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The Smartest Investment Book You'll Ever Read: The Simple, Stress-Free Way to Reach Your Investment Goals

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Investing Demystified

How to Invest $50-$5,000: The Small Investor's Step-By-Step Plan for Low-Risk, High-Value Investing

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How to Get Started Investing

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How to Invest in Bonds

How to Invest in Stocks

There are roughly 10,000 publicly traded companies on the U.S. stock markets alone. Though you can buy the individual stocks of any of these companies, most beginning investors find that researching and selecting a handful of individual stocks to buy among thousands of potential candidates is too risky and time-consuming to be practical, let alone profitable. Instead, another strategy for beginners—as well as for most seasoned investors—is to buy stocks through mutual funds and ETFs (see How to Invest in Mutual Funds and How to Invest in ETFs).

But even if you don’t buy any individual stocks, it’s still essential to know the basic principles of stock investing. If you’re determined to research and buy individual stocks, this section explains the basics to help you get started.

Why Invest in Stocks?

Buying stocks can help you build wealth in two ways:

Capital appreciation: Occurs when a stock’s share price increases as demand for the shares grows. Share-price increases can happen for a variety of reasons, such as growth in the company’s profits, a strong overall economy, or as a result of pure speculation. If share prices rise, shareholders who bought the stock at lower prices can sell at higher prices for a profit.
Dividends: Some companies—often older, more established companies—return a portion of their profits to investors as dividends instead of reinvesting those funds back into the business. Dividends can be paid in cash or in additional shares of the company’s stock. A stock’s dividend yield is the ratio of the dividend to the stock price: for example, a stock that has a $100 share price and pays annual dividends of $5 per share has a dividend yield of 5%. The dividend yield changes over time as share prices fluctuate.

The Main Types of Stocks

Investors use a number of different methods to classify and group stocks:

Growth vs. value
Company size (or market cap)
Industry group (or sector)
Geographic location (domestic vs. international)

Growth Stocks vs. Value Stocks

Investors divide stocks into two broad categories: growth stocks and value stocks.

Growth stocks: Growth companies tend to be newer, rapidly expanding companies whose sales growth and earnings growth are expected to outpace that of the market as a whole. Though share prices of growth stocks may rise more quickly than share prices of value stocks, growth stocks are considered riskier than value stocks because they tend to be priced at a premium to the overall market and rarely pay dividends.
Value stocks: Value investors look for companies whose stock appears to be undervalued relative to underlying fundamentals (key company statistics such as sales, earnings, dividend yield, and so on). Value stocks often are older companies that pay dividends and tend to be less risky and volatile than growth stocks, though they also tend to offer less opportunity for large returns. Value investors must be careful to avoid value traps—stocks that appear to be undervalued but actually are suffering from serious problems in their company or industry, which have in turn depressed their stock price.

Investors with low risk tolerances tend to prefer the relative safety and reliable income of value stocks, whereas more risk-tolerant investors tend to favor growth stocks.

Company Size (Market Cap)

A company’s market capitalization, or market cap, is the total value of a company’s publicly traded stock. Market cap equals the number of publicly available shares multiplied by the current share price. For example, a company with 10 million shares outstanding and a share price of $10 has a market cap of $100 million. A company’s market cap fluctuates as its share price moves up or down.

The Five Market Cap Categories

Stocks can be placed into five general groups based on the size of their market cap. (Note that the specific market cap ranges included in these descriptions often vary.)

Mega-cap stocks: Giant companies, such as General Electric and Microsoft, with market caps over $100 billion. Mega-caps, along with some large-caps, are also known as blue-chip stocks.
Large-cap stocks: Companies with market caps of $10–100 billion. Large-cap stocks are typically well-known household names, such as Apple.
Mid-cap stocks: Companies with market caps of $2–10 billion. Examples of mid-cap companies include Hilton Hotels and Urban Outfitters.
Small-cap stocks: Companies with market caps of $100 million–$2 billion. Many small-cap stocks are of companies whose names you probably wouldn’t know.
Micro-cap stocks: Companies with market caps under $100 million. These stocks often trade on markets other than the NASDAQ, AMEX, or NYSE. These markets, known as the OTCBB (over-the-counter bulletin board) or pink sheets, are less rigorously regulated by the SEC than the more popular exchanges, which makes buying these stocks very risky.

To provide a more precise description of a company, investors often combine the growth-value classification with market cap, resulting in descriptions of stocks as “large-cap growth, “ “small-cap value,” and so on.

Market Cap and Risk

Market cap and risk tend to correlate in the following ways:

Smaller-cap stocks tend to be more risky but often have higher prospects for growth and significant share-price increases.
Larger-cap stocks tend to be less risky but usually offer less chance of huge growth and returns.

