The first thing you should know about stocks before adding them to your portfolio is that they carry a certain amount of risk. This is because the returns on stock are not guaranteed; not by the government, not by the company issuing the stock, and certainly not by your broker. That means that there is a chance that your actual return will be different than what you had expected. For instance, you might purchase stock under the expectation that its price will rise steadily over time and that it will pay you annual dividends. However, if the company experiences financial problems, you may not receive the price appreciation or the dividends that you expected. In fact, the company could even go out of business, in which case you could lose your entire investment. On the flip side, however, there is always the chance that the stock will outperform your expectations. It could double in price and start paying out hefty dividends, in which case you would enjoy a gain greater than what you had expected. Because there is uncertainty regarding which of the various possible outcomes will occur, you bear a certain amount of risk when purchasing the equity.
How do the risks associated with stocks affect your overall portfolio? That depends upon what other investments are in your portfolio. In general, the risks associated with investing in stocks are greater than the risks associated with investing in bonds or money markets . At the same time, however, the risks associated with investing in stocks are less than the risks associated with investing in options or futures . Of course, not all stocks pose the same level of risk: some (such as internet stocks) are much higher risk than others (such as utilities), so it's important to understand the amount of risk you would be taking on with any given investment.
In order to manage the risks associated with investing in stocks,most investors turn to a practice called diversification when building their stock portfolios. Diversification is a method of risk reduction in which investors buy multiple securities instead of just one. As a shareholder in several companies, the diversified investor knows that if one of his or her stocks happens to fail then there is always the chance that another one could gain enough to offset the loss. It's basically just a way for you to not put all your eggs in one basket, which is also the concept underlying mutual funds . There are two ways to increase your diversification (and reduce your risk): increase the number of stocks you own or own stocks that are fundamentally different from one another. Of course, you can't totally eliminate all the risks involved in stock investing because there is still market risk, the risk that the entire market will fall. In that case, no matter how well diversified you are, your portfolio will suffer.
The other variable that will influence the amount of risk in your stock portfolio is your time horizon. Over the long, long term (several decades), history has shown time and again that stock prices outperform almost all other investments. However, in the short run stock prices often go down (about half the time, if the time period is sufficiently short). That means that if you are at a point in your life when you may need to sell your stocks in the short run (such as if you're close to retirement), then you may want to think twice about investing in stocks. There is a definite possibility that the stocks that you buy now may be worth significantly less one or two years in the future. Most likely, however, they will be worth significantly more ten or twenty years in the future. So before you invest in stocks, you should sit down and examine both your own time horizons and those of the market in order to see whether or not you can bear the risks associated with short term stock investing.
Once you've thought about the risks associated with stock investing and figured out your plans for diversification, the next issue to consider when adding stocks to your portfolio is which stocks to add. You'll first want to take a look at your particular investing objectives. If you're looking for steady income with low risk, you may want to consider investing in income stocks . On the other hand, if you're looking for opportunities that may result in a big payoff and you're not too concerned about the risks involved, you might want to try investing in growth stocks . There are a number of different stock strategies that you can use to try to meet your goals .
Once you've decided on a strategy, the last step is to determine whether or not you should buy the stocks you want given the prices at which they are selling. In order to do this, you value the stocks you are interested in according to what you believe they are worth and then compare them to their market prices. If you think your stocks are worth more than what they are selling for, then they are good candidates for purchase. If you think they are worth less than their price, then you might want to wait before purchasing them. The method of determining a stock's worth is called valuation, and there are many different approaches to it. Some investors look at a company's fundamentals while others look at quantitative data regarding the stock's price and its trading patterns . You'll probably want to look at both of these techniques in detail before settling upon which one you think is the best method for you to value stocks for your portfolio. You should also check out our "Choosing a Stock" section for more advice on how to select individual stocks to invest in .