Lesson 5: Your Future in Stocks

When you buy a share of stock, you are buying a piece of the issuing company. Admittedly, it's probably a small piece. But that share gives you the right to participate in the company's growth (or decline) and to vote on matters of some importance--directors, company auditors and some shifts in corporate policy. In some cases, you will also be entitled to dividends--payments of cash or stock to shareholders. Some companies also provide their shareholders with perquisites such as tickets to the company's theme parks or discounts on its merchandise.

When it comes to risk, investors can take some comfort in the fact that over very long periods, stocks have appreciated faster than the rate of inflation and have outperformed other traditional types of investments. That's because companies tend to grow with the economy and to prosper and because shares in them allow stockholders to participate in that prosperity. Of course, none of this is any guarantee that you'll make money on the stocks you buy, or that being invested in stocks during a market downturn won't be plenty painful.

History also tells us, incidentally, that investors in small companies have done better than investors in large companies over the long haul (average annual return of 12.2% versus 10.5%, respectively), but in bad times, small-company stocks carry more downside risk than big-company stocks. When their prices fall, they drop further and faster, and they stay depressed longer.

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These heady climbs and sickening slumps--in regard to any investment--are called volatility. If you're considering something as volatile as the stock market, it would be unwise to invest unless you have a fairly long time horizon, so you can ride out any price swings.

How long is "fairly long"? That depends on you and why you are investing.

Let's say you want to buy a house in five years and you're trying to determine where to invest what you've been accumulating for a down payment. The stock market would be a good place for all or part of that money as long as you wouldn't be crushed if your home-buying plans had to be put off because of a stock market slump that depressed the value of your investments and thus reduced the amount you had intended for the down payment.

Stocks are also ideal for a retirement portfolio. The younger and further from retirement you are, the greater the percentage of your investments that can be in stocks--and the riskier those stocks can be. Stocks are also a good choice for college funds for young children.

As a rule of thumb, money that is going to be left invested for 10 years or more ought to be in stocks.

Since there's an art and a science to picking stocks and most folks would rather a trained professional make those choices, mutual funds have skyrocketed in popularity. Mutual funds are investment companies that pool the money of many people and invest it. The stocks a fund buys are determined by the fund's investment objectives--they're spelled out in the prospectus--and by the fund manager, who makes the investment decisions.

When you buy a piece of an equity fund, you're actually buying an interest in all of the different stocks held by that fund. That gives you the benefit of diversification, reducing the risk that your stock portfolio will be savaged by a single bad stock. Although they are affected by the same forces that affect the market as a whole, many funds are managed to take advantage of upward trends or to protect investors against bear markets.

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Most stock investors will want to hold some foreign equities. Just as U.S. companies issue ownership interests in the form of stock, so do companies abroad.

The risks and rewards of foreign stock markets are similar to those of the U.S. stock market, but they are frequently magnified. There are a variety of reasons. These may include political instability or the fact that many foreign markets are smaller than the U.S. market and their stocks may be more thinly traded. That tends to make them subject to wider price swings. That's simply because of supply and demand. When supply is short, a boost in demand can rapidly drive prices higher. Conversely, a sharp drop in demand can send prices plunging.

In addition, U.S. investors who buy foreign equities face something called currency risk.

When you buy foreign stock, you buy the shares with that country's currency. When you sell them, you get paid in that country's currency too. Before you can spend the proceeds in the United States, you have to convert the foreign currency into U.S. dollars at the going exchange rate. And exchange rates vary day to day based on the relative strength of any given country's balance sheet and the interest rates that country is paying on government securities. (That's the equivalent of U.S. Treasury bills.)

If the value of the country's currency has risen since you purchased your foreign stock, you win when you exchange the currency. If it has fallen, you lose.

In some cases, currency swings can be more significant to your total return than the actual appreciation or depreciation of the particular stock you purchased.

On the bright side, there are years when a foreign country's stock market can nearly double in value.

And if currency values are working in your favor at the same time, your returns can be stunning.

Traditionally, foreign and domestic stock investments have been thought to perform differently at any given time, and thus investing in foreign markets is seen as wise diversification. But recently, markets have become more global and thus may be becoming more synchronized.