Stock Market Basics
Knowing What and When to Buy
Don't Go There
Don't be persuaded to jump on the bandwagon and invest all, or most of your money in one area—technology stocks come to mind. It's never a good idea to put all your eggs into one basket, regardless of how good the basket looks at the time.
Stocks represent ownership, or equity, in a public corporation. When you buy the stock of a particular company, you're actually buying a tiny piece of the business. If the company prospers, you as a stockholder share in its profits (frequently in the form of dividends) and benefit from any rise in the market value of its stock. Conversely, if the company runs into problems, the value of your investment could decline.
Because their prices tend to fluctuate suddenly and sometimes sharply, stocks are considered more risky than bonds or cash investments. Over time, however, stocks have offered the highest returns of the three asset classes—as well as the best hedge against inflation.
So how do you know what stocks to buy, and when you should buy them?
Unless you're a real daredevil with lots of money to play around with, it's a good idea to invest your money in industries and companies that are stable, with good earning histories. Sure, you might be tempted to buy a few stocks in a sexy, new firm that's just starting up, or sink some of your money in a hot, new growth industry, and that's fine. The majority of your money, however, should go to buy stock that is tried and true.
There may be opportunity for increased profits in more risky stocks, but you should look for those that have reasonable price-to-earnings ratios. Price-to-earnings (P/E) ratios determine how the market is pricing a company's stock, and can help you to get an idea of the strength of a company.
Some investors target growth industries and only buy stock from companies within those industries. Some examples of growth industries at the present time include the following:
- Home healthcare services
- Computer and data processing services
- Residential care
- Water supply and sanitary services
- Management and public relations
While it's fine to invest some of your money in companies in these industries, it's not a good idea to rely only on growth industries.
There is risk involved whenever you buy stock, but some stock involves less risk than others. The risk of the stock you own going up and down in value because the entire stock market goes up and down is called systematic risk. Chances are, if the entire stock market drops by 10 percent, the stocks you own will decrease in value, as well. And the same is true if the overall market value increases. You can minimize the effects of systematic risk by investing in other forms of securities, such as bonds.
Unsystematic risk is that which affects only a particular business or industry. The good news is that diversifying your portfolio can minimize unsystematic risk. That means that you have a variety of investments in different types of companies and industries. If one sector of the stock market experiences a major downturn, you'll still have stocks in other areas to offset your losses.
So when you're looking for companies in which to invest, make sure you mix them up. Your portfolio should include a mixture of some of the many kinds of stock. Blue-chip stock, for instance, is that of the tried and true companies such as IBM and General Motors. Companies experiencing unusual growth issue growth stocks. Emerging market stocks are those in new markets, in the United States and around the world.
You can find out a lot about companies in whose stock you're interested by checking out their financial statements in their annual reports. You also should look at some of the company's ratios, including price to earnings (P/E), earnings per share (EPS), return on investment (ROI), and return on equity (ROE). Pay special attention to a company's profitability and how much debt it has.
Investors have been trying since investing began to time when they buy, trade, and sell stock. Even experienced investors, however, get hung up when they try to time the market. Ideally, you want to buy stock when the price is low, and sell it when the price is high.
Realistically, however, you should buy when you (and your financial advisor, if you have one) feel the time is right. Trying to time the market might be interesting, but it rarely pays off. The best time to buy stock is after you've explored your options, researched the companies, and decided that the stock is right for you.
More on: Understanding Finances
Excerpted from The Complete Idiot's Guide to Personal Finance in Your 40s and 50s © 2002 by Sarah Young Fisher and Susan Shelly. All rights reserved including the right of reproduction in whole or in part in any form. Used by arrangement with Alpha Books, a member of Penguin Group (USA) Inc.
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