Investing in Stocks

E-162 8-02 INVESTING IN STOCKS Jason Johnson and Wade Polk* Historically (1926 through assess your risk tolerance and exceeded the inflation rate. 1997), stocks have averaged a make stocks part of a well Inflation has averaged about 3.1 compound total return of 11 per- designed investment plan. percent since 1926. When the rate cent, far better than government of inflation rises, many companies Financial advisors often use this bonds (5.2 percent) or cash invest- can pass on their higher costs to general guideline to determine ments (3.3 percent). This is the consumers, which means their how much of a person’s long-term most persuasive argument for profitability, and resulting stock investments should be in stocks: investing in stocks. When you pur- prices, are less affected by infla- Subtract your age from 100 (for chase shares of stock in a compa- tion. conservative investors) or 120 (for ny, you share in the future success more aggressive investors). The Finally, there are a number of or failure of the business. Over the resulting number is a reasonable tax benefits to owning stocks. last century, stock prices have con- percentage of long-term invest- Capital gains on stocks are not sistently risen or fallen with corpo- ment money to allocate to stocks. taxed until you sell. Capital gains rate earnings, or profits. While As your age increases, the less you tax rates may be lower than ordi- stock prices may temporarily over- should be invested in stocks nary income tax rates. Also, any shoot or undershoot the stock’s because the less time you have to capital gains on your stock invest- true value, eventually, prices fol- withstand the volatility of the ments pass to your heirs tax free. low earnings. stock market. The potential profit from a stock Types of Stocks investment is unlimited, while Benefits of Owning There are many types of stocks potential loss is limited to the Stocks to choose from. Each represents a amount of the investment. Stock There are many benefits to different “investment style.” prices (and thus the value of your owning stocks, whether you pur- Sometimes the market favors one investment) are dynamic and can chase them individually or collec- style of investing, sometimes fluctuate wildly. Sometimes the tively through mutual funds. Aside another. A well diversified portfo- market settles into a period of little from their historical appreciation lio helps balance out such shifts in or no growth and lower values for in value, stocks also can produce the market. stocks. This is called a “bear mar- income from dividends. From 1926 ket.” By contrast, a “bull market” to 1997, the dividend income of 1. Growth, income, and value is a period when stock values are stocks in the Standard & Poor’s stocks increasing. An investor must be 500 Stock Index averaged 4.6 per- Growth stocks are shares in emotionally prepared for bad times cent annually. Thus, 42 percent of companies that reinvest much of as well as good. The easiest way the 11 percent historical returns their profits to expand and to ensure peace of mind is to from stocks has been attributable strengthen the business. Although to dividends. they often pay little if any divi- * Assistant Professor and Extension dend, investors buy these stocks Economist–Management, and Extension Owning stocks is one of the because they expect the price to go Program Specialist–Risk Management, best ways to combat inflation, as up as the company grows. Growth The Texas A&M University System. their returns have consistently stocks usually do better when the companies, blue chips usually your investment. Some common economy is slow and investors are offer investors stable, predictable stocks pay a regular dividend and willing to pay a premium for the income and steady-to-slow growth some do not. A company that has relatively few companies that can in value. already issued common stock may sustain solid earnings growth also choose to issue preferred Penny stocks are just the oppo- rates. Growth stock investors look stock, which in many ways is site. They generally sell for $5 or for long-term appreciation and more like a bond than a stock. If less a share and are inexpensive want to postpone taxes until they the company goes out of business for an excellent reason—the com- sell the stock. and there is any money to distrib- panies’ prospects are dicey at best. ute to investors, preferred stock- Stocks that have paid dividends Many of these companies may holders are paid off before com- for 50 consecutive years or more never be profitable, or may even mon stock owners. Preferred stock are known as income stocks. go out of business. In spite of this dividends also take priority over Investors often buy them for a reli- extreme risk, some investors find dividends on common stock and able source of income. Income penny stocks attractive because of are generally higher per dollar stock investors often do well when the potential for their value to invested than those of common the overall market is flat or falling; increase dramatically. shares. Preferred stock dividends a generous dividend can help are fixed, just as a bond’s interest soothe the pain for shareholders 3. Defensive or cyclical stocks rate is set by the issuer. Therefore, when stock prices aren’t going up. Defensive stocks are stable and relatively safe in declining markets they are less vulnerable to the for- Value stocks are ones that or economic slowdowns. Stocks tunes of the company. appear inexpensive, perhaps that commonly fit this category 5. Stocks based on market because the companies have had include food companies, drug difficulties, their potential for manufacturers and utilities. Their capitalization growth has been underestimated, value tends to decline less during Investors also can choose or they’re part of an industry that recessions because demand for between large, medium and small doesn’t currently interest investors. their products is the same in any companies. A company’s size is Value companies may not see economic climate. Many investors often defined by its market capital- much earnings growth at all, but include them in their portfolios as ization, or the number of out- they own various assets that make a hedge against sharp losses in standing shares multiplied by the them attractive to some investors. other stocks. Cyclical stocks, on current price of one share. Large- These assets may include real the other hand, are shares in com- cap stocks have market capitaliza- estate, new products or a trusted panies whose earnings tend to tions exceeding $5 billion. Large- brand name. Value stocks tend to fluctuate sharply with changes in cap stocks often pay dividends, prosper most during the early the business cycle or fundamental although many provide growth as stages of a market recovery, when changes within a specific industry. well. They’re often more resilient stocks that had been ignored often When business conditions are in tough times because they have come to life. Value investors look good, the company’s earnings rise more assets, but tend to be more for companies whose cloudy out- and the stock price rises rapidly. expensive than other stocks. Mid- look enables their stock to trade However, when business condi- cap stocks have market capitaliza- relatively inexpensively in relation tions deteriorate, the company’s tions between $750 million and 5 to their earnings, assets and divi- earnings and stock price deterio- billion. These stocks are shares in dends. The value investors ulti- rate rapidly. companies that have survived mately make money when the infancy, but have not yet expanded companies improve and other 4. Common or preferred into larger businesses. Small-cap investors bid up their stock prices. stocks stocks have market capitalizations between $50 million and 750 mil- 2. Blue chips or penny stocks A company can issue two different classes of stock—common or lion. Stocks in small companies Blue chip stocks are shares in are usually bought as growth the largest, most consistently prof- preferred—to appeal to different types of investors. If you purchase stocks, but some also provide itable, and most prestigious com- income. In tough economic times panies. They typically have a long common stock, you share directly in the success or failure of the small-cap stocks may decline more history of paying dividends during than others because small compa- good and bad years. Although blue business. If the company has large profits, your return increases; how- nies have fewer resources to fall chip stocks often cost more than back on. stock in lesser known or smaller ever, if it has a bad year, so does Exchange Traded Funds G VIPERs (stock ticker VTI) — of these indices have been used by Another way to own stocks is to track the Wilshire 5000 Total investment professionals for more purchase shares in a fund that Stock Market Index. than 25 years. WEBS are listed on the American Stock Exchange and owns all the stocks tracked by a There are also select sector spi- trade like any other stock. certain market index. Such funds ders that track individual sectors are called exchange traded funds, of the U.S. economy, for example: EFTs operate much like special- or ETFs. They are designed to basic industries (ticker XLB); con- ized mutual funds, but have much show the same price and yield per- sumer services (XLV); consumer lower fees and expenses. formance as the portfolios of staples (XLP); cyclical (XLY); ener- stocks on which they are based. gy (XLE); financial (XLF); industri- For further information: Some of the most popular kinds of al (XLI); technology (XLK); and Edelman, Ric.

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