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Stocks represent ownership in a company. They are traded publicly
on stock exchanges throughout the world. Shareholders have the
right to vote at shareholders’ meetings and review the books of the
company. Generally, I don’t recommend holding more than five percent
of an investor’s portfolio in individual stock due to the risk factor
associated with stocks. There are two types of stock we discuss:
common and preferred.
Common Stock
Common stock can help you accumulate wealth in two ways. First,
they provide income through dividends, which are distributed to
shareholders from corporate earnings. Second, the stocks can appreciate
in value. This is generally the result of successful company
management and products, or the prospect of future successes. Common
stocks allow the stockholder, as part owner of the company, to
participate in the firm’s profits.
It is important to remember that the stock value may depreciate
as well. A number of reasons may go into why a stock depreciates
instead of appreciating. It varies from stock to stock and industry to
industry. For instance, Lucent Technologies was trading at around
five to six dollars per share during the summer of 2001. This doesn’t
mean that it’s a bad company, or even a poor investment. Depending
on your risk tolerance and your outlook, you might think purchasing
some shares of Lucent right now is a good investment decision that
will pay off in the future.
Stocks traded publicly are easily converted into cash. Because of
this, they are considered readily marketable investments. They aren’t
considered liquid, though, because the sale of the stock could result
in a loss of principle. Nonpublicly traded stocks are neither liquid nor
readily marketable because they are difficult to sell and the selling
price is uncertain.
Publicly traded stocks are exchanged on stock exchanges around
the world. The largest exchanges in the United States are the New
York Stock Exchange (NYSE) and the American Stock Exchange
(AMEX). Both of these exchanges are located in New York City, but
the NYSE is the largest. The NASDAQ (National Association of
Securities Dealers and Automated Quotations) is an automated information
system that provides stockbrokers and dealers with price
quotes for over-the-counter stocks. There are other American
exchanges, such as the Philadelphia Exchange and the Pacific
Exchange.
Common stocks can be segregated into many different categories,
and some stocks may fall into more than one category. While
it may not always be easy to pigeonhole stocks, here are a few ways
to categorize them.
BLUE CHIP STOCKS. These are stocks of companies that have the
highest overall quality. Because of the blue chips’ high quality, many
investors are drawn to them. These companies are known for being
financially stable and distributing dividends in both good and bad
years. They are usually leaders in their industries or industry segments.
All 30 companies that make up the Dow Jones Industrials are
classified as blue chip stocks, as well as other utility companies and
large, consistently successful companies.
Special note: A lot of emphasis is put on watching what the
market does every day. It’s important to remember that the
Dow Jones Industrial Average (DJIA) only comprises 30 companies.
The NASDAQ Composite Indes and the S&P 500 are
much more representational of what the market is doing
because of their size. The S&P is made up of 400 industrial,
40 utility, 40 financial, and 20 transportation stocks, whereas
the NASDAQ contains 5000 companies.
The DJIA, as well as the other Dow Jones averages, are priceweighted
indices. Throughout every trading day, and at the
end of each day, the averages are computed by adding the
prices of the included stocks and dividing that number by a
specified divisor. This divisor changes all the time, usually
daily. No one stock will have a greater influence on the index
than another.
The NASDAQ Composite and the S&P 500 are both valueweighted.
The value of a given stock will affect the index in
proportion to its value.
VALUE STOCKS. Companies whose stock is considered undervalued
(trading at a price lower than expected) fall under this heading.
The stock may be undervalued because of inner company strife
(management change, etc.), business operations restructuring, or
perhaps that particular industry is currently unpopular. Generally,
value stocks have a lower price-per-earnings ratio than growth stocks
do, and thus, their price per share is lower.
Many times a value stock may be reclassified as a growth stock.
Although growth stocks have dramatically outperformed value
stocks in certain years, over time, the returns of value stocks have
surpassed those of growth stocks.
GROWTH STOCKS. These are companies that are expected to have
dramatic growth rates in business and/or earnings. Generally, stock
of companies that are emerging or very young would be considered
growth stocks. These companies tend to reinvest their earnings,
rather than distributing them to stockholders, to help them increase
their business. Therefore, the only income stockholders would see
from growth stocks would come in the form of stock appreciation at
the time of sale. Growth stocks are also a riskier investment than blue
chip or value stocks. Their share prices usually increases much faster
than those of blue chips or value stocks, making their potential for
appreciation very great. However, the share prices are just as likely to
decrease very quickly. Growth stocks also tend to do poorly in down
market times.
Depending on your risk tolerance, objectives, and time frame,
growth stocks may not be appropriate for your portfolio. If you are
willing to assume the risk associated with growth stocks and are
investing for long-term potential growth and appreciation, then
growth stocks may be a good fit for you.
INCOME STOCKS. Companies that consistently distribute high
dividends fall under this heading. Income stock companies are those
that are in mature, stable industries. While their dividends are generally
a high percentage of corporate earnings, the tendency for their
share prices is to hold fairly steady. This is due to the fact they distribute,
rather than reinvest, their earnings.
