Investing in Stocks
Stocks are important investing tools. However, you don't necessarily need to invest in individual stocks. For the most part, you'll have others doing that for you (in your company's 401(k) plan, for example). However, you should have a basic understanding of what is happening with your money.
Publicly owned companies sell shares of stock to raise money for operations or business expansion, invest in new technology or equipment, or meet other financial needs. When you own stock, you actually own part of that company, and the value of your share rises and falls as the company's value changes.
When stock prices go down, you don't actually lose anything unless you sell while the price is low. A loss that is only on paper can be recouped the next time the stock rebounds, but selling locks in your loss and makes it final. This is one of the reasons it's important to “buy and hold,” which means you pick solid stocks or funds and hang on to them through thick and thin unless there's an underlying flaw that affects the stock's ability to recover. Of course, not all stocks that decline in value recover. Another school of thought recommends setting a lower and upper level for the price of the stock and selling when either threshold is reached. For example, you buy a stock at $30.00 per share and at the time of purchase you set a price range of $25.50 to $34.50 (15 percent below and above your purchase price, respectively). If the stock falls to your lower threshold, you sell. If the stock rises to the upper threshold, you sell. This way you can limit your losses and take advantage of gains.
Stock Price
It's important to understand that a stock's price has more to do with investors' perceptions than it does with the actual financial standing of the company. Internet stocks are a prime example. Yahoo!, Amazon, and other Internet stocks were inflated far beyond their real value because investors were enamored with the concept and the demand for the stocks kept pushing up the prices. When the bottom fell out of the technology market, some of these stocks lost most of their value. Yahoo!, for instance, was once at $250 per share, traded below $5 per share in September of 2001 and September of 2002, and was valued at just $30 per share as the U.S. markets reached historically high levels in 2007.
In fifty-two weeks, General Electric's stock price fell from $41.83 to $21.41, losing nearly half its value. A $20,000 investment in GE would be worth only $10,236 at the end of that year. An investment of $20,000 in an indexed stock mutual fund for the same period would be worth around $16,000.
When a stock price gets so high that investors are reluctant to buy, the company may declare a stock split. With a two-for-one split, you receive a free share of stock for every share you own, and the price per share is cut in half. The value of your investment doesn't change, but the lower price may make it more attractive to investors and demand for the stock may eventually push the price up. Since you have more shares, your investment is worth more than it would have been without the split. Stock splits don't always result in higher prices, though.
Risk Level of Stocks
Stocks don't offer a guaranteed return, which is why it's important to choose them carefully instead of acting on some hot tip you heard in an elevator or from your uncle's business partner's cousin. Don't ever invest in something you don't understand. Do your homework. Making an informed decision to assume risk creates an opportunity for a greater return on your investment. Jumping into investments you know nothing about, or that you hope will create a quick profit, puts your money at risk.
Stock Indexes
A stock index reports changes in prices for the market that it tracks. There are many U.S. and international stock indexes, but the best known in the world is the Dow Jones Industrial Average (DJIA), which tracks thirty U.S. blue-chip stocks. Blue chips are the stocks of very large, well-established companies (in poker, the blue chips are the ones with the highest dollar value).
Other U.S. indexes include the Russell 2000, which measures the overall performance of small- to mid-cap companies (“caps” are explained in “Market Capitalization,” later in this chapter); the S&P 500, an index of the 500 largest companies in America; and the Wilshire 5000, which tracks the entire stock market. It's helpful to compare the performance of your stock or mutual fund to the applicable index. If you have a small-cap mutual fund, compare its return to the Russell 2000. If the fund consistently underperforms the index, consider selling your shares and putting the money in a fund with better performance.
How to Buy Stocks
You can buy stocks through a full-service brokerage or a discount brokerage by calling a stockbroker and placing an order, or you can use a discount Internet broker such as E*TRADE (
Another way to buy stocks is through dividend reinvestment plans (DRIPs) offered by many corporations. Corporations often pay out part of their earnings as dividends to shareholders, usually quarterly. The dividend can be paid in cash or stock. With a DRIP, you can reinvest the dividends in additional shares of stock, often without paying a commission. When the stock price goes up, so does the value of your reinvested shares. If you take your dividends in cash instead of stock, you lose the opportunity for them to increase in value as the price of the stock goes up.
The best way to invest is to do your research, choose a good stock or mutual fund, and stick with it for the long haul. There will no doubt be dips and rises, but historically the stock market has outperformed all other investments. You don't need to “churn” your stocks, buying and selling constantly and trying to anticipate ups and downs in the market. You can't afford to ignore changes in the financial condition of the companies you've invested in, but you shouldn't have to review their status more than quarterly. If something fundamental about a company has changed and you believe the stock won't regain its value, think about selling it.
