Equity

Stock is very nearly like the ownership. This is ownership is understood in the most literal sense. The more shares someone buys, the bigger his or her stake becomes.

Stock Valuation

The stock market itself is basically a daily referendum on the value of the companies that trade there.

Risk

While history shows that stocks will rise given the fullness of time, there are no guarantees – especially when it comes to individual stocks. Unlike a bond, which promises a payout at the end of a specified period plus interest along the way, the only assured return from a stock is if it appreciates on the open market. The worst-case scenario is that a company goes bankrupt and the value of your investment evaporates altogether. More often, a company will run into short-term problems that depress the price of its stock for what seems an agonizingly long period of time.

For all the risk, however, there are ways to manage your exposure. The best is to diversify by owning a variety of stocks. It's also important to remember that investors are well compensated for rolling the dice with equities. Historically, the long-term return from stocks is about 12% annually (with dividends reinvested), while bonds – which are less risky – return just 4%.

Along with ownership, a share of stock gives client the right to vote on management issues. Company executives work at the behest of shareholders, who are represented by an elected board of directors. By law, the goal of management is to increase the value of the equity of the corporation. To the extent this doesn't happen, shareholders can vote to have management removed.

That's the way it is supposed to work, anyway. One of the grim realities of the stock market is that individual investors rarely amass enough stock to be able to exert any tangible influence over a company – that's left to big institutional shareholders or groups of company insiders.

MARKET CAPITALIZATION – or market value – is a term that frequently arises. It is defined as the number of shares a company has outstanding in the market, multiplied by the share price. If a company had five million shares outstanding and each one traded for $5, its „market cap“ would be $25 million.

As the name suggests, large-capitalization stocks are the biggest players in the market. The bigger clients are, the harder it is to grow quickly, so large caps don't tend to expand as fast as their average upstart. But what they lack in flash, they make up in heft. The classic „blue chip“ has steady revenue, a consistent stream of earnings and a dividend. It also has critical mass, which means it can withstand ill economic winds better than its smaller cousins.

Risk/Reward

Because of their size and stability, true large-cap stocks are not generally speculative in nature and appeal to a more risk-averse investor. That's not to say they can't run into serious trouble, but they tend to grow along predictable trend lines and, since they are well known to Wall Street analysts, their problems often come with ample warning. Big companies (with the notable exception of many technology blue chips) also tend to pay regular dividends, which act as ballast by attracting income-oriented, long-term investors. Don't be fooled: Large caps can experience jarring price swings. But there's no doubt they are less volatile than small, hot-growth stocks.

Lower risk comes with a price, however. Except during periods of rampant uncertainty, large-cap stocks tend to produce lower returns than small caps (9.34% annually vs. 9.71%). But with the addition of the technology blue chips, some researchers think those statistics may be shifting in favour of the big guys. Still, many investors consider large caps their core holdings and augment their returns with a choice of fast-growth, higher-risk companies.

SMALL-CAPITALIZATION STOCKS have a reputation for being the market's speed demons. That's not entirely accurate, since there are plenty of small, stodgy banks and rust-belt manufacturers in the group. And there are periods when small caps suffer because investors have no stomach for high volatility. But companies with a market value below $1 billion can also grow more quickly than bigger companies. Indeed, the good ones can post explosive earnings that drive double-digit returns for investors.

Rapid growth is clearly the appeal of small-cap stocks. But they aren't for the faint of heart. Little companies are significantly more volatile than big companies – meaning there's much more downside risk. And they don't pay dividends as often, a real detriment for investors who want some income.

International Equities

International stocks have special risks, such as fluctuations in foreign exchange rates. It's also true that foreign companies are subject to different rules of accounting and usually far less government scrutiny than U.S. investor is used to. Within the overseas category, emerging markets are the riskiest of all. Economies can collapse, as we saw with Argentina, and governments can fail. Compared to nations with more-developed economies, these countries remain riskier bets.

Tech Stock

Tech stocks are no longer at the top of every investor's wish list. Fearful of shrivelling profits amid an economic slowdown, many people have abandoned growth stocks in sectors such as technology and have sought out safety in less-volatile arenas like pharmaceuticals and financials. Most of those who have stayed in the game have sworn off Internet stocks like Priceline.com and CMGI. Instead, they've gravitated to more-established companies Dell Computer and Microsoft.

The good news is that after a few tough years, tech stocks are now better understood. Previously thought to be somewhat immune to business cycles, technology is, we now know, subject to many of the pitfalls of other sectors. The result is that investors are demanding to see earnings – not just the promise of them someday – as well as a plan that can pull a company through rough economic times. Investors will return to the good companies once the dust has cleared.

Risk/Reward

While technology stocks as a group tend to be more volatile than the broader market, all tech stocks are not created equal. Indeed, as the revolution in computing and communications matures, a new breed of more stable high-tech stock is emerging. Even the stocks of giants tend to bounce around more than a traditional blue chip. But their earnings have become predictable enough to eliminate the wild volatility found among tech companies relatively new to the scene.

A selection of these high-tech blue chips should be in everyone's long-term portfolio, since the volatility they do exhibit is offset by their superior growth prospects over time. Many experienced investors then try to augment their returns with riskier stocks that offer the possibility of even greater growth.

The core advice is this: Investing in these uncertain waters requires diversification so that your exposure to any one stock is limited. With a significant amount of time and effort, you can create a well-diversified portfolio yourself. Or you can buy one of the many technology mutual funds out there and hand the management responsibility over to a professional.

Stock evaluation

Many beginning investors make the mistake of thinking that a low stock price means the company is inexpensive. Share price is total market value divided by shares outstanding. And since the number of shares is largely arbitrary, so is the stock price.

