Investors must assess risks when investing in stocks
Wall Street is considered the world’s safest stock market for investors, but that doesn’t mean there aren’t risks. COURTESY/YAHOO.COM
TAHLEQUAH – One of the glowing lights of the American economy and its markets is the idea that anybody could conceivably start with very little and amass a fortune through hard work and wise investment.
Of course that doesn’t happen very often, but there are common ways that people might improve their economic standing. Perhaps, a kid from a working class family earns a terminal degree from a university and becomes a wealthy professional. Or maybe someone makes prudent investments over a lifetime and retires with enough funds accumulated to avoid financial worries.
Stocks or equities in private companies are among the favored financial instruments used by everyday non-professional investors in 401(k)s or IRAs to build wealth. They are offered in an array of flavors for application to different timelines and horizons. There are common and preferred, blue chip and micro cap, domestic and foreign.
While an employer’s 401(k) plan may offer a number of mutual fund options with a match of a few percentage points, the investor can directly manage a traditional or Roth IRA.
“A good investor is diversified,” said Dr. Michael Toyne, emeritus professor of finance for Northeastern State University. “They will have money spread across a number of stocks, and some money in several bonds.”Common or Preferred?
As its name suggests, common stock is most often issued. Those holding common stock in a company have voting rights – usually a vote per share - when it comes to seating a chief officer or board of directors. They tend to outperform preferred stocks, assuming the company grows.
So common stocks have their advantages, but if the company can’t meet all its dividends, preferred shareholders get paid first. In fact, if a corporation goes over the cliff and common shareholders try to recover their investment, they must wait their turn at the carcass after creditors, bondholders and preferred stockholders, and by that time there may be nothing left.The Right Sized Caps
Another method investors use to categorize stocks is “caps” or capitalization. The classifications generally suggest a level of risk. A large company with a market capitalization – the full market value of outstanding shares – of more than $50 billion is big and stable. Small caps and micro caps are smaller and might be more vulnerable in the tempest of market forces. Small cap companies have a market capitalization of no more than $2 billion; micro caps no more than $300 million. If an investor is feeling adventurous, “nano caps” have capitalizations of less than $50 million.
Smaller capitalizations may grow into giants, but usually don’t. A prudent investor won’t risk half the portfolio looking for the next garage enterprise to crack the Big Five. But there are many reasons an investor might consider a small company. It might grow rapidly for a few years before leveling off. It might get scooped up in a merger, or have an interesting business idea.
However, small companies are not as harshly regulated as larger firms. The capacity for fraud is almost as problematic as the possibility of bankruptcy, and volatility is the norm even in the short term. Passive investors seeking rapid growth for part of their portfolios can lessen the anxiety by buying into index funds that spread risk among many small enterprises.
Though it isn’t referred to as a cap, investors favor the “blue chip” stock. Blue chips are the large companies with excellent reputations that have demonstrated sustained growth for years or decades.
While blue chips have consistently shown growth over the long term, they can still take big hits from market shocks. The bluest chips are in the Dow Jones Industrial Average of the 30 largest companies in the U.S., and the Dow 30 shed 10 percent of its value during the last five trading days of February.
Being listed in the Dow 30 doesn’t mean a company will stay big or last forever. When Gen Xers opened their retirement accounts there was no Google or Facebook, and Amazon hadn’t turned a dime of profit. Dow 30 alumnae of recent decades include Eastman Kodak, Westinghouse, International Harvester, and Sears Roebuck and Company.Sending Money Overseas
The U.S. stock market draws investment from around the world partly because of its stability and reliability. Fraud among big American companies isn’t common, and there are some security measures in place to protect investors.
But that can also result in slower growth than in other more rowdy markets around the planet. An investor can certainly consider putting part of the investment account in foreign equities, if the investor is willing to accept some greater risks.
The best performing market each year is usually not Wall Street, and foreign stocks are a further diversification. Downsides include risks to liquidity – it may be difficult to pull investments out of the market – changes in the currency exchange rates, and transactions cost more in many countries. A nation with a rapidly growing economy might hit the brakes by raising interest rates and slowing the growth of investments.
Another risk has little to do with investor activity. Asian and Middle Eastern markets may react to political upheaval in their respective regions. Some government strongman might nationalize an industry in which international money is invested. One more word might help investors remember to exercise prudence when choosing foreign investments: Brexit.
Hence, stock investing inherently involves some cognizance of events that might affect stock prices. During the last week of February, the spread of a new coronavirus sparked the biggest stock selloff since 2008. Despite the cratering, it is not uncommon for investors to pick through the wreckage for stock bargains.
“Someone starting to invest at that time might have had a blue light special on the market,” Toyne said. “A lot of investors jump in when things get ugly.”
The dip sent the markets into “correction” territory, meaning they lost 10 percent of their valuation. If stocks have simply retreated to a more sensible price, buying would make sense. But there are no sure things when investing in stocks. An investor must always acknowledge the risk and decide whether it’s worth it.
“The market reaction during those few days was over something that really hadn’t happened yet,” Toyne said. “You can’t always be sure how investors will respond.”
It is also important to consider how stock earnings will be taxed. Traditional IRAs are tax deferred, and Roth IRAs are tax free, but dividends and capital gains are taxed in a typical brokerage account. Stocks sold a year or less after purchase are subject to higher capital gains taxes than those held longer. Non-qualified or ordinary dividends are taxed as regular income. Qualified dividends are taxed based in filing and income status, usually at lower rates. Consult with an investment specialist.