11 percent historical
returnsfrom stocks has been attributableto dividends.
Owning stocks is one of thebest ways to combat inflation,
astheir returns have consistently
exceeded the inflation rate.Inflation has averaged about
3.1percent since 1926. When the rateof inflation rises, many
companiescan pass on their higher costs toconsumers, which means
theirprofitability, and resulting stockprices, are less affected by
infla-tion.
Finally, there are a number oftax benefits to owning
stocks.Capital gains on stocks are nottaxed until you sell. Capital
gainstax rates may be lower than ordi-nary income tax rates. Also,
anycapital gains on your stock invest-ments pass to your heirs tax
free.
Types of StocksThere are many types of stocks
to choose from. Each represents adifferent “investment
style.”Sometimes the market favors onestyle of investing,
sometimesanother. A well diversified portfo-lio helps balance out
such shifts inthe market.
1. Growth, income, and valuestocksGrowth stocks are shares
in
companies that reinvest much oftheir profits to expand
andstrengthen the business. Althoughthey often pay little if any
divi-dend, investors buy these stocksbecause they expect the price
to goup as the company grows. Growth
E-1628-02
INVESTING IN STOCKS
Jason Johnson and Wade Polk*
* Assistant Professor and ExtensionEconomist–Management, and
ExtensionProgram Specialist–Risk Management,The Texas A&M
University System.
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stocks usually do better when theeconomy is slow and investors
arewilling to pay a premium for therelatively few companies that
cansustain solid earnings growthrates. Growth stock investors
lookfor long-term appreciation andwant to postpone taxes until
theysell the stock.
Stocks that have paid dividendsfor 50 consecutive years or
moreare known as income stocks.Investors often buy them for a
reli-able source of income. Incomestock investors often do well
whenthe overall market is flat or falling;a generous dividend can
helpsoothe the pain for shareholderswhen stock prices aren’t going
up.
Value stocks are ones thatappear inexpensive, perhapsbecause the
companies have haddifficulties, their potential forgrowth has been
underestimated,or they’re part of an industry thatdoesn’t currently
interest investors.Value companies may not seemuch earnings growth
at all, butthey own various assets that makethem attractive to some
investors.These assets may include realestate, new products or a
trustedbrand name. Value stocks tend toprosper most during the
earlystages of a market recovery, whenstocks that had been ignored
oftencome to life. Value investors lookfor companies whose cloudy
out-look enables their stock to traderelatively inexpensively in
relationto their earnings, assets and divi-dends. The value
investors ulti-mately make money when thecompanies improve and
otherinvestors bid up their stock prices.
2. Blue chips or penny stocksBlue chip stocks are shares in
the largest, most consistently prof-itable, and most prestigious
com-panies. They typically have a longhistory of paying dividends
duringgood and bad years. Although bluechip stocks often cost more
thanstock in lesser known or smaller
companies, blue chips usuallyoffer investors stable,
predictableincome and steady-to-slow growthin value.
Penny stocks are just the oppo-site. They generally sell for $5
orless a share and are inexpensivefor an excellent reason—the
com-panies’ prospects are dicey at best.Many of these companies
maynever be profitable, or may evengo out of business. In spite of
thisextreme risk, some investors findpenny stocks attractive
because ofthe potential for their value toincrease
dramatically.
3. Defensive or cyclical stocksDefensive stocks are stable
and
relatively safe in declining marketsor economic slowdowns.
Stocksthat commonly fit this categoryinclude food companies,
drugmanufacturers and utilities. Theirvalue tends to decline less
duringrecessions because demand fortheir products is the same in
anyeconomic climate. Many investorsinclude them in their portfolios
asa hedge against sharp losses inother stocks. Cyclical stocks,
onthe other hand, are shares in com-panies whose earnings tend
tofluctuate sharply with changes inthe business cycle or
fundamentalchanges within a specific industry.When business
conditions aregood, the company’s earnings riseand the stock price
rises rapidly.However, when business condi-tions deteriorate, the
company’searnings and stock price deterio-rate rapidly.