Investors’ value stocks based on one question: If client puts money into specific company, what are the chances that he or she will get a better return than if he or she invested in something else? It's a matter of risk vs. reward. The safest investment is a U.S. Treasury bond because its return is guaranteed by the „full faith and credit“ of the federal government. A stock's value proposition starts there – how much more will it return than a Treasury bond and at what risk?

When someone buys a stock, his or her return is a stream of earnings over time – which is hardly guaranteed. The more reliable that stream, however, and the more quickly it grows, the more investors will be willing to pay for it. Clients’ traditional electric utility has reliable earnings but utilities don't grow very fast, so they tend to be sleepy stocks.

In order to evaluate companies against each other (and against themselves), investors long ago developed a measure called the price-to-earnings ratio, or P/E. It's derived by dividing a company's price per share by its earnings per share. If a company has a P/E ratio of 20:1 (usually displayed as just 20), for instance, that means investors are paying $20 for every $1 of earnings. If the P/E is 18:1, they're only willing to pay $18 for that same $1 profit. Most people only use the top number when referring to a company's P/E.

A company's P/E fluctuates with investor perceptions about how quickly its earnings will grow in the future. That's why two companies with the exact same earnings per share over the past year may have different multiples. If Company A and Company B each earn $1 a share, but Company A is trading for $20 and Company B is trading for just $18, the market is making a judgment on their earnings prospects. Based on any number of factors – company health, outside competition, better management, the economy, the outlook for the sector – investors think Company A's earnings are better poised for growth. Consequently, they're willing to pay $2 more right now to lay claim to them.

For that we have to look at a stock's behaviour over time. Most established companies trade up and down in a range depending on how investors are weighing their earnings prospects. Sometimes disappointing news – a lacklustre quarterly-earnings report, for instance – can depress the price for a period of time. Other times good news sparks a flood of investor interest.

This ebb and flow is reflected in the P/E, which can be compared both to a company's his­torical range and that of other companies in its industry. It can also be compared to the market as a whole.

The object of investing is to buy low and sell high. And as you can see, that often means looking for stocks that are temporarily out of favour. If you buy stocks near the top of their range, the danger is they will reverse course and tumble downward. If you buy near the bottom – or when the stock is cheap relative to its true potential – you can enjoy the full ride back upward. (The catch, of course, is to do careful research so you can be confident the stock will, in fact, head north once again.) The art of investing is deciding when to strike – and acting on that decision before everybody else does.

Margin Trading

Margin Trading allows the client to purchase more shares of a stock than he'd or she’d be able to with the paltry sum stashed away in his or her own bank account. When client opens a margin account his or her broker will ask him or her to sign a contract called a margin agreement. Usually, client’ll be required to make an initial investment of at least $2,000 (though some brokerage firms require higher minimum investments). And once the account is opened, client can borrow up to 50% of the purchase price of a stock, so long as he or she has enough money in account to cover the balance.

Client can usually keep the loan out as long as he or she wants – with a couple of provisos. First, when client finally sells the shares of stock in his or her margin account, client will have to immediately pay back the money he or she borrowed plus interest and any trading commissions. Second, if the value of his or her portfolio falls below a certain threshold, the brokerage reserves the right to „call“ the loan, meaning he or she has to pay back what he or she borrowed whether the client wants to or not. This ominous event is referred to as a „margin call.“

But client should beware – when the markets are tumbling quickly, he or she may not get a margin call at all. His or her broker might just liquidate his or her account for him or her. Most margin agreements give brokers the right to sell off a customer's margin account without notice if such a move is necessary to protect the broker's capital.

More Than 100%

The worst-case scenario is when someone loses more than 100% of the original equity. Let's say client bought $34,000 worth of Gap (GPS), back in May 2001, thinking it had finally figured out how to stem its declining sales. The stock was trading at $34 in late May, and at the time, few people would admit that the nation was in a recession.

Unfortunately, the recession had indeed begun. Gap's sales continued to decline. The stock fell 55% to $15 in the beginning of September. Things would have been bad for the client if he or she had bought the shares outright, but he or she would have been in even worse shape if he or she bought half using $17,000 cash and used a $17,000 margin loan with 8% interest to buy the rest. In stead of just being left with $16,000 worth of stock, investor would have to sell the rest of his or her shares and pony up another $1,340 just to cover the $17,000 he or she borrowed plus the interest the loan accrued.)

Options

First of all, some people confuse options contracts with futures contracts, since they're both derived from underlying commodities, currencies or financial instruments like Treasury bonds or stocks. But there are important differences. A futures contract is a legal pact in which the purchaser agrees to buy or sell a certain amount of the underlying instrument at a set date in the future. That makes them incredibly risky, because the holder is required to live up to the contract no matter what's happened in the market.

Option contracts, by contrast, give buyers the option of exercising the contract at their own discretion. In other words, they offer a choice. There are options on stocks, bonds, commodities, interest rates and currencies. Let’s stick with stock options since that's what interests most individual investors.

When client purchases an option, it gives him or her the right to buy or sell a certain number of shares of the stock in question at a predetermined price (the „strike price“), before or at the contract's ex­piration date. For this right, client pays the seller a fee, called a „premium,“ which is a tiny fraction of the shares' market value. During the life of the contract, client controls the shares in question. Contracts can last anywhere from one month to three years. (Options more than nine months in duration are called Long-Term Equity Anticipation Securities, or Leaps. They trade just like options.)

Puts and Calls

There are two kinds of option contracts: a put and a call. A put is an option that gives the buyer the right to sell the underlying stock; a call is an option giving the buyer the right to buy the underlying stock.

People generally use puts to hedge their bets. They're paying money now for the right to sell a certain number of shares later at a price agreed on today.

Call options are contracts in which the buyer pays for the right to purchase shares at a certain date in the future. These are often used to take a long position in a stock without actually buying the shares now.