Choosing a Stock

Once you determine that securities (stocks and equities) should house at least a part of your investment dollars, how do you determine the right ones to invest in? Let's start off by saying that there is no sure thing in the world of stock investing. A stock's performance is based on many factors, including the economy in general, the state of a specific industry, as well as the company's earnings and growth. Based on that fact, you must first make the decision whether investing in stock is appropriate for your goals depending on the age and stage of your life.

If you make the decision that stocks may be the place for you to put your investment dollars, you must now determine the primary purpose of your stock investment. While this is true for any investment, it is particularly true for stocks. It's not as simple as "buy low, sell high."

Income and growth. The two primary stock investment goals are income and growth. You can have a combination of the two in one stock investment, but the features are almost never equal. In other words, although growth and income may co-exist in a particular stock investment, and we are not suggesting that the two are mutually exclusive, the investment choice you make should take into account the primary strength of the stock.

What characterizes a stock as income- or growth-oriented? Growth stock is stock in a company that doesn't pay cash dividends, but instead reinvests its profits into the company. The idea behind this strategy is that the company will continue to grow and become more profitable, driving the price of the stock up. Income stock is stock in well-established companies that do not need to reinvest their profits into their companies and therefore use their profits to pay dividends to stockholders. Income stock is often more expensive than most growth stock because the income stream and security of the investment is greater. When investing in growth stocks, the objective is to buy the company's stock when the price is low and to sell when the stock price rises. Your age and stage in life, as well as your overall financial health, are the major factors in deciding whether you can handle the risk involved in investing in growth stock. To a lesser extent, but nonetheless still important, is your emotional risk tolerance. All stock investments are risky, but growth stocks represent a gamble too huge for some investors.

Tip Many investors invest in the stock market through mutual funds. Mutual funds are professionally managed and are easier to diversify your investments in, which makes them less risky than investing in individual stocks. You still have to do your homework and determine what type of stock will best suit your investment goals, but the average investor finds it less stressful to invest in the stock market through this method.

Which are the right stocks for you? If you've decided that investing in stocks is right for you, where do you start to learn about the right stocks for you to invest in?

Many investors seek assistance from brokers when deciding what securities they should invest in. Brokerage firms buy and sell securities for investors and earn commissions on the transactions. Investment firms also employ analysts that rate securities based on their research. The Financial Industry Regulatory Authority (FINRA) regulates brokerage firms and their representatives. Before being permitted to sell securities, a broker must be licensed by FINRA. The licensing process includes rigorous training and testing as well as a screening process that looks into the background of the applicant. You can access information on brokers, as well as information on investments, on the FIRNA website. The SEC website also has information available regarding investment advisors.

You should be aware that brokers and advisors that sell securities are also subject to state laws. You can check with your state security regulators for details at your location.

If you go to a broker to buy or sell securities, they will open a personal brokerage account for you. FINRA also requires that brokers complete and keep on file questionnaires that contain information about investors that can be used to determine the types of securities investments that best fit them. These questionnaires are another safeguard against putting investors into securities where their risk is too high based on their net worth or their age or stage in life.

Brokers are a valuable source of information when it comes to investing in securities. The large majority of brokers earn their commissions by not only performing buying and selling transactions for you, but also by sharing their recommendations for investments suited for you. However, turning over your investment decisions lock, stock and barrel to brokers (or investment advisors, financial planners or accountants for that matter) is a big mistake. At one extreme, disaster could result if your investments are too risky and you lose everything with not enough time at your age and stage of life to get back on track and reach your investment goals. Almost equally awful is the plan that doesn't keep pace with your investment goals and you find out too late to catch up.

You may be thinking that you and most others you know have left the decisions up to your brokers and advisors, and you couldn't have done any better for yourself. What we're suggesting is that your input combined with a broker's advice is the best way to go. Granted, it may look like your broker has been making good choices for your portfolio, but frankly, if you don't keep abreast of your investments, how do you know he or she is making the best choices for you? If you don't make use of the information available to you, you may just think your broker is doing a good or great job with your investments because you don't even know about all the lost opportunities that might exist!

The SEC was created by Congress to regulate the securities industry, which includes stocks, bonds and mutual funds. One of the methods the SEC uses to ensure that investors have all the information about potential investments is to require brokers who offer public investments to provide investors with a prospectus. The SEC must approve a prospectus before it is issued. Here's the information a prospectus contains:

• The objective of the investment
• The company's financial condition
• How investors' money will be used
• The risks of ownership
• Expenses, management fees, and sales charges

The prospectus is a valuable tool that should be used by brokers and investors to determine whether they should recommend or invest in a particular security.

Warning A vast majority of investors do not even glance at the prospectuses, annual reports, and the like of companies that they invest in--don't be one of them! While you might rely on your broker or other sources for information, it's important that you carefully read through a prospectus, ideally before you commit any of your funds. Feel like some of the information is over your head? Don't be intimidated. You can ask your broker or investment advisor, or do some research on your own on a site such as this one. Remember, information and knowledge is the biggest investment asset you own! Take advantage of the safeguards available to you.

What the SEC doesn't do is guarantee that a stock investment is a safe risk. The stock market is a market--that is, it fluctuates as all markets do. The SEC's purpose is to ensure that you have all the facts necessary to determine the level of risk involved and whether it's a level that's right for you at your age and stage of life. You still have to do your homework.

