ALL ABOUT STOCKS

DEVELOP YOUR FINANCIAL PLAN
The investment process begins with a financial plan that lists your
financial objectives and the road map to achieving those objectives.
If you don’t know where you are heading, you won’t know how to
get there.

1. List Your Financial Objectives
The first step in any investment plan is to determine what you want to achieve from your investments and when you want this money to be available. You probably have many objectives, namely, saving for retirement in 20 years, paying for your children’s education in 10 years, and making a down payment on a vacation house in 2 years. Financial objectives are the financial milestones that you would like to achieve through investing. Take a few moments to list your financial objectives and determine how much you want to achieve with each objective in the future. Possible objectives include
* Funding an emergency fund within one year
* Funding the purchase of a car in five years
* Funding a child’s college education in 10 years
* Building a retirement fund over the next 25 years
Investing for retirement is not the same as investing for shorterterm objectives owing to the time horizon and risk factor
Time Horizon
Listing the time horizon is important because it gives you a better idea of how much you will need to fund each objective. The amount of money that you have to fund each objective is directly related to your financial condition or net worth. . Net worth is the difference between what you own and what you owe.
Reviewing your monthly budget also may assist you in determining how much you have to invest and the level of risk that you can accept.
Risk
Evaluate your objectives with regard to risk, which may be characterized as follows:
n Safety of principal
n Stream of income
n Capital growth

Safety of Principal
Money market securities, such as bank accounts, savings accounts, CDs, money market mutual funds, Treasury bills, and commercial paper, offer safety of principal and low rates of return. Short-term objectives such as building an emergency fund and saving for short-term purchases within the year fall into this category of investments. Returns from these securities often do not cover inflation and taxes.
Stream of Income Investments that provide a steady stream of income with higher rates of return than money market securities include bonds and preferred stock. The tradeoff in seek-ing higher levels of return from bonds and preferred stock is the possible loss of principal. When bonds and preferred stock prices decline below their acquisition costs, investors experience losses of capital (principal loss) should they have to sell the investments.
High-risk, high-return bonds (junk bonds) offer the potential of
higher streams of income than investment-grade bonds, but junk
bonds are also more likely to default on the repayment of principal
to their bondholders. Investors looking to fund objectives with
one- to five-year time horizons use bonds with matching maturities
to their time horizons to earn higher rates of return than money
market securities.

Capital Growth
Investing for capital growth has the poten-tial to provide an increase in value of the investments also referred to as capital growth. Stocks offer the potential for capital growth when stock prices increase above their acquisition prices. The risk is that a stock’s price can decline below its acquisition cost, resulting in a capital loss. For this reason, you need a longer time horizon (greater than five years) in order to be able to wait out any losses in the stock market. Some stocks pay dividends, thereby providing stockholders with a stream of income. Generally, the yields on dividend-paying stocks tend to be lower than the yields of bonds. However, not all stocks pay dividends, and investors invest in these stocks for their potential capital growth. Stock investments are suit-
able to fund investors’ longer-term objectives (with a time horizon of greater than five years), such as building a retirement fund.
In summary, there is a tradeoff between risk and return. Low-
risk investments (money market securities) guarantee principal but
provide low returns in the form of income. Fixed-income securities
(bonds and preferred stock) provide higher levels of income but
carry a risk of loss of principal in the event of default for bonds or
having to sell preferred stock at a lower price than the purchase
price. Common stocks offer the greatest total return (capital growth
and income) over long periods of time but carry a higher risk of
loss of principal over short periods of time. Your personal circum-
stances (age, marital status, number of dependents, net worth, and
income) determine your tolerance for risk as a guide to your choice
of investments.