Income stocks are best held by people who look for their investments
to provide cash flow. Those investors seeking growth and
share price appreciation are typically disappointed with the performance
of income stocks. However, if you were to participate in dividend
reinvestment programs (DRPs), over time there would be a
large capital appreciation of your shares. DRPs are discussed later.
GROWTH AND INCOME STOCKS. This group is really just a combination
of the two previous groups. These are stocks that not only pay
a reasonable dividend, but also offer the potential for appreciation
over time.
CYCLICAL STOCKS. Cyclical stocks generally follow the business
cycle. The housing sector is an example of a cyclical sector because
as the economy does well, more people are likely to purchase or
build houses. Likewise, when the economy is in a recession or
depression, people generally don’t build or purchase new homes.
Investing in cyclical stocks is not without risk. Investors who want to
make money from cyclical stocks aim to purchase the shares before
a market upswing and sell them prior to a market downturn.
DEFENSIVE STOCKS. In essence, defensive stocks are the opposite
of cyclical stocks. They tend to perform better when the market is
down and, comparatively, worse when the market is doing well.
Defensive stocks are used to help balance the risk in a portfolio
because of this. These are companies that produce goods that are still
in demand when the economy is not doing well. Food and beverage
companies are good examples of defensive stocks.
SMALL TO MIDSIZED COMPANY STOCKS. Small-cap or mid-cap
stocks are those from companies that have a smaller market share
than their large-cap counterparts. These companies have shown, in
the past, to have a better overall performance than the larger companies,
but they have also proven to be more volatile.
SPECULATIVE STOCKS. Stocks that present a greater risk to the
investor than common stocks in general are speculative. Typically,
hot new issues and penny stocks are speculative. While some stocks
may be easily qualified as speculative, others may not be so easy.
Over the past few years, we’ve seen many small companies,
particularly dot.coms, release new issues of their companies or take
them public for the first time. These offerings found a highly competitive
marketplace, thus driving their share prices skyward.
Unfortunately for investors, the market for these stocks usually
drops just as fast as it rises, sometimes even resulting in the companies
going bankrupt.
FOREIGN STOCKS. Although the easiest way for investors to hold
foreign stock is through different types of mutual funds, Americans
can buy stocks in individual foreign companies through American
Depositary Receipts (ADR). These receipts are listed on U.S. stock
exchanges and are an alternative to direct investing. Asset allocation
usually recommends that a portion of an investor’s portfolio be held
in foreign stocks.
Stocks may sound like the perfect investment choice for you, but
remember, not everything is as great as it seems. Until the year 2000,
the United States was experiencing unprecedented economic growth.
While the stock market, on the whole, soared to new record heights,
there were some low points. Throughout the first six months of 1987,
the market gained almost 30 percent. However, on October 19, 1987,
the stock market suffered its worst crash to date. The Dow Jones
Industrial Average dropped 508 points. That day a few new records
were set: largest point drop, largest one-day volume of shares traded,
and the largest percentage drop. The Dow dropped 23 percent, which
was nearly double the previous record. Ten years later, on October
27, 1997, the market dropped precipitously again. This time, it fell
554 points, a new record. However, the percentage drop wasn’t as
bad due to the value of the Dow at the time. It fell a mere 12 percent.
However, within two weeks, the market had regained all its losses of
October 27. It took the market nearly two and a half
years to recover from the October 19, 1987 crash.
This isn’t designed to scare you when it comes to investing in
common stocks. It’s just a reminder of what can happen in the market.
In the past decade, this country has seen such unbridled enthusiasm for investing in individual stocks, with ever-increasing returns,
it’s easy to forget what has happened in the past. When it comes to
common stocks, there is no such things as either a safe investment, or
a guaranteed thing. This is why I generally don’t like my clients to
hold more than five percent in an individual stock.
Market capitalization—The price per share of a company
multiplied by the number of outstanding shares.
Large-capitalization stocks—The stock of a company with
market capitalization of more than $5 billion.
Mid-capitalization stocks—The stock of a company with
market capitalization between $1 billion and $5 billion.
Small-capitalization stocks—The stock of a company with
market capitalization of less than $1 billion.
Preferred Stock
Just like common stock owners, preferred stock owners own a part of
the company. However, there are more rights that come with preferred
stock that aren’t associated with common stock. First, preferred
stock holders hold the right to be paid their dividends before
they are distributed to common shareholders. Second, should the
company have to liquidate, preferred shareholders hold the right to
receive the par value of their stock before there is any distribution to
common shareholders.
Dividends on preferred stock are fixed, much like the interest
rates on bonds are. The price of preferred stock also differs from that
of common stock, and is affected by interest rate changes. They
almost always have a higher dividend yield than common stock does,
but preferred stock doesn’t have the growth and price appreciation
potential that common stock does because preferred stock doesn’t
participate in the corporate earnings growth of the company.
Other features of preferred stock include more voting rights than
common shareholders (either more total votes or the ability to elect
more directors), the right to receive more than the stated dividend
amount in certain conditions, the right to exchange preferred shares
for a fixed number of common shares, and the right to cumulation of
dividends. Cumulation of dividends may happen if any preferred dividends
have been missed. If this has happened, all prior and current
preferred dividends must be paid out before common shareholders
receive their dividends. | 
Disclaimer
