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Basics of Investing: Stocks
What are stocks?
When you buy a stock, you are buying a share of ownership — equity — in a company. As an owner, you participate in that company's growth and future profits. Conversely, you also lose if the company suffers a loss or is unprofitable.
The price you pay for that stock is determined in the stock market where hundreds of thousands of investors buy and sell the company's shares based on their perception of the company and its potential for providing them with positive investment returns. Stocks are not insured, and their value will vary with fluctuating market conditions.
Perhaps one of the most compelling arguments for owning stocks and stock mutual funds is that, over the long term, U.S. stocks have historically outperformed long-term U.S. government bonds and Treasury bills over the past 50 years, while keeping investors well ahead of inflation.
Although past performance is no guarantee for the same performance in the future, stocks may make sense for investors looking to achieve long-term investment objectives, such as planning for retirement or funding a college education. Long-term investing doesn't have to mean 50 years, either. History has shown that just five years can make a big difference.
The many thousands of stocks (and stock mutual funds) available to investors are typically categorized by style, size and investment sector.
Style: Growth and Value
Stocks fall primarily into two investment styles: growth and value.
Growth stocks represent companies that pay little or no dividends, are growing rapidly and have strong potential for continued, above-average revenue and earnings.
Although these companies offer the investor the possibility of high, long-term investment returns, investors should expect some volatility along the way. For most long-term investors, however, growth stocks could be the core holding within their investment portfolio.
Value stocks represent companies whose stock is considered "cheap" on the basis of the company's earnings power. The company may be experiencing difficulties, but is nevertheless fundamentally strong.
When a company's stock is temporarily out of favor with investors, its stock price may be depressed (undervalued). Value investors could be rewarded with potential gains when market perception changes in favor of the company.
Such investments are subject to risks that their intrinsic values may never be realized by the market, or such stocks may turn out not to have been undervalued.
Size: Large-Cap, Mid-Cap and Small-Cap
Classifying stocks as either small-cap or large-cap is based on a company's market capitalization. Market capitalization is determined by multiplying the company's current stock price by the total number of shares outstanding.
- Large-cap - These companies are generally valued between $10 billion to $100 billion. These companies tend to be well-established, but they may have lower growth potential than mid- or small-cap companies. They tend to pay dividends to investors and may provide some stability in an investment portfolio.
- Mid-cap - These companies are generally valued between $2 billion to $10 billion.
- Small-cap - These companies are generally valued between $500 million to $2 billion.
Mid- and small-cap companies tend to be newer companies and can react more quickly to changes in the marketplace and economy. Both are considered to offer greater potential for growth and investment returns, but theytypically also add a greater degree of risk to an investment portfolio.
Stocks may also be classified by the market sector, or broad industry group, to which they belong. For example: communication services, energy, health care and technology are all examples of sector stocks.
Investing in a particular market sector means you are concentrating your investments in one specific area of the market. This lack of market diversification may involve greater risk: When a sector stock is in favor, you can win big; when it's out of favor, you can lose big as well. (Remember the performance of technology stocks during the 1990s?)
The Advantages of Investing in Stocks and Stock Mutual Funds
Stocks may offer investors many advantages: the potential for dividends, growth in value and above-average returns. They can provide a way to keep ahead of inflation and, historically, have outperformed bonds and cash equivalents over the last 50 years.
Stocks can be purchased individually or through stock mutual funds. Mutual funds may provide the stock investor with many benefits including:
Diversification - Stock mutual funds provide a degree of diversification that individuals simply can't get on their own. By distributing the pool of shareholder dollars across dozens of securities, the mutual fund can diversify its holdings.
A diversified portfolio may reduce risk should some investments turn sour and may increase the chance of picking up potential winners. The average investor would find it difficult to amass a portfolio as diversified as that of a mutual fund. Diversification does not guarantee a profit or protect against loss.
Choice - There's a fund to fit every investor need. A mutual fund investor has more options than ever before — there are literally thousands of stock, bond and money market funds available — enough to satisfy all levels of risk tolerance, from the most conservative to the most venturesome. In addition, specialized funds are available; for instance, those that invest only in certain geographic regions or in certain sectors or industries (like health care, technology or energy). There are even funds that have adopted certain social objectives or that follow specific investment philosophies.
Flexiblility - While some investors prefer to pick a single fund and stick with it, others look for a "family" of funds — several different funds available from one fund company. In a family, investors can generally transfer portions of their investments into other funds with different objectives as their own needs or financial circumstances change.
Liquidity - Mutual fund investors can cash in all or part of their shares at any time and receive the current net asset value of their investment, which may be more or less than the original cost. They do not need to find a buyer; the fund is always ready to buy back (redeem) its shares.
Current per-share values are calculated daily based on the market worth of the underlying securities. These values change as the values of the underlying securities move up or down and as the fund changes its portfolio by buying new securities or selling existing ones. Investors can find the per-share calculations (known as "net asset values") published each day in the financial sections of most major newspapers.
Small- and mid-cap stocks may be subject to a higher degree of risk than larger, more established companies' securities, including higher risk of failure and higher volatility. The illiquidity of the small- and mid-cap markets may adversely affect the value of these investments so those shares, when redeemed, may be worth more or less than their original cost. There is no assurance that a diversified portfolio will produce better returns than an undiversified portfolio, nor does diversification assure against market loss.
There are some risks associated with investing in the stock markets: 1) Systematic risk - also known as market risk, this is the potential for the entire market to decline; 2) Unsystematic risk - the risk that any one stock may go down in value, independent of the stock market as a whole. This also incorporates business risk and event risk; and 3) Opportunity risk and liquidity risk.
Actual investment return and principal value of mutual funds will fluctuate so that an investor's shares, when redeemed, may be worth more or less than their original cost. A plan of regular investing does not assure a profit or protect against loss in a declining market. You should consider your financial ability to continue your purchase throughout periods of fluctuating price levels. Please obtain a prospectus for complete information including charges and expenses. Read it carefully before you invest or send money.