2. Allocate Your Assets
Asset allocation is the assignment of your funds to different invest-
ment asset classes such as money market funds, bonds, stocks, real estate, gold, options, and futures. Your particular asset allocation plan depends on several factors such as your time horizon, tolerance for risk, and personal financial situation.
In general, the younger you are, the greater can be your allocation toward capital growth investments (common stocks and real estate). The closer you are to retirement, the greater should be your allocation to bonds and money market securities, which provide income, and the smaller should be your allocation to stocks, which provide growth to the portfolio. Figure 1-3 gives two examples of asset allocation plans: The first is for a married couple in their thirties who are investing primarily to build a retirement fund over 30 years. The second is for a couple who are in their mid-forties, indicating a slightly reduced percentage allocated to stocks with a 20-year time horizon to retirement.
3. Identify Your Investment Strategy
Your investment strategy conforms to your objectives and asset
allocation plan. Your perception of how efficiently stock and bond
markets process relevant information with regard to the pricing of
their securities determines your investment strategy. If you believe
that securities markets are efficient, meaning that all current and
new information is reflected quickly and efficiently in stock and
bond prices, you would pursue a passive investment strategy. For
example, when there are undervalued stocks, they will be bought
immediately, driving up their prices to their fair or intrinsic values.
Consequently, there will be very few underpriced or overpriced
stocks in an efficient market. An efficient market means that few
investors will be able to consistently beat the market returns on
a risk-adjusted basis (seeking returns that are greater than the
market by investing in securities with the same level of risk).
Investors who believe that the markets are efficient would hope to
do as well as the market averages, seeing that they cannot beat the
market averages. Such investors would pursue a passive invest-
ment strategy of buying and holding a diversified portfolio of
stocks that resemble market indexes.
If investors believe that the markets are inefficient (slow to reflect pricing information), there will be many under- and overvalued stocks. Consequently, such investors use financial and technical analysis to find those underpriced stocks in order to earn larger returns than those of the market averages. Investors following an active investment strategy buy stocks when they are undervalued and sell those stocks when they are perceived to be overvalued. Asset allocation plans change in response to circumstances in the market, and the percentage allocated to stocks will increase when the stock market is perceived to be undervalued and will be reduced when the stock market is perceived to be overvalued.

4. Select Your Investments
After you formulate your objectives, asset allocation plan, and investment strategy, it is time to select your investments. Your decision as to which stocks to buy is guided by your investment strategy. Investors following a passive investment strategy choose diversified investments in each investment asset class. A diversified stock portfolio includes stocks from different sectors of the economy (technology, energy, health care, consumer, industrial, financial auto, basic materials, manufacturing, and utilities) whose returns are not directly related.
An investor following an active strategy uses fundamental and technical analysis to assemble stocks to buy that are undervalued and then sells them when they become overvalued and replaces them with new undervalued stocks.
Irrespective of whether you are an active or passive investor, you need to even out the risk of loss by having a diversified portfo-
lio. In other words, you should not have all your eggs in one basket.

5. Evaluate Your Portfolio
You should evaluate your portfolio periodically because a change in your circumstances might necessitate a change in your asset allocation plan. In addition, fluctuating economic and market conditions might affect your asset allocation plan. Similarly, a change in a company’s business will have a direct bearing on the valuation of that company’s stock in your investment portfolio.

WHAT INVESTING IN STOCKS CAN DO FOR YOU
If you have a long investment time horizon and you can sleep well at night when there is a decline in the stock market, you should consider investing in stocks because
* Stocks provide returns in the form of dividends and capital
appreciation. Historically, returns from stocks have been
greater than the returns received from bonds and money
market securities over long time horizons (seven-plus
years). Investing in stocks provides growth to an invest-
ment portfolio in addition to any dividend income.
* Stocks provide a store of value. Buying and holding appre-
ciated stocks in a portfolio is a tax-efficient way to increase
wealth in that if the holding period is longer than a year be-
fore selling a stock, the capital gain is taxed at a maximum
of 15 percent at the federal level. Gains from stocks held for
less than a year are taxed at your marginal tax bracket,
which could be as high as 35 percent. Check with your
accountant that Congress has not made any changes to the
Tax Code for the taxation of capital gains.
* Dividend income from qualified stocks is taxed at lower
rates than interest from bonds and money market securities