In his 1990 book "Up on Wall Street," former Fidelity fund manager Peter Lynch advised readers to investigate stocks before buying.
"Investing without research is like playing stud poker and never looking at the cards," Lynch wrote.
He should know.
When Lynch started managing the Fidelity Magellan Fund in 1978, its assets totaled about $20 million. Today, its worth exceeds $50 billion.
While it may be nearly impossible to emulate Lynch's astronomical capital gains, the average investor can research stocks as well as any Wall Street analyst and learn how to spot potential stock investments early in conjunction with building a stable financial portfolio.
A stock, or equity, represents a piece of a company. As a stockholder, an investor owns a fractional piece of a much larger entity. Because the stock market carries far more risk than investing in bonds or even a diversified mutual fund, stocks historically have garnered the largest investment returns.
Shareholders can make money buying individual stocks in one of two ways: dividend income and capital gains.
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Dividends constitute periodic, usually quarterly, payments to stockholders. Expressed on a per-share basis, the dividend, when divided by the stock price, delivers the dividend's yield. For example, each share of General Electric paid a dividend of $1.32 last year, representing a 1.94 percent yield. When the stock price goes up, yield increases as well, thus adding to the stock's overall payoff.
However, the majority of stock return results from capital gains or price appreciation. While dividends take longer to pay out, price appreciation is simple: an investor buys one share of AT&T stock for $55 and sells it for $75, netting a $20 gain, minus, of course, taxes, broker commission and other fees.
As with any investment, diversification is essential to hedge the overall portfolio in case one stock's price plunges in value. Darden Finance Prof. Robert M. Conroy said he recommended to spread about $5,000 over 16 stocks across various industries to achieve a comfortable level of diversity.
"You're better off diversifying rather than putting your money in one stock," Conroy said. "If you put all your money in one company, you end up risking a lot more than if you spread it around."
Although in the past stockbrokers encouraged consumers to buy shares in increments of 100, today's investor can buy a fraction of that without being penalized by brokerage fees and transaction costs.
Unfortunately, researching individual stocks requires a little legwork. Conroy advises those unfamiliar with equity investment to read Berkshire Hathaway Inc. CEO Warren Buffett's annual letters to shareholders, available online. After amassing more than a $20 billion fortune through investing, Buffett, like Lynch, obviously knows what he's talking about.
In terms of research, a potential investor ideally should be familiar with the company itself, in addition to its product and potential for overall growth and profit.
"Never invest in a company that you don't understand what they do," Conroy said. "Make sure you feel comfortable with the management's ability to execute its goals and strategies for the future."
For this reason, many first-time stock purchasers may opt to buy shares of the so-called "blue-chip" companies, such as Coca-Cola and General Electric, which have a long-term history of profitability and stability.
The price is right
The concept "Buy low and sell high" remains the hallmark of making money in the stock market. Simply looking at a stock table gives an investor an idea of where a company stands financially. Stock prices reflect a few concrete factors, such as the company's total worth and its future prospects.
Total worth represents the number of shares issued by the company multiplied by the price per share. For example, General Electric has 9.93 billion shares outstanding. At market's close Friday, each share traded at $37.11, for a total company value of more than $368 billion.
The stock's "52-week high/low" is the best indicator of how expensive a share is at any given point in one year, displaying the highest and lowest price that a particular stock has traded at in the last 52 weeks
The price/earnings ratio (more commonly referred to as the P/E ratio) indicates the relationship between the current market price of the stock and its earnings per share. The P/E ratio indicates how many times earnings investors are paying for a single share, giving a general sense of the stock's expensiveness.
Historically, the overall stock market has had a P/E ratio of about 15, meaning that on average, stocks are valued at about 15 times their earnings per share. A stock with a high P/E ratio, either relative to the overall market or to its own historical P/E, does not necessarily mean the stock will decline; it just indicates that investors are optimistic about the company's future prospects.
Companies with high P/E ratios, commonly referred to as growth stocks, expect that they will continue to expand their earnings, market shares and profits, all which lead to an even higher stock price.
A low P/E means the opposite: the stock trades cheaply compared with its current earnings. Generally called value stocks, shares that trade with low P/E ratios typically indicate companies that are past their prime growth potential.
Companies that have lost popular appeal with consumers or Wall Street, such as cigarette and beer manufacturers, or those whose profits have not met expectations, such as telecom companies, tend to be classified as value stocks.
Buyer beware
Although investors can make huge profits in stock speculation, there is an inherent likelihood of losing large amounts of money.
Because more than 300,000 professionals try to find stocks worth more than their current price, a first-time investor may be disappointed to realize that making money in the short run is difficult, said Richard B. Boebel, a visiting finance professor at Darden. "If you're going to invest in individual stocks, you assume that you have an information superiority or you're smarter than someone else and can put information together better."
"Without one of those advantages, I'm hesitant to encourage people to invest in individual funds, but to go with indexes instead," he added.
For example, Lynch saw the potential growth of L'eggs pantyhose, invested in the stock and later sold his shares for more than 1,000 times their initial price. But opportunities of that magnitude are rare.
"If you can predict things like that, you can make a lot of money," Boebel said. "If you can't, you should read last week's article ["Planning for the Future: Building a Portfolio, Feb. 11] and go with an index fund.
Remember the reason for investing
Historically, stocks have risen over time and thus have built wealth for investors, but buying and selling stock in the short run can turn disastrous for a novice investor. Although some people, such as Lynch and Buffett, get lucky, many investors do not.
"Investing is a long-run issue, so the sooner you start, then the better off you are," Conroy said. "Build wealth over the long run. There's no such thing as a quick buck."
Before buying stock, an investor must evaluate a set of priorities or goals for something they may not need now, but for something they will need in the future.
"The only reason to invest in anything is because you want something you don't have enough money for now," Boebel said. "Always keep that in the back of your mind"
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