How To Invest In Stocks

How To Invest In Stocks
April 9, 2013

Stocks represent ownership of a company. For example, if you think of a company as a pizza with eight slices, each slice could represent a share. In this case, the total number of shares outstanding would be eight, and the market capitalization (or stock market worth) of the company would be the price of each share times the total number of shares, or eight times the slice price.

Stocks are considered more risky than bonds because in the event of a bankruptcy and liquidation of a company's assets, bondholders would be paid in full before stockholders.

A common mistake investors make in buying stocks is thinking a low priced stock is cheaper than a higher priced stock. For example, a share worth $8 could be much more expensive than a share worth $80. What is important is the value of each share, not the price. The value is determined by the future perceived earnings of the company.

A common measure of value would be the price/earnings (P/E) ratio. This is the price of the stock divided by the earnings per share. You should look at this number and see how the company compares to other companies in its industry, and to the market in general. If the P/E of a company is 80, and the P/E of the market is 15, that company could be very overvalued. Or it could be valued properly because it is growing at a much greater rate than the market, or because for some reason investors expect the earnings to increase dramatically. So you can see that there are many ways to value stocks and no hard rules that work perfectly all of the time.

You should really think of your stock holdings as part of an entire portfolio first. The first step would be to determine your asset allocation, or percentage devoted to stocks versus bonds. A good place to start would be to think of "your age in bonds" as a starting percentage. For example, if you are thirty years old, 30% of your portfolio would be in bonds, and 70% would be in stocks. If you are able to or want to take on more risk, you could adjust your stock percentage upward. You should revisit your percentages no less than every five years and rebalance your percentage holdings once a year if they are off by more than five percentage points from what you want your stock percentage to be.

It is important to be very diversified in your stock holdings. Your portfolio should hold big and small companies, "growth" and "value" companies, domestic and international companies. A good choice to accomplish this diversification with a single holding would be the Vanguard Total World Stock Market ETF (Ticker symbol VT). This index ETF gives you complete worldwide diversification to the entire global stock market at a very low cost.

Take 5% of your stock market holdings and experiment in buying individual company shares. You should realize that you are taking much greater risk in owning individual company shares; be prepared to lose 100% of your money. But you can learn valuable lessons in owning shares. Also, individuals are capable of making good decisions and have much more patience and less pressure to perform than professional investors. Perhaps you work in a particular industry and have insight and knowledge of that industry. Or you use the product of a company you admire. Try following your instincts and see what happens.

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