A stock is a share of a company or corporation. When you purchase a cup of coffee from Starbucks, say, you become a customer of Starbucks. When you purchase stock in Starbucks, you become a part-owner of the company, with a stake in every cup of coffee customers buy. The more shares you purchase, the larger your stake in the company.
Stocks are traded—bought and sold—on “exchanges,” such as the New York Stock Exchange (NYSE) and the National Association of Dealers Auto-mated Quotations exchange (NASDAQ). Stockbrokers are individuals employed by a firm that is a member of a stock exchange. Their job is to buy and sell stocks and other securities for clients.
Here’s how you would buy stock in Starbucks, for example, which is traded on the NASDAQ:
Step one. Contact a stockbroker at an investment firm that is a member of NASDAQ and place an order for the number of shares you wish to purchase. The broker quotes you the most recent price at which a single share of Starbucks was traded. Multiply that figure by the number of shares you wish to buy, add the broker’s commission, which the broker will give you, and that is the amount you must pay for your purchase.
Step two. The broker writes a ticket for your order, enters the order into a computer, then sends it to his firm’s “stock trader” to execute the order. The stock trader’s sole job is to buy and sell stock for this particular firm. He or she either sells you the stock from a block of Starbucks shares he or she may be holding for the firm’s clients, or finds another trader on the exchange who is willing to sell you the shares.
Step three. If another trader is involved, your trader sends your order to him for execution at a price that normally is pretty close to the originally quoted price and sends the report back to your broker. Your broker issues you a trade confirmation reflecting the number of shares of Starbucks you purchased.
A great deal of risk is involved in purchasing stock. While history has shown an overall upward trend in stock prices, there is no guarantee that the stock you purchase will increase in value. Between 1997 and 2000, many grew rich when it appeared that the stock market would go up forever. However, most people lost more than the fortunes they gained when the stock market spiraled downward through 2003.
The best way to manage the risk in owning stocks is to diversify your holdings by purchasing a variety of stocks.
The two types of risk involved with purchasing stocks are “unsystematic” risk and “systematic” risk. Unsystem-atic risk is specific to an industry or firm. A strike at Starbucks, for example, represents risk that is specific only to Starbucks.
Systematic risk is inherent to the entire market or entire market segment. The federal government’s decision to raise interest rates in order to slow the growth of the economy presents an inherent risk to the price of stocks, including Starbucks. If you own only Starbucks stock, both at the time of a strike at that company and an interest rate hike, you have both unsystematic and systematic risk in your portfolio. The more diversified your portfolio is, the less unsystematic risk you have.
The ideal portfolio has no unsystematic risk and minimal systematic risk, which cannot be completely eliminated. Many portfolio managers limit each stock’s value to 5 percent of their total portfolio value. If, for example, a portfolio manager owns $1 million worth of stock, no single stock would account for more than $50,000 of the portfolio.
The percentage of each investment category—stocks, bonds, or cash—in your portfolio is your “asset allocation.” The purpose of asset allocation is to reduce risk by diversifying the portfolio. It is said to be the single most important aspect of any portfolio, sometimes accounting for as much as 90 percent of portfolio return.
Each person’s portfolio has a different asset allocation, based primarily on the individual’s risk tolerance. A younger investor may have an asset allocation of 70 percent in stocks and 30 percent in bonds. Stocks are more volatile than bonds, meaning their value fluctuates more that that of bonds, but they tend to have a longer return over time. The younger investor has time to recover from major market fluctuations.
An investor who is near or in retirement may have an asset allocation of 20 percent stocks and 80 percent bonds. An individual who is thinking of retirement should primarily be concerned with conserving capital and not investment appreciation.
Each asset allocation should remain the same throughout the life of the portfolio, unless the investor decides to change it. As the market goes up and down, so will the asset allocation. It is up to the investor to rebalance the portfolio periodically to assure that the asset allocation remains as he or she wishes it to be.
Next: How to pick a good investment.
Ryan C. Mack is founder and CEO of Optimum Capital Management L.L.C., a wealth-management firm in New York City. He can be reached at firstname.lastname@example.org .