Historically (1926 through1997), stocks have averaged acompound total return of 11 per-cent, far better than governmentbonds (5.2 percent) or cash invest-ments (3.3 percent). This is themost persuasive argument forinvesting in stocks. When you pur-chase shares of stock in a compa-ny, you share in the future successor failure of the business. Over thelast century, stock prices have con-sistently risen or fallen with corpo-rate earnings, or profits. Whilestock prices may temporarily over-shoot or undershoot the stock’strue value, eventually, prices fol-low earnings.

The potential profit from a stockinvestment is unlimited, whilepotential loss is limited to theamount of the investment. Stockprices (and thus the value of yourinvestment) are dynamic and canfluctuate wildly. Sometimes themarket settles into a period of littleor no growth and lower values forstocks. This is called a “bear mar-ket.” By contrast, a “bull market”is a period when stock values areincreasing. An investor must beemotionally prepared for bad timesas well as good. The easiest wayto ensure peace of mind is to

assess your risk tolerance andmake stocks part of a welldesigned investment plan.

Financial advisors often use thisgeneral guideline to determinehow much of a person’s long-terminvestments should be in stocks:Subtract your age from 100 (forconservative investors) or 120 (formore aggressive investors). Theresulting number is a reasonablepercentage of long-term invest-ment money to allocate to stocks.As your age increases, the less youshould be invested in stocksbecause the less time you have towithstand the volatility of thestock market.

Benefits of OwningStocks

There are many benefits toowning stocks, whether you pur-chase them individually or collec-tively through mutual funds. Asidefrom their historical appreciationin value, stocks also can produceincome from dividends. From 1926to 1997, the dividend income ofstocks in the Standard & Poor’s500 Stock Index averaged 4.6 per-cent annually. Thus, 42 percent ofthe 11 percent historical returnsfrom stocks has been attributableto dividends.

Owning stocks is one of thebest ways to combat inflation, astheir returns have consistently

exceeded the inflation rate.Inflation has averaged about 3.1percent since 1926. When the rateof inflation rises, many companiescan pass on their higher costs toconsumers, which means theirprofitability, and resulting stockprices, are less affected by infla-tion.

Finally, there are a number oftax benefits to owning stocks.Capital gains on stocks are nottaxed until you sell. Capital gainstax rates may be lower than ordi-nary income tax rates. Also, anycapital gains on your stock invest-ments pass to your heirs tax free.

Types of StocksThere are many types of stocks

to choose from. Each represents adifferent “investment style.”Sometimes the market favors onestyle of investing, sometimesanother. A well diversified portfo-lio helps balance out such shifts inthe market.

1. Growth, income, and valuestocksGrowth stocks are shares in

companies that reinvest much oftheir profits to expand andstrengthen the business. Althoughthey often pay little if any divi-dend, investors buy these stocksbecause they expect the price to goup as the company grows. Growth

E-1628-02

INVESTING IN STOCKS

Jason Johnson and Wade Polk*

* Assistant Professor and ExtensionEconomist–Management, and ExtensionProgram Specialist–Risk Management,The Texas A&M University System.

stocks usually do better when theeconomy is slow and investors arewilling to pay a premium for therelatively few companies that cansustain solid earnings growthrates. Growth stock investors lookfor long-term appreciation andwant to postpone taxes until theysell the stock.

Stocks that have paid dividendsfor 50 consecutive years or moreare known as income stocks.Investors often buy them for a reli-able source of income. Incomestock investors often do well whenthe overall market is flat or falling;a generous dividend can helpsoothe the pain for shareholderswhen stock prices aren’t going up.

Value stocks are ones thatappear inexpensive, perhapsbecause the companies have haddifficulties, their potential forgrowth has been underestimated,or they’re part of an industry thatdoesn’t currently interest investors.Value companies may not seemuch earnings growth at all, butthey own various assets that makethem attractive to some investors.These assets may include realestate, new products or a trustedbrand name. Value stocks tend toprosper most during the earlystages of a market recovery, whenstocks that had been ignored oftencome to life. Value investors lookfor companies whose cloudy out-look enables their stock to traderelatively inexpensively in relationto their earnings, assets and divi-dends. The value investors ulti-mately make money when thecompanies improve and otherinvestors bid up their stock prices.

2. Blue chips or penny stocksBlue chip stocks are shares in

the largest, most consistently prof-itable, and most prestigious com-panies. They typically have a longhistory of paying dividends duringgood and bad years. Although bluechip stocks often cost more thanstock in lesser known or smaller

companies, blue chips usuallyoffer investors stable, predictableincome and steady-to-slow growthin value.

