by Christina Pomoni

Created on: August 11, 2008   Last Updated: July 09, 2009

Stocks are financial assets of equity investing, which offer partial ownership of the firm to the investor.

Stocks are primarily classified into common and preferred, which are both issued by corporations to individuals and institutions. Common stocks offer more rights and privileges than preferred stocks, while preferred stocks pay regular dividends.

Stocks are also classified into several types depending on their growth potential (growth stocks), income potential (income stocks), their correlation to the broader economic environment (cyclical stocks) and their geographical allocation (domestic or international stocks). Growth stocks are issued by fairly low-cost companies, which can potentially increase in value and one variation of them is the value stocks. Income stocks have low growth potential but consistently generate high dividends. Cyclical stocks are subject to economic ups and downs. International stocks are stocks in foreign companies, which may be traded on U.S. exchanges.

An investor should primarily understand how stocks operate. When a firm is viable and profitable, its market capitalization increases and so does the value of its stocks. The next step is to set the investment goals. Investors have different investing profiles, which differ in the level of risk that investors are willing to undertake. Risk-takers investors invest in aggressive stocks, which produce income. Risk-averse investors prefer stocks that give them average returns on a long-term horizon.

To determine their return on investment, investors need to determine (1) the capital gains or losses and (2) the dividends. Capital gains are the difference between the market price and the price that the investor bought the stock. If the difference is positive then investor receives gains. If the difference is negative, then investor endures losses. Dividends are non-guaranteed, periodic payments to investors that range from zero to any amount a firm affords to pay.

Example

We assume investor buys 100 shares of company X at $30 per share. Dividend is $1 per share and the current market price of is $32 per share. The holding period yield (HPY) would be calculated as follows:

HPY = (Dividend + Price Change) / Purchase Price = ($1+$2) / $30 = 10%

Another important consideration when buying stocks is to understand a firm's fundamentals. Learning to read balance sheet and cash flow statements provides investors with an understanding of the broader potential of the firm in terms of revenue, earnings, assets, liabilities and growth. In addition, historical data about the firm's trading performance in the past offers the grounds to assess the potential of future performance. Financial ratios such as price/earnings (P/E), price/book value (P/BV) and price/cash flow (P/CF) are also good indicators of a firm's trading performance.

Investors should also diversify their portfolio mix because diversification leverages investment risk by allocating it in different classes of assets. In doing so, losses from on asset are offset from gains in another asset of the portfolio.

Finally, being constantly informed about corporate news, stock analyses and investments strategies facilitates investment process and offers a great chance of effective investment decision making.

Learn more about this author, Christina Pomoni.
Click here to send this author comments or questions.