4. Common or preferredstocksA company can issue two differ-
ent classes of stock—common orpreferred—to appeal to
differenttypes of investors. If you purchasecommon stock, you share
directlyin the success or failure of thebusiness. If the company
has largeprofits, your return increases; how-ever, if it has a bad
year, so does
your investment. Some commonstocks pay a regular dividend
andsome do not. A company that hasalready issued common stock
mayalso choose to issue preferredstock, which in many ways ismore
like a bond than a stock. Ifthe company goes out of businessand
there is any money to distrib-ute to investors, preferred
stock-holders are paid off before com-mon stock owners. Preferred
stockdividends also take priority overdividends on common stock
andare generally higher per dollarinvested than those of
commonshares. Preferred stock dividendsare fixed, just as a bond’s
interestrate is set by the issuer. Therefore,they are less
vulnerable to the for-tunes of the company.
5. Stocks based on marketcapitalizationInvestors also can
choose
between large, medium and smallcompanies. A company’s size
isoften defined by its market capital-ization, or the number of
out-standing shares multiplied by thecurrent price of one share.
Large-cap stocks have market capitaliza-tions exceeding $5 billion.
Large-cap stocks often pay dividends,although many provide growth
aswell. They’re often more resilientin tough times because they
havemore assets, but tend to be moreexpensive than other stocks.
Mid-cap stocks have market capitaliza-tions between $750 million
and 5billion. These stocks are shares incompanies that have
survivedinfancy, but have not yet expandedinto larger businesses.
Small-capstocks have market capitalizationsbetween $50 million and
750 mil-lion. Stocks in small companiesare usually bought as
growthstocks, but some also provideincome. In tough economic
timessmall-cap stocks may decline morethan others because small
compa-nies have fewer resources to fallback on.
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Exchange Traded FundsAnother way to own stocks is to
purchase shares in a fund thatowns all the stocks tracked by
acertain market index. Such fundsare called exchange traded
funds,or ETFs. They are designed toshow the same price and yield
per-formance as the portfolios ofstocks on which they are
based.Some of the most popular kinds ofETFs are:
� DIAMONDs (stock tickerDIA) — track the Dow JonesIndustrial
Average;
� SPDRs or “spiders” (stockticker SPY) — track theStandard &
Poor’s 500 StockIndex;
� QUBEs (stock ticker QQQ) —track the Nasdaq 100 StockIndex;
and
� VIPERs (stock ticker VTI) —track the Wilshire 5000 TotalStock
Market Index.
There are also select sector spi-ders that track individual
sectorsof the U.S. economy, for example:basic industries (ticker
XLB); con-sumer services (XLV); consumerstaples (XLP); cyclical
(XLY); ener-gy (XLE); financial (XLF); industri-al (XLI);
technology (XLK); andutilities (XLU).
EFTs known as WEBS (WorldEquity Benchmark Shares) allowU.S
investors to invest in a diversi-fied portfolio of foreign
stocks.There’s a WEBS Index Series foreach of 17 countries,
includingAustralia (EWA), Germany (EWG),Mexico (EWW) and Japan
(EWJ).Each WEBS index series seeks tomatch the performance of a
specif-ic Morgan Stanley CapitalInternational (MSCI) Index.
Many
of these indices have been used byinvestment professionals for
morethan 25 years. WEBS are listed onthe American Stock Exchange
andtrade like any other stock.
EFTs operate much like special-ized mutual funds, but have
muchlower fees and expenses.
For further information:Edelman, Ric. The Truth About
Money. Harper CollinsPublishers: New York, 1998.
Eisenberg, Richard. The MoneyBook of Personal Finance.Warner
Books: New York, 1996.
Ibbotson, Roger G. and Rex A.Sinquefield. Stocks, Bonds,
Billsand Inflation Yearbook.Ibbotson Associates: Chicago,Illinois,
1998.
The American Stock Exchangewww.amex.com