Penny stocks are just the oppo-site. They generally sell for $5 orless a share and are inexpensivefor an excellent reason—the com-panies’ prospects are dicey at best.Many of these companies maynever be profitable, or may evengo out of business. In spite of thisextreme risk, some investors findpenny stocks attractive because ofthe potential for their value toincrease dramatically.

3. Defensive or cyclical stocksDefensive stocks are stable and

relatively safe in declining marketsor economic slowdowns. Stocksthat commonly fit this categoryinclude food companies, drugmanufacturers and utilities. Theirvalue tends to decline less duringrecessions because demand fortheir products is the same in anyeconomic climate. Many investorsinclude them in their portfolios asa hedge against sharp losses inother stocks. Cyclical stocks, onthe other hand, are shares in com-panies whose earnings tend tofluctuate sharply with changes inthe business cycle or fundamentalchanges within a specific industry.When business conditions aregood, the company’s earnings riseand the stock price rises rapidly.However, when business condi-tions deteriorate, the company’searnings and stock price deterio-rate rapidly.

4. Common or preferredstocksA company can issue two differ-

ent classes of stock—common orpreferred—to appeal to differenttypes of investors. If you purchasecommon stock, you share directlyin the success or failure of thebusiness. If the company has largeprofits, your return increases; how-ever, if it has a bad year, so does

your investment. Some commonstocks pay a regular dividend andsome do not. A company that hasalready issued common stock mayalso choose to issue preferredstock, which in many ways ismore like a bond than a stock. Ifthe company goes out of businessand there is any money to distrib-ute to investors, preferred stock-holders are paid off before com-mon stock owners. Preferred stockdividends also take priority overdividends on common stock andare generally higher per dollarinvested than those of commonshares. Preferred stock dividendsare fixed, just as a bond’s interestrate is set by the issuer. Therefore,they are less vulnerable to the for-tunes of the company.

5. Stocks based on marketcapitalizationInvestors also can choose

between large, medium and smallcompanies. A company’s size isoften defined by its market capital-ization, or the number of out-standing shares multiplied by thecurrent price of one share. Large-cap stocks have market capitaliza-tions exceeding $5 billion. Large-cap stocks often pay dividends,although many provide growth aswell. They’re often more resilientin tough times because they havemore assets, but tend to be moreexpensive than other stocks. Mid-cap stocks have market capitaliza-tions between $750 million and 5billion. These stocks are shares incompanies that have survivedinfancy, but have not yet expandedinto larger businesses. Small-capstocks have market capitalizationsbetween $50 million and 750 mil-lion. Stocks in small companiesare usually bought as growthstocks, but some also provideincome. In tough economic timessmall-cap stocks may decline morethan others because small compa-nies have fewer resources to fallback on.

Exchange Traded FundsAnother way to own stocks is to

purchase shares in a fund thatowns all the stocks tracked by acertain market index. Such fundsare called exchange traded funds,or ETFs. They are designed toshow the same price and yield per-formance as the portfolios ofstocks on which they are based.Some of the most popular kinds ofETFs are:

� DIAMONDs (stock tickerDIA) — track the Dow JonesIndustrial Average;

� SPDRs or “spiders” (stockticker SPY) — track theStandard & Poor’s 500 StockIndex;

� QUBEs (stock ticker QQQ) —track the Nasdaq 100 StockIndex; and

� VIPERs (stock ticker VTI) —track the Wilshire 5000 TotalStock Market Index.

There are also select sector spi-ders that track individual sectorsof the U.S. economy, for example:basic industries (ticker XLB); con-sumer services (XLV); consumerstaples (XLP); cyclical (XLY); ener-gy (XLE); financial (XLF); industri-al (XLI); technology (XLK); andutilities (XLU).

EFTs known as WEBS (WorldEquity Benchmark Shares) allowU.S investors to invest in a diversi-fied portfolio of foreign stocks.There’s a WEBS Index Series foreach of 17 countries, includingAustralia (EWA), Germany (EWG),Mexico (EWW) and Japan (EWJ).Each WEBS index series seeks tomatch the performance of a specif-ic Morgan Stanley CapitalInternational (MSCI) Index. Many

of these indices have been used byinvestment professionals for morethan 25 years. WEBS are listed onthe American Stock Exchange andtrade like any other stock.

EFTs operate much like special-ized mutual funds, but have muchlower fees and expenses.

For further information:Edelman, Ric. The Truth About

Money. Harper CollinsPublishers: New York, 1998.

Eisenberg, Richard. The MoneyBook of Personal Finance.Warner Books: New York, 1996.

Ibbotson, Roger G. and Rex A.Sinquefield. Stocks, Bonds, Billsand Inflation Yearbook.Ibbotson Associates: Chicago,Illinois, 1998.

The American Stock Exchangewww.amex.com