Of all the major asset classes, stocks have consistently delivered the highest return over the longest period of time. It is therefore critical for you to understand basic information about stocks if you want to achieve better returns than those yielded by long-term bonds.

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. Stocks are susceptible to a number of risks. These risks include interest-rate risk, inflation risk, company risk, financial risk, liquidity risk, political or regulatory risk, exchange-rate risk, and market risk.

Understanding stocks requires you to understand a new set of terminology, which is included in this section. There are a number of different classifications for stocks. You should realize that these classifications are temporary: they may differ from investor to investor and from one time period to another. Investors make money on stocks in two ways: dividends and capital gains.

The goal of stock valuation is to determine the intrinsic value of a company (in other words, the company’s fundamental economic value). If the market price of the company’s stock is greater than the company’s intrinsic value, the investor should sell the stock. If the market price of the company’s stock is less than the company’s intrinsic value, the investor should buy the stock. Determining a company’s intrinsic value is one of the most challenging responsibilities that an investor has. Determining this value is accomplished using various tools, including dividend discount models, fundamental analysis, cash-flow analysis, and technical analysis. Proper stock valuation is a difficult, time-consuming, and challenging activity.

There are many reasons why stocks fluctuate in value. The most common reasons include changes in interest rates; perceived risk of the company; company earnings, dividends, and cash flow; supply and demand; and investor sentiment in the market.

There are a number of different strategies for investing in stocks. The most common strategies are the buy-and-hold strategy, the dollar-cost averaging strategy, and the dividend-reinvestment strategy.

The costs of investing in stocks can be divided into three categories: explicit costs, implicit costs, and hidden costs.

Now that you have completed this section, ask yourself the following questions:

1. Have you reviewed risk and return for stocks?
2. Do you understand stock terminology?
3. Do you understand how stocks are valued?
4. Do you know why stocks fluctuate in value?
5. Do you know stock-investing strategies?
6. Can you calculate the costs of investing in stocks?