Today’s financial planning tip is Investing in Stocks.

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Turn on the TV nowadays, or surf the Internet, and you’re certain to run into someone talking about making a fortune from owning one specific stock or another.  Even the 6 o’clock news generally recaps the day’s trading activity, including what stocks went up or down, and what the S&P 500 or Dow Jones Industrial Average closed at for the day.  Ever wonder what exactly is a stock, and what it means to own shares in a company?  Many people today invest in stocks without even knowing what they’re investing in, or what the fundamentals are for a specific company.  This video lays out the basics of investing in stocks, along with a few tips on what to do, and better yet, what not to do.

Stocks represent an ownership position in a company.  More specifically, corporations issue shares of stock to raise capital to fund their growth, which is used for R&D, new projects, product development, supply-chain expansion, acquisitions, or many other business-related activities.  Investors can purchase these shares of stock, which are listed on a stock exchange or exchanges, through a broker by opening up a brokerage account.  Stock is generally purchased from another investor who wants to sell her shares.  In other words, most stock trades involve a buyer and a seller, although it is possible to purchase shares directly from the issuing company.  Owning shares of stock in a corporation entitles the owner to vote in shareholder meetings, receive dividends paid out of company profits, and (potentially) share in the appreciation of the company’s share price.  Not all corporations pay dividends, but many of the larger, more mature companies do pay dividends, typically quarterly.  Stocks are sometimes referred to as equity or equities.

OK, with that out of the way, why would someone want to own shares of stock?  Simply put, to make money by participating in the capital growth of the company through appreciation of the share price, and to earn the dividends being paid out to shareholders.  Over the long-term, stocks have provided higher returns than bonds or cash, but this superior performance comes with higher risk and volatility.  In the short-term, some stocks can be very volatile, meaning their share price can rise or fall quickly and sometimes unexpectedly.  Owning an individual stock also subjects the shareholder to unsystematic or company-specific risk.  Unlike systematic risk, which can be thought of as the risk associated with the entire market, unsystematic risk can be reduced through diversification.  Investors wanting to reduce their unsystematic or company-specific risk can buy additional stocks within the same industry, but can also buy stocks spanning many industries.  For example, an investor owning Ford but wishing to diversify his holdings might also buy shares of GM, BMW, and Toyota, for example, to broaden his exposure within the auto sector.  To diversify even further, this investor might also want to own stocks of a few retailers, health care providers, utilities, banks, technology companies, energy producers or distributors, and some consumer products firms.

Broadly diversifying a portfolio can help reduce downside risk and volatility, but it does tend to dilute the impact of the investor’s “best ideas”.  In other words, if an investor has 3 or 4 “great stock ideas” which she believes in with high conviction, just buying those stocks would result in a very concentrated portfolio with high risk and volatility.  If the investor’s “best ideas” work out, that concentrated portfolio might grow more rapidly than, say, a well-diversified stock portfolio spanning all 11 sectors of the US economy.  But if those “best ideas” don’t work out as the investor anticipated, that concentrated portfolio might drop precipitously in value over even a relatively short period of time.  Owning stocks is not for the weak of heart.  If a company goes out of business, the company’s shareholders can lose everything.  In other words, shares of stock in companies filing bankruptcy and liquidating assets generally go to zero.  Common stockholders don’t get paid in a bankruptcy liquidation until creditors, bondholders, and preferred shareholders have all been paid.

To adequately diversify a stock portfolio, it generally takes upwards of 50 different stocks, and it might be necessary to own several hundred different stocks, depending on which market or markets the investor is trying to diversify across (e.g., US large-cap, entire US, developed world, entire world).  This is why many investors, particularly beginning and hands-off type investors, choose to employ mutual funds or exchange-traded funds (ETFs) rather than trying to assemble a diversified portfolio themselves.  It’s important to realize, however, that purchasing a single mutual fund or ETF doesn’t necessarily fully diversify an investment portfolio.  You can learn more about that in my Mutual Funds and ETFs video.  And bear in mind there are several different asset classes, such as US large-cap stocks, foreign developed country stocks, or emerging market stocks, as well as different investing styles, such as value or growth.  That’s not to mention modern strategies like growth at a reasonable price, or GARP, alternative investments, theme-oriented investing, or factor-based investing.

Before I wrap this up, let me offer a few other suggestions derived from many years of observing and participating in the stock market.  First, do your homework, don’t just invest in a stock because you heard about it on the Internet or at the gym or from Cramer on CNBC.  You need a solid stock selection or filtering approach and a buy/sell process.  Fundamental analysis takes into account a company’s fundamentals, such as their revenues, earnings, return on equity, profit margins, and growth metrics, as well as the company’s management team, competitive positioning, brand strength, supply chain, and cost of doing business.  Technical analysis analyzes a company’s stock chart, and considers things like support levels, resistance levels, short and long-term trends, trading range, and recognizable repeatable patterns.  Although a lot of stock information is available online for free, many firms provide detailed stock information and analysis on a subscription basis, such as Standard & Poor’s, Value Line, Argus Research, Morningstar, and Zack’s.

Once you’ve done an analysis and decided to purchase a stock, make sure you know ahead of time the price level at which you’ll sell the stock to lock in your gains if the share price were to rise, or the price at which you’ll sell if the stock price starts to drop.  Limit and stop-loss orders can be used to automate your buy-sell targets.  And most importantly, don’t get emotional about a stock holding.  Many investors make the mistake of waiting for a losing stock position to return to its original price before they’ll even consider selling.  That can be a big mistake!  Once you’ve bought a stock, think of it like a sunk cost.  What’s done is done.  If the stock price drops 25% in the first month, re-evaluate whether you want to continue holding it at this new price, independent of your original purchase price.  If, based on your research and knowledge, there are better investment opportunities now, don’t hang on just to avoid a loss because you don’t want to admit to yourself or someone else you made a mistake.  On the other hand, if your conviction is still strong, and nothing fundamental has changed – other than the 25% drop in share price – you might decide to continue holding the stock because you believe the current share price is too low and will eventually go up.

Finally, don’t chase returns.  In other words, if a stock has gone up 69% over the past 8 months, that doesn’t mean it’ll automatically go up another 69% over the next 8 months.  In fact, many times stocks that run up significantly in price over a relatively short time period may “mean revert”, meaning come back down to earth and have sub-par performance over the ensuing time-period.  Last year’s winners are sometimes this year’s losers.  It doesn’t always happen that way, but this “law of averages” concept does come into play frequently with stock investments.  Part of the challenge is sorting out companies whose stock may run up for many years in a row from those who may have had a good quarter or year or couple of years, but then revert to a lower-growth, or sometimes negative-growth, trajectory.  And be aware of a wise old axiom of investing that goes something like this: “It’s not (necessarily) market-timing that produces wealth, it’s time in the market.”  Which is another way of saying, to take advantage of the excellent long-term returns produced by stocks, investors need to actually be in the stock market a good portion of the time in order to let the markets work their magic.  This is an important concept to remember.

Now, assuming you’ve done your homework and you’re willing to take the risk, go out and buy some stocks!

Nothing in this video should be considered a recommendation or endorsement of specific stocks or techniques. Investors should conduct their own research before buying or selling any stock or stock fund.

Scott McClatchey is a CERTIFIED FINANCIAL PLANNER™, CFP® with WWM Financial in Carlsbad, California. Scott can be reached at 760-692-5190 or Scott@WWMFinancial.com.

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