Why Include Stocks in Your Portfolio?

Stocks, or equities, are an important part of most investors’ portfolios. As an asset class (and not as individual stocks), common stocks have a history of delivering strong, long-term capital gains: stocks are the best and most tax-efficient type of investment return. Having individual stocks in a diversified portfolio can reduce the overall risk of the portfolio. In addition, dividends on stocks are taxed at a much lower rate (15 percent) than interest on bonds, so earnings from stocks are a viable alternative to earnings from bonds.

Investing in individual stocks can be risky. Stocks are susceptible to changes in the domestic and world economy as well as changes in the company and political environment. Stocks are also somewhat illiquid. The growth of a stock or equity investment is susceptible to a number of risks; therefore, a stock’s growth is not solely determined by interest rates.

Stocks and Risk: All Risk Is Not Equal

Stocks are susceptible to a number of risks. These risks include the following:

• Interest-rate risk: Interest rates may rise or fall at any time, resulting in a decline or increase in a stock’s value. Rising interest rates require that future cash flows have a higher rate of return, which lowers the present value of a stock.
• Inflation risk: A rise or decline in inflation may result in an increase or decrease in the value of a stock. For most stocks, a higher rate of inflation results in a lower value of a stock. The inverse of this situation is also true. Rising inflation rates require that future cash flows have a higher rate of return, which lowers the present value of a stock.
• Company risk: The share price may rise or decline because of problems with the company that the stock represents. The better the future prospects for a company, the lower the required rate of return and the higher the present value of the stock. The inverse of this situation is also true.
• Financial risk: Whether or not a company is viewed as a financial risk has the potential to affect the company’s stock. Companies that are less risky or have better prospects can usually borrow money at lower rates of interest; hence, these companies have lower expenses and higher earnings. The inverse of this situation is also true.
• Liquidity risk: Investors take the risk that they may be unable to find a buyer or seller for a stock when they need one. Often, liquidity is more closely related to market conditions than company conditions.
• Political or regulatory risk: Unanticipated changes in the tax or legal environment may have an impact on a company. Since taxes and the legal environment affect the outlook of a company, any regulatory changes that improve a company’s long-term prospects will generally result in a higher price for that company’s stock. The inverse situation is also true.
• Exchange-rate risk: Changes in exchange rates may affect profitability for international companies. As exchange rates strengthen, the cost of domestically produced goods increases when these goods are sold overseas. The inverse situation is also true.
• Market risk: Overall market movement may affect the price of a company’s stock. Investors often monitor the way a stock responds to movement in the market. A measure of how sensitive a stock is to movements in the market is called a beta (β). A stock with a beta of one moves very closely with the market. A stock with a beta that is greater than one will be more volatile than the market. A stock with a beta of less than one will be less volatile than the market. Betas can help investors determine a stock’s market risk.

As you are building and monitoring your portfolio, you should track the beta of your portfolio, or the weighted beta of each of the individual stocks or mutual funds in your portfolio. This will tell you how risky your overall portfolio is in comparison to the market.

A diversified portfolio moves with the market: one company’s successes or failures cannot affect it as much. Remember the fourth principle of good investing: stay diversified. Do not invest solely in individual stocks—invest in a broad range of financial assets. Do not invest solely in large-cap stocks either; broaden and deepen your portfolio to include international and small-cap stocks as well.

Beware of using leverage. Using leverage is the process of increasing your purchasing power by borrowing money to invest in financial assets. Leverage increases risk: it magnifies capital gains and losses because the rate of return on the loan is fixed, while the rate of return on the investment is not. Do not use leverage to invest. Leverage is simply another form of debt.