Since the end of World War II the average large stock has returned close to 10% a year -- well ahead of inflation, and the return of bonds, real estate and other savings vehicles. As a result, stocks are the best way to save money for long-term goals.
What is a stock?
When you own a share of stock, you are a part owner in the company with a claim -- however small it may be -- on every asset and every penny in earnings. As a company's earnings improve, investors are willing to pay more for the stock.
How do I buy stocks?
You can easily open a low-cost brokerage account online, at sites like Fidelity, Charles Schwab, TDAmeritrade or Scotrade. You can move money electronically into your account and start trading. Most discount broker sites charge a set fee of around $10 per trade.
What different types of stocks are there?
There are thousands of stocks to choose from, so investors usually put stocks into different categories: size, style and sector.
A company's size refers to its market capitalization, which is the current share price times the total number of shares outstanding. It's how much investors think the whole company is worth.
Companies with large market capitalizations, or "large-cap" companies tend to be established and stable, but because of their size, they have lower growth potential than small caps.
Over the long run, small-cap stocks have tended to rise at a faster pace. With less developed management structures, small caps are more likely to run into trouble as they grow.
Mid-caps, or medium-sized companies, fall somewhere in the middle.
A "growth" company is one that is expanding at an above-average rate, much as tech companies did in the 1990s. Catch a successful growth stock early on, and the ride can be spectacular. But again, the greater the potential, the bigger the risk. Growth stocks race higher when times are good, but as soon as growth slows, those stocks tank.
The opposite of growth is "value." There is no one definition of a value stock, but in general, it trades at a lower-than-average earnings multiple than the overall market. Maybe the company has messed up, causing the stock to plummet -- a value investor might think the underlying business is still sound and its true worth not reflected in the depressed stock price.
A "cyclical" company makes something that isn't in constant demand throughout the business cycle. For example, steel makers see sales rise when the economy heats up, spurring builders to put up new skyscrapers and consumers to buy new cars.
But when the economy slows, their sales lag too. Cyclical stocks bounce around a lot as investors try to guess when the next upturn and downturn will come.
Standard & Poor's breaks stocks into 10 sectors and dozens of industries. Generally speaking, different sectors are affected by different things. So at any given time, some are doing well while others are not.
In most cases, finance, health care and technology tend to be the fastest growing sectors, while consumer staples and utilities offer stability with moderate growth. The other sectors tend to be cyclical, expanding quickly in good times and contracting during recessions.
How do I choose?
Although there are more than 6,000 publicly traded companies, the core of your stock portfolio should consist of financially strong companies with above-average earnings growth.
There are only about 200 stocks that fit that description. A well-balanced stock portfolio should consist of 15 to 20 stocks, across seven or more different industries.
As a general rule, stocks with moderately above-average growth rates and reasonable valuations are the best buys. Statistically, high-growth stocks are usually overpriced and have a harder time meeting inflated investor expectations.
The first thing to look at is the stock's price/earnings ratio compared with its projected total return. Ideally, the P/E should be less than double the projected return (a P/E of no more than 30 for a stock with 15% total return potential).