Equities have a history of producing higher returns than most other types of investment over time, though past performance is no guarantee of future results and there also have been extended periods in which they have not outperformed. Because of their greater potential for higher returns, stocks also involve greater risk. Different types of stock and some of the strategies for investing in them involve different levels of risk. By seeking stocks that suit your profile as an investor and using an appropriate strategy for acquiring them, you may be able to manage risk in ways that are comfortable for you.
No matter what strategy you use, you should research your choices. A financial professional can help you make choices that are appropriate for you.
Caution: All investing involves risk, including the potential loss of principal, and there can be no guarantee that any investing strategy will be successful.
Buy and hold
You could work hard to identify what seem to be some good, high-quality stocks, and then hold them for a long time, trying not to be too concerned by day-to-day ups and downs. This so-called buy-and-hold strategy is appropriate if you hope to benefit from a long-term upward price trend. It is also an excellent way to avoid one of the most common investment mistakes, which is frequent trading. All too often, investors buy a stock, hold it for a short period of time, become impatient and sell it, only to see the stock move higher when they no longer own it.
On the other hand, if the reason for buying the stock no longer exists--for example, if a company was bought for robust dividends that it no longer pays--investors should think carefully about whether they still want to own the security.
Caution: Buy and hold isn't the same as holding on to a position after it's outlived its original role in your portfolio, just because you've suffered a big loss and cling to the idea of recouping that investment. When it comes to stock selection, there are no guarantees, which is why it is wise to build a diversified portfolio.
One advantage of a buy-and-hold strategy is that it takes advantage of the compounding effect of reinvesting any dividends you may receive. Dividends can be automatically reinvested in additional full and fractional shares instead of in cash. Virtually all mutual funds allow you to reinvest dividends and capital gains distributions. Today, many companies offer what is called a DRIP, or dividend reinvestment plan.
Caution: Unless your shares are held within a tax-deferred retirement plan, like an IRA, 401(k), or similar plan, the dividends you reinvest will be taxable just as if you received them in cash.
Some buy-and-hold investors also like the idea of acquiring additional shares in a company through repeated stock splits over time. With a stock split, you have more shares for every one you own, although the market price of each share also splits by an equivalent amount. A split doesn't change the value of your investment, though splits often are associated with companies that have experienced share price gains and want to make the stock more affordable for retail investors. Not all splits are positive; sometimes companies do a reverse split and investors end up with fewer shares that carry higher prices. However, stock splits often are seen as a favorable trend, though there is no real change in a share's economic value.
Unfortunately, holding stocks for a long time does not assure a gain. No matter how hard you work to find solid companies that appear to have bright futures, you could be disappointed. Even some widely admired companies that once seemed invincible have stumbled. Some have even gone bankrupt amid widely publicized scandals. This is one reason why diversification is so important; not having all your eggs in one basket means that losses on a single position have much less impact on your overall portfolio.
Buy low, sell high
No matter what strategy they use, every investor's goal is to buy stocks when they're selling at low prices and sell them when they're high. Market timers--people who try to get in and out of a stock or the market at just the right times--have this as a primary goal. Speculators who invest for the short term may buy a stock one day and sell it the next, or as soon as the price rises above the price they paid for it, hoping to realize enough profits to justify the trading fees involved. By contrast, investors working toward long-term goals may be more patient. If the stock price drops, these investors may stay the course or even buy more shares if they believe the price will rise again at some point.
Tip: Some investors who find they've bought a stock that declined in value get discouraged and decide to get out as soon as the stock price returns to where it was when they bought it. In fact, you might be better off selling the stock at a loss to create a possible tax deduction, and putting the proceeds to work elsewhere.
Deciding when to sell a stock may be even harder than deciding when to buy it, so many investors use a disciplined strategy. They set an upside target price in advance. If the stock rises to that level, they sell it, or at least take a long, hard look at it, asking themselves whether it makes sense to take profits now rather than risk holding it too long. Many investors also set a downside target, called a stop loss target. If the stock falls below that level, they sell it and avoid a longer ride down.
Example(s): John buys 100 shares of ABC at $20 a share, for a total investment of $2,000, and plans to sell when it reaches $30, so he can earn a profit of $1,000. If he also set a stop loss target at $16, he would sell the stock once it fell to that level.
Bear in mind that you don't realize a capital gain (or loss) until you actually sell a security. Unrealized (or paper) gains or losses may be here today and gone tomorrow, literally.
