Investors can take a variety of approaches when deciding which stocks to include in their portfolio. Some pursue an approach called technical analysis where they observe patterns and trends in the price of the stock and the volume of shares traded. Technical analysts believe these patterns can help them anticipate future moves in the stock's price.

A more mainstream approach is fundamental analysis. With this approach, the investor considers factors like the business outlook for the company's industry, anticipated demand for the company’s products, earnings projections, the stock's dividend payouts and to what extent these and other factors are already reflected in the stock price.

Within the realm of fundamental analysis, there are two primary philosophies — value and growth.

Value investors can be thought of as the investment world's "bargain hunters." They seek stocks they perceive to be unjustifiably unpopular with the rest of the investment community and tend to favor companies with lower price earnings (PE) ratios and higher dividend yields.

Growth investors are generally willing to pay more for a stock based on certain criteria. They are comfortable buying stocks with higher PE ratios and lower dividend yields, focusing instead on the companies' prospects for growth and favoring those whose earnings per share (EPS) are expected to rise faster than others.

The market tends to move in cycles, with value stocks and growth stocks taking turns in leading the market. When the market as a whole is rising sharply, growth stocks tend to outperform value stocks. However, because of its bias toward less expensive stocks, value investing has a defensive nature that often leads value investors to perform better than their growth counterparts in declining markets.

While value and growth investing are often described as two mutually exclusive philosophies, in practice, many investors will incorporate elements of both styles in their stock selections.

Stock Terms To Know
Earnings per share (EPS)	The company's earnings for a quarter or year divided by total outstanding shares.
Dividends per share	The share of company profits paid to shareholders for each share they own, usually paid quarterly.
Dividend yield	The projected annual dividends divided by the current market value of the stock.
Price earnings (PE) ratio	The market value of the stock divided by the annual earnings per share.

Buy Low, Sell High

Wall Street has created a number of familiar expressions, perhaps none repeated more than "buy low, sell high." The advice sounds obvious, but inexperienced investors often do just the opposite — buying high and selling low.

These inexperienced investors choose stocks whose shares have recently risen the most. They pay little attention to the fundamentals underlying the investment and simply hope the upward trend will continue. Too often, these investors end up "buying high" — that is, buying a stock whose price has gotten too far ahead of its underlying value.

Many inexperienced investors make the mistake of holding onto stocks with falling prices, hoping the stock price will come back at least to where the investor bought the stock rather than focusing on whether or not the stock is still a good investment at the lower price. Selling winners too quickly and holding onto losers too long are the primary reasons inexperienced investors have worse investment performance than experienced investors.

Stock Splits

Often, after a company’s stock has increased greatly in value, the company will execute a stock split. When this happens, the company gives you additional shares. After a two-for-one stock split, you have two shares for every one you owned before the split. For example, assume you own 100 shares of Company XYZ and it currently trades at $50 per share. If XYZ declares a two-for-one split, you would now own 200 shares of the company.

Have you just doubled your money? Unfortunately, no. Because there are now twice as many shares being traded, the market will reduce the price by half. Instead of owning 100 shares at $50 per share, you now own 200 shares at $25 per share. Your investment is worth $5,000 before and after the split.

Why do companies declare splits? When a stock’s price has risen greatly, some investors become more hesitant to purchase them, even though they should be more focused on the underlying fundamentals than the share price. The split brings the price back down to a level that may be more appealing to those investors.

A company can also declare a “reverse split” if its shares have fallen very low. In a reverse split, shareholders receive fewer shares and the market adjusts the price upward to account for the reduced number of total shares outstanding.

Selling Short

While most individuals try to make money by buying stocks that go up in value, some investors try to profit from a stock’s falling price. How? By "selling short."

In a short sale, investors borrow stock from their broker and immediately sell it, hoping to replace the borrowed stock with shares purchased at a lower price, keeping the difference as profit.

For example, Judy borrows shares of XYZ and immediately sells them at their current market value of $15 per share. A month later, she buys XYZ at $10 per share and returns them to her broker, keeping the $5 per share difference as her profit.

Shorting stocks is very risky as there is no limit to how much the investor can lose. Investors should not short stocks until they are very comfortable that they fully understand and can assume the risks.

Next: Bond Basicss

Updated Thursday, February 22, 2007