Understanding Stocks
Investors buy stocks for potential price appreciation (e.g.,
capital gains) and dividends. It helps to have a basic
understanding of stocks to increase your investment successes,
says Pat Swanson, CFP® and families specialist with Iowa
State University (ISU) Extension’s Invest Wisely Project
(www.extension.iastate.edu/investwisely).
There are several ways to categorize stocks. Income stocks
are those of companies that regularly pay a high percentage of
their earnings in dividends. Blue chip stocks are large
industry-leading companies. They tend to be of low or moderate
risk with consistently increasing dividends. “These
are the types of stocks that you can hold and have less concern
for ups and downs in the market,” Swanson says.
Growth stocks are shares of companies that have shown relatively
fast growth in earnings, which cause their price to rise. Typically
growth companies are in new or fast-growing industries. They
make no or small dividend payments because the company puts its
earnings back into the company for future growth. “Growth
stocks are considered riskier; individuals who invest here are
willing to accept more volatility in hopes of making large capital
gains over the long run,” Swanson adds.
A stock whose price does not reflect its earnings is considered
to be a value stock. Value stocks have relatively low prices
compared to their historical earnings and the value of the company’s
assets. A company that has had a temporary setback but
is fundamentally sound may be another kind of value stock.
Cyclical stocks tend to rise and fall with the economy. For
example, stocks of companies in the travel industry are cyclical
because individuals and companies cut back on travel when the
economy slows. On the other hand, defensive stocks such as utility
stocks are not affected significantly by changes in the economy
Speculative stocks are those of start-up companies or companies
that have lost much of their value and may or may not recover. Penny
stocks refer to low-priced (below $5) speculative stocks of very
small companies. “There is much volatility with these
stocks,” Swanson says. “Although there are
some winners, most speculative stocks do not do well.”
Swanson says if
you are investing for an investment goal many years in the future,
you may not want to receive cash dividends. Instead, you
may want to reinvest any dividends to purchase additional shares. “Companies
that have dividend reinvestment plans, also known as DRIPS, allow
you to automatically reinvest any dividends to purchase additional
shares as well as to buy more shares with extra cash you want
to invest. A DRIP is an easy and less expensive way to
purchase additional shares of stock.”
However, Swanson suggests that if you don’t have the skill
or time to select and monitor individual stocks or sufficient
wealth to adequately diversify through purchase of many different
companies, you may want to consider mutual funds that pool money
from many investors to purchase a basket of stocks. A fund’s
objective may be growth, income, a combination of the two
or many other objectives.
Index funds include stocks that compose a benchmark index such
as the Standard and Poor’s (S&P) 500. “Over
the past three years the S&P 500 has outperformed more than
65 percent of mutual funds invested in large company stocks.
Historically the return of the S&P 500 has been around 10
to 11 percent,” Swanson
concludes.
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The ISU Extension Invest Wisely
Project provides a series of newspaper, radio, and web resources
for investors. It is funded by a grant from the Investor
Protection Trust (IPT). The IPT is a nonprofit organization
devoted to investor education. Since 1993 the IPT has
worked with the States to provide the independent, objective
investor education needed by all Americans to make informed
investment decisions. www.investorprotection.org.
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