Tip If you're like most people, you wouldn't dream of buying a major appliance, an insurance policy or a car without doing your research on price, quality, and the like. Yet these very same people do little or no research when investing in the stock market. Just like it's OK to consider your brother's good experience with a certain make and model of car or the fact that your grandmother swears by a specific brand-name of refrigerators as one of the factors when making your buying decision, it is OK to take into account your broker's or financial advisor's (sometimes friends who have experience with investments can be helpful too) recommendations. Just be sure to do your homework. Remember, most brokers and financial advisors are salespeople and proceed accordingly.

Do you have to use a broker if you want to purchase stock? Not necessarily. Many companies allow you to purchase or sell stock through a direct stock plan (DSP). You can get more information on DSPs from the specific company you're interested in or go to sharebuilder.com for a list of companies and information about them. You may also choose to have dividends you would have received in cash from certain companies automatically reinvested into more shares through a dividend reinvestment plan (DRIP). For more information on purchasing stock through this method, you can check the SEC's website. You may have to pay a fee for investing or reinvesting in this manner.

So how exactly do you pick a stock worth investing in? There's really no magic involved here. This is where most investors run into problems. Unlike the large majority of other investment vehicles, stocks are seen as the get-rich-quick scheme. The stock market is the investment everyone wants to "make a killing in." When many people talk about their stock market investments, they don't look at them as investments for the long-term. Is it impossible to turn a quick, large profit in the stock market? No. Is it probable? No. Should you count on it? No.

The only strategy that has proven successful for investing in stocks is to pick wisely when you first invest and then hold on for the long term. Bull markets (when the stock market is on an upswing) and bear markets (when stock prices are going down) are part of the inevitable cycle that is the stock market. Even if you spent every waking moment analyzing stocks and the market, you wouldn't be able to reliably predict which way the market was headed until it was too late to turn a quick profit. If you invest in stocks, you should be prepared to ride out the roller coaster ride that is sometimes involved, and don't try to get off in the middle or you'll probably get hurt. On the other hand, it's important to know when to sell stock that is only going to go down in value and cut your losses.

Still tempted to try and make a quick buck by investing in stocks? It probably seems that everyone from your cabdriver to your colleagues are investing in stocks and pointing to their paper profits in the market. This is exactly the point. While we are sure you're a smart cookie, there are a lot of smart cookies out there. If something is that great of a deal, a lot of other people are already on it. Maybe you're tempted to jump on a stock bandwagon--the latest darling of fellow investors who regularly play at the market. Remember that by the time a stock becomes a favorite, it's too late for most investors to make a quick profit on it because by that time the price will have been driven up by the demand.

When choosing a company's stock, read through the prospectus and the annual report. You should also read through the research done by your brokerage for stocks they are recommending. You can also go to many online financial sites for excellent recommendations and information on stock investments.

Warning Keep in mind that brokerage firms or other financial institutions sponsor many financial web sites and they may have a vested interest in recommending certain stocks . Also, annual reports usually present a company's data in the most favorable, though perhaps not the most accurate, light possible. However, by checking independent resources and going with a consensus of sources, you can cut down your risk.

Assessing a company and its stock. Here are some of the basics to keep in mind for assessing a company's investment potential:

• The ratio of assets to debt
• Inventory of unsold goods
• Earnings per share of stock outstanding
• Price/earnings ratio or P/E (The price per share divided by the company's annual earnings per share)
• The company's longevity, reputation and product demand (Blue Chip Stocks)

When deciding whether to buy or sell a stock, it's important to look at the market as a whole as well as the performance of the individual stock you're interested in. Why? There are two very good reasons. The first is to ascertain the likely direction a particular stock is going to take. It's a pretty good rule of thumb that most stock prices rise and fall together, particularly if the stocks are in the same industry or sector (for example, technology stocks). This affects not only your decision of whether you should buy a particular stock, but when you should buy it or sell it. The second reason to look at the market as a whole is to get an accurate picture of how a stock is doing in relation to other stocks. You may think a stock is doing well because it has held the same price for six months, but if stocks as a whole have been rising that entire time, it's not really a well-performing stock. Of course, this doesn't mean this reason alone is enough to stop you from purchasing or holding a specific stock, but it is definitely a factor to consider and keep an eye on.

How do you keep track of what the stock market is doing? You use one of major stock indexes. You've no doubt heard of the Dow Jones Industrial Average, the NASDAQ Composite and the Standard and Poor's 500. These stock indexes use a mathematical formula whose basic premise is to average the prices of certain stocks. For example, the Dow Jones uses the prices of 30 stocks traded on a major exchange such as the New York Stock Exchange (NYSE) and computes whether the prices of these stocks have gone up or down and by how many points. These numbers are important to investors because they indicate the direction of the stock market in a reliable manner. The major indexes have such an important influence on investments that a report of the market going in either direction can further drive the market that way, creating a cause and effect situation.

If you ignore all our advice and invest in a company that your rich Aunt Molly swore was a sure winner despite all indications to the contrary, how long do you hold on to the stock if the only direction the price has gone in is south? Or suppose you invest in a company that produces a product that people no longer need? These are instances where selling and cutting your losses may be the best path to take. While the general rule is that you are investing in stocks for the long-term, there are specific circumstances when you should salvage the investment dollars you have left and put them to work for you elsewhere.

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