Dollar cost averaging
Dollar cost averaging is a strategy widely used by people buying individual securities, shares of mutual funds, exchange-traded funds (ETFs), and other pooled investments. You invest a fixed sum at regular intervals--monthly, quarterly, or semiannually--in a fund that fluctuates in price, without worrying about whether the price is high or low. When stock prices are high on the day you invest, the amount you set aside buys fewer shares; if prices are low, you acquire more shares. This strategy is automatic if you invest using a payroll deduction plan where you work, or an automatic investment plan through a mutual fund or bank. It can be a relatively low-stress way to invest.
Example(s): Jane decides she'll invest $2,000 each month into ABC Mutual Fund. At the end of the first month, ABC Mutual Fund closes at $20/share, so Jane purchases 100 shares. The following month, ABC has fallen to $16/share, and Jane's $2,000 investment gets her 125 shares of ABC Mutual Fund. The following month, the fund prices rise to $25, and Jane's $2,000 gets her only 80 shares. At the end of the third month, Jane has purchased a total of 305 shares and has an average cost of $19.67.
As the example shows, dollar cost averaging allows investors to take comfort that with ongoing purchases of a security or pooled investment vehicle, they'll likely have a better chance to get close to an average price than with making a single purchase, which could occur at the wrong time. This aspect of dollar cost averaging takes away the pressure many investors feel to pick the bottom price or otherwise carefully time their purchases.
Caution: Dollar cost averaging does not guarantee you a gain or protect you from loss. If you invest in a stock or mutual fund that goes steadily down, you would lose money. In addition, since dollar cost averaging involves continuous investment regardless of fluctuating prices, you should consider whether you'll be financially able to continue purchases during bad times.
Dollar cost averaging in taxable accounts can make tax filing more complicated. The fixed sum you invest buys shares at various prices, so you may need to calculate your average cost basis to determine what the tax consequences may be when you sell your shares. If this strategy is combined with dividend reinvestment--another kind of automatic dollar cost averaging program--the tax calculation becomes even more complicated.
Broker-dealers and other financial intermediaries are required to track your cost basis for stocks purchased after January 1, 2011, and report that cost basis to both you and the Internal Revenue Service. The same provision applies for stocks bought through a dividend reinvestment plan after January 1, 2012, and to shares of mutual fund bought after that date. However, brokers are not required to track the cost basis for shares bought before the specified dates.
No matter which investment strategy you use, a diversified stock portfolio should be a primary objective. When a portfolio is diversified, it means that the assets are spread out (allocated) among different companies, different industries, different size stocks (large cap, midcap, small cap, or microcap), different types of stock (aggressive growth, growth, value, or income), or different parts of the world. Even greater diversification benefits can be achieved through asset allocation between non-correlated asset classes such as stocks, bonds, and other investment classes.
Caution: Diversification alone does not guarantee a profit or protect against the possibility of loss.
Mutual funds that invest in common stocks are diversified, although the level of diversification varies by fund. Fund managers are responsible for the selection and level of diversification of the funds they manage. Some invest in a diversified portfolio of one type of stock, such as small-cap stocks; others allocate investors' assets over different types of securities, including stocks and bonds, in varying proportions.
Caution: Before investing in a mutual fund, carefully consider its investment objectives, risks, fees, and expenses, which can be found in the prospectus available from the fund. Read it carefully before investing.
The advantages of diversification are clear. Say, for example, that you invested only in the stocks of an emerging market. If the economy in the country where those companies are located lapses into political turmoil and the overall stock market there declines, you would likely suffer a loss if all your assets were focused in that one geographical area. On the other hand, if your investments are more diversified and emerging-market stocks make up only, say, 10 percent of your stock investments, your loss would be substantially less. It might even be offset by strong performance of stocks in other countries.
Caution: The stocks of companies located in emerging markets could be substantially more volatile, and substantially less liquid, than the stocks of companies located in more developed foreign markets. Also, differences in financial reporting, currency exchange risk, as well as economic and political risk unique to the specific country, can adversely affect the value of these securities.
There is nothing wrong with buying stock in the company you work for. You may believe the company has a great future, and you may be right. But experienced investors caution against making this the sole or dominant component of your overall portfolio. It makes more sense to diversify.
However, diversification is not a panacea. It can also limit gains. Let's say you invest in emerging-market stocks because you think the potential rewards outweigh the risks. If those stocks soar, your biggest gains might be limited to 10 percent of your portfolio--a less risky but less spectacular result overall.
Content in this material is for general information only and not intended to provide specific advice or recommendations for any individual. All performance referenced is historical and is no guarantee of future results. All indices are unmanaged and may not be invested into directly.
The information provided is not intended to be a substitute for specific individualized tax planning or legal advice. We suggest that you consult with a qualified tax or legal professional.
LPL Financial Representatives offer access to Trust Services through The Private Trust Company N.A., an affiliate of LPL Financial.
This article was prepared by Broadridge.
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