Although these rules generally hold, they’re not always true. For example, Google was already a large-cap company when it went public in 2004, yet its stock price still rose tremendously over the following year. On the other hand, the pharmaceutical mega-cap Merck plunged more than $100 billion in value over the period from 2000–2005.

Sector

Stocks can also be classified by industry, or sector—the general type of business in which the company is involved. For example, major industry/sector groups include technology, healthcare, utilities, financial, consumer goods, industrial goods, and so on. Stocks within a given industry or sector often share certain predictable traits, such as how quickly they grow and whether they pay dividends. For a more extensive list of industries, see the Industry Center on Yahoo! Finance at biz.yahoo.com/ic/ind_index.html.

Domestic Stocks vs. International Stocks

U.S.–based investors have the opportunity to include both domestic (U.S.–based) and international (foreign-based) companies in their portfolio. International stocks can help to diversify a portfolio. However, they also carry risks related to foreign exchange rates and political stability.

Some foreign economies, such as those of western Europe, Australia, and Japan, are well-established, developed economies. Others, such as Brazil, Russia, India, and China, though growing rapidly, are much less stable—either politically or economically or both. These less stable countries are termed emerging markets and can be very risky.

How to Research and Analyze Stocks

Fundamental analysis is the process of analyzing a company’s financial results to determine its prospects for the future and to assess whether its stock is fairly valued. The goal of fundamental analysis is to find bargain stocks, or stocks whose share prices are below where the market should be pricing them. When investors refer to a company’s fundamentals, they mean the company’s financial well-being, as determined by three main factors:

Profits (earnings): The total amount of money the company actually earns after expenses
Debt: The company’s outstanding financial obligations to suppliers, banks, and so on
Assets: The company’s valuable property, including cash, inventory, real estate, and so on

Investment Statistics and Ratios

With data on earnings, debt, and assets, you can use a variety of simple statistics and ratios to assess a company’s fundamentals and determine whether a company’s stock is worth buying. The most commonly used of these ratios and statistics are:

Earnings per share (EPS): The portion of a company’s profits that each share of the company’s stock contains. To calculate it, divide a company’s profits by the number of publicly traded shares. If all other factors are equal, given two stocks with similar profits, investors tend to favor the stock with fewer publicly traded shares, and therefore higher EPS.
Price-to-earnings (P/E) ratio: A ratio that compares a company’s share price to its current EPS. To calculate it, divide the company’s share price by the company’s EPS. Companies with lower P/E ratios relative to those of other stocks in the same industry tend to be good values, assuming that all other factors are equal.
Beta: A measure of a stock’s historical volatility relative to the broader market’s volatility, which is represented by a beta of 1. Stocks with betas greater than 1 are more volatile than the broader market. They tend to move up and down in price more often and in greater extremes than the market. Stocks with betas of less than 1 tend to be less volatile.

You don’t need to calculate these ratios and stats on your own. A faster way is to use financial websites that aggregate and publish these data as they become available and calculate the most helpful ratios and stats for you. Among the best sources for stock-related reports, data, and stats is Yahoo! Finance (finance.yahoo.com).

How to Buy and Sell Stocks

Once you decide to trade (buy or sell) a particular stock, the process will differ slightly based on whether you’re working with a full-service broker or an online brokerage. For instance, if you want to buy 10 shares of Google at $400 per share:

If You’re Trading Through a Broker

You’ll contact your broker and tell him or her you want to buy 10 shares of Google.
Your broker will ask you the highest price per share you’re willing to pay for the shares.
Your broker will place the order with a brokerage.
The brokerage will send your order to the exchange, where either a person, known as a market maker or specialist, or a computer will fulfill the order.
The exchange will send back confirmation once your order executes, or is filled.
In your investment account, $4,000 will immediately convert to 10 shares of Google stock. A commission for the trade will also be deducted from your account.

If You’re Trading Online Through a Brokerage

You’ll place the order directly with the brokerage by logging into your account online and filling out a stock order form. To fill out the form, you’ll need to know the number of shares you wish to buy, the ticker symbol, and the type of order you prefer (explained below).
The brokerage will send your order to the exchange, where a person or a computer will fulfill the order.
You’ll receive an email confirming that your order has been placed, then a follow-up when your order executes.
In your investment account, $4,000 will immediately convert to 10 shares of Google stock. A commission for the trade will also be deducted from your account.

Types of Stock Orders

There are two types of orders you can use when buying or selling a stock:

Market order: You agree to buy or sell a particular stock at the price specified by the market.
Limit order: You specify the maximum price at which you’re willing to buy or the minimum price at which you’re willing to sell.

Commissions are generally lower for market orders than for limit orders, but market orders are also riskier and the price difference is rarely substantial enough to justify the increased risk. It’s a good idea to use limit orders every time you buy or sell stock. Use market orders only if you absolutely must sell your shares of a stock, regardless of price.

Acknowledgments & Disclaimer