Stocks 101: the Basics of Stock Investing

What is a Stock?

Stock is an interest in the ownership of a company. So, when you buy a stock, you are purchasing the company's entire operation, its proceeds and its liabilities. This includes earnings (profits), losses, liabilities, debt... everything.

Why Buy Stocks?

One word: returns. We invest in stock because the investment is likely to earn more money through returns. There was a time when the main returns from stocks came from dividends, which are a company's payment of a portion of its profits to shareholders.

Now, however, dividends are only a small part of a stock's potential returns, and some companies do not even pay dividends at all.

Rather, returns today are largely due to an increase in the value of the stock itself. That is, investor demand for a company's stock drives its share price up.

What Makes a Stock a Good Investment?

Here's where it gets tricky. Not all stocks are good investments, and every stock has the potential to be a bad investment, no matter how successful the company is. Even Microsoft, the clear market leader in consumer operating system software was a bad investment in 2000, because investor demand had so inflated its price. If you had purchased $1,000 of Microsoft stock at its peak in 2001 you'd have a little over $500 in 2006. And Microsoft has been a profitable company. There are two important factors most stock investors use to evaluate stocks, and they have evolved into the two main schools of investing: growth and value.

Growth Investing

Growth investing focuses on the stocks of financially healthy companies that have exhibited consistent earnings growth over time. Looking at a company's past earnings announcements and seeing that, year over year, the company has posted increasing earnings is a sign that the company is healthy and will continually produce increased earnings. As a result, investor interest will increase and the stock price will rise.

Value Investing

Value investing focuses on the price of a stock and its relationship to the underlying company's financial health and earnings outlook. Value investing relies on the theory that there are inefficiencies in the stock market that can be exploited. Sometimes a stock will be ignored or overlooked by the investing community as a whole, and as a result the stock will be undervalued. Eventually, of course, investors on the whole will take note and the stock price will rise to a more appropriate price.

Other Strategies

Not all stock investors fall into the clearly defined categories of growth or value. In fact, there is often disagreement over which category a stock belongs in.

Some investors will focus on an individual sector, such as Biotechnology. Other investors will focus on distressed securities, the stock of companies which have fallen into financial trouble and whose stock has plummeted as a result.

There are a few qualities that all good stock investors share:

Know what you are buying, and why you are buying it. If you are buying distressed stock in a company that has a threat of going bankrupt, it is important to know that you may lose all of your money, and it is important to know why you think it won’t go bankrupt. If you are buying a stock because you think it is undervalued, it is important to evaluate that stock over time, to see if you still feel it is undervalued after, say, three years.
Invest without emotion. This is a hard one, because we are all emotional whether we like to admit it or not. Ego is the emotion we’re talking about here. It is important to keep the company’s fundamentals, financial health, earnings growth, and cash flow front and center, and continually evaluate the company to make sure it is still the great investment you first thought it was, even as its share price fluctuates.
Buy sparingly. An individual’s stock portfolio should have no more than 18 stocks, and usually 12 is more than enough. There is no shame in holding cash with your broker because there are not good investments at the time.
Limit your losses. Most seasoned investors employ a stop-loss whereby they sell a stock if it drops more than a specified amount (frequently 8%-10%). This ensures that no single investment will significantly deteriorate your portfolio.