Advantages and Risks of Stock Investing
Investing in stock is a way for your investment to keep up with inflation. By investing in companies that are growing with the economy, you seek to be sure your portfolio grows with inflation. Stocks hold none of the payment promises of bonds; your investment is only as strong as the companies you're buying. The government encourages investment in shares by giving preferred tax rules to stock owners.
Watch your terms. The words “equities,” “shares,” and “stocks” are all used interchangeably. As for fixed-income issues, “bonds” can be issued by governments or commercial interests. “Paper” usually refers to commercial bonds. Notes are short-term Treasury issues. “CDs” are also considered fixed income and are issued by banks.
The Plusses and Minuses of Stock Ownership
Companies sell ownership shares to fund their operations. Stock buyers are rewarded with an investment that is pegged to the fortunes of the company. The goal of a good stock portfolio is to generate growth by creating a diversified mix of stocks, owning many different companies of different sizes and in a variety of industry sectors and countries.
The size of the company makes a difference. Larger companies tend to grow at a slower rate than smaller ones. They have established businesses and are considered safer than smaller companies. As an added perk, some of them pay dividends to stockholders. Dividends are not a guaranteed payment like a bond payment, but they are a nice source of extra income that can offset some of the risk of owning the stock.
Small and midsize companies have historically grown at faster rates than larger ones, but they are riskier. Also called small cap and mid cap, respectively, a number of these companies fail or disappoint investors expecting high returns each year. To diversify against this risk, many investors buy baskets of small and mid-cap companies through mutual funds or index shares rather than picking individual company shares.
Diversification is an important way to protect your investment. By owning investments that are affected by different economic factors, you reduce your risk. As one part of the economy is doing well, another might be struggling. The risk of loss is higher if all your investments are similar and are affected by the same economic factors.
Tax Benefits
Tax laws are often governmental policy tools to encourage a certain behavior, and the taxes on stock gains are no different. Qualified dividends are taxed at a lower rate than interest payments from bonds. When you sell a stock, your profit — or capital gain — is taxed at a lower rate than other income sources such as wages or bond interest. If you've lost value in your stock, you can sell and count the loss against other gains you may have had in the same year, thus reducing your capital gains taxes. If you don't have gains, you can count a limited amount of realized capital losses against your regular income — saving even more tax.
Different Risks
Most people think of market risk when they think about stocks. “Market risk” is the chance that your investment loses value because other potential buyers of your stock are willing to pay less for your shares than you paid. You can protect against market risk by buying stocks that are in different markets. Small companies have different appeal to buyers than mid-cap or large companies. Better yet, adding international companies to your portfolio protects against risks in the U.S. stock market.
“Company risk” is the risk that something damaging happens with the company whose shares you own, eroding their value. You can protect against company risk by buying stock in many companies that are unrelated to each other and having a diversified portfolio.
Own shares of companies in many different industry sectors to protect yourself against “industry risk,” or losses related to the economic fortunes affecting one industry. Many people were caught by surprise in 2000 when the technology sector, which had been growing meteorically, collapsed. Be sure your portfolio is balanced among industries that are dependent on different parts of the economy.
Be careful not to put too many eggs in one basket. Make sure you keep your exposure to any one stock below 10 percent of your investment portfolio. If the company is also your employer, try to keep your stock holdings below 5 percent, when you can.
Measuring Tools
Measuring tools called indexes were created so investors could easily see how well a particular market has performed or compare their own investments to the performance of the market. One of the first of these indexes was the Dow Jones Industrial Average. Created in the nineteenth century by the founders of the Wall Street Journal, the average price performance of thirty industrial companies was calculated at the end of each day and published in the paper. Readers and investors could use changes in the Dow Jones average to gauge how the market as a whole was doing.
Nowadays, investors are concerned about measuring many more than just one market. There are indexes for practically everything you could imagine. Popular indexes for U.S. stocks are the Standard and Poor's 500 — or the S&P 500 — that measures large-cap stocks, the S&P 400 for mid-cap stocks, and the Russell 2000 for small-caps.
