Creating a diversified investment portfolio is essential if you want to increase your wealth. A strong portfolio includes a collection of assets like stocks, bonds, mutual funds, real-estate etc that can generate good returns with minimum risk. Investing in stocks and bonds is the most popular investment option and it can get you very good returns provided you make your choices smartly.
Allocating the right portion of your income towards these investments is the key to making reasonable profits and avoiding large losses. A simple and practical strategy would be to allocate around a third of your investment money to stocks and bonds each and the remaining third to real estate.
Before you invest in stocks and bonds, it is important to understand what they are, how they put your money to work and the risks involved in such investments.
Chapter 1: Investing In Stocks
Chapter 2: Risks Associated With Investing In Stocks
Chapter 3: Stock Investing Tips
Chapter 4: Where To Actually Invest In Stocks
Investing in Stocks
Companies need money to expand their business by setting up new branches, factories, hiring more workers etc. For that, they either borrow funds or raise money by allowing investors to purchase stock of their company.
By owning a share in the company, you own a part of the company and are entitled to a proportional share of profit. Though being a very small shareholder does not give you much say in the company’s functioning, as you buy more and more stock in it, you start having a greater say in its decisions.
Benefits of Investing in Stocks
Stocks offer an attractive risk-reward ratio, as long as you choose the right companies to invest in. Here are a few benefits you can enjoy by investing in stocks.
Dividends – A company’s profits are distributed among its shareholders in the form of dividends. Declared by the company’s board of directors, dividends are usually given in the form of cash but a few companies give it in the form of stock equal to the amount of your dividend.
You can choose to spend all your dividend money or reinvest it to make more money. DRIPs or dividend reinvestment plans automatically invest your dividend amount to purchase additional stock that can result in considerable growth of your wealth.
Increase in stock value – The value of the stock you have invested in can increase over a period of time, provided the company expands its business and increases it profits. But the value of your stock can also increase hugely through other corporate actions, like an offer to buy back stock or a merger announcement.
Liquidity – Another benefit of owning stocks is their high liquidity. In case of an emergency, you can make quick cash by selling your stocks easily through a stock broker or your online trading account.
Different Types of Stocks
There are thousands of companies that offer their stocks for purchase. Stocks can be broadly classified based on the company’s size, growth and the sector or industry it belongs to.
Classification of stocks based on size – The value of a particular stock can depend on the company’s size or its market capitalization. The market cap of a company is calculated by multiplying its current share value by the total umber of its shares outstanding.
Classification of stocks based on return expectations – Investing in the stocks of a growth company, with an above-average growth rate, will increase the growth potential of your portfolio, along with the risk involved in it. The stock of a ‘value’ company is traded at a rate that is lower than the market average. A cyclical company’s stock, as its name indicates, does not have a constant demand and keeps fluctuating throughout business cycles.
Classification of stocks based on sector – Stocks can be further divided into a few broad sectors and industries. While the financial, healthcare and technology sectors tend to grow fast, sectors like consumer durables and utilities grow moderately. Most other sectors usually see cyclical growth and stock values change depending on the supply-demand equation and economic conditions.
Common stocks and Preferred Stocks – Common stock usually refers to the stock owned by a majority of investors. Common stock holders are eligible for dividend income and also have a right to vote for choosing the board of directors. Preferred stock holders are given the first priority when it comes to dividend payment, which they receive consistently. However, they do not get the right to vote for major company decisions.
Understanding Stock Prices
Stock prices are volatile and tend to change very often depending on the supply and demand of shares. Different stocks can be priced differently based on factors like expected profits and the company’s asset base. Consider the following terms to understand stock prices better.
Price earning or P/E ratio – To get the P/E ratio, divide the current price of each share by earnings per share. But as stock earnings are not the same throughout, consider a share’s earnings in the past four quarters to get an accurate reflection of past earnings and a near estimate of the future earnings. Although you cannot decide to sell or buy shares based on the P/E ratio alone, you can determine if the stock is overpriced or underpriced.
Price/sales ratio – The other aspect investors are concerned about when investing in stocks is the revenue that the company generates. Divide the stock price by the total sales per share for the past year to get the price/sales ratio.
Price/book value ratio – Book value refers to the company’s total assets after removing its liabilities. You can calculate the P/B ratio by dividing the price per share by the book value per share. The book value per share can be obtained by dividing the total book value of the company by the number of outstanding shares.
Next Chapter: Risks Associated With Investing In Stocks
