Investor’s Guide to Equity Basics

Equities, also known as stocks, are a core element of any investment plan. If you are considering investing in equities, the following primer will help you better understand the fundamentals of stocks as an asset class and as an investment vehicle.

In this primer on equities you will learn:

• How equities represent an ownership stake in a company
• Why financial professionals recommend investing in stocks as part of a diversified portfolio
• How shareholder voting rights work
• How equities prices are established
• Key factors to consider when evaluating potential stock investments
• Tools and aids that will help you understand equities and stock investing

This primer will focus exclusively on equities within the context of U.S., rather than global, markets.

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Equities are securities that represent a fractional ownership interest in a business. Both privately held and public corporations may issue equity shares to investors, which essentially makes the investors partial owners of that business. Equities are more commonly referred to as “stocks,” and the terms are used interchangeably here.

Typically, small businesses and start-ups fund their operations and expansions from investment by founders and early investors, reinvested profits, or loans from financial institutions. As a business grows, management may seek to access larger pools of capital. A pool of equity, distributed as shares among a number of owners, allows a company to secure greater amounts of funding from a larger number of investors.

Let’s take a simple hypothetical example based on a private company. Your sister wants to open a bakery, and she sets up her company as a private corporation with 1,000 shares of stock. When she offers an opportunity to invest, you purchase 100 shares. Congratulations: you now hold a 10% equity ownership stake in the business.

When you purchase shares of a public company listed on a stock exchange, you are making the same kind of transaction. Of course, when it comes to publicly-traded companies like Apple, Wal-Mart or Coca Cola, there are millions of available shares, so the vast majority of investors will hold only a small fraction of ownership.

If an investor owns shares in a company that continues to expand and generate profits over time, the value of those shares is likely to grow, creating a capital gain for the investor. Moreover, shareholders may receive regular payments in the form of dividends (explained in more detail below).

That potential upside of capital gains, plus dividend income, has made equities an attractive investment for millions of Americans. And it’s why investments in equities continue to be one of the building blocks of pension funds, retirement plans, mutual funds and other investing vehicles that seek to deliver reliable returns to investors and beneficiaries.

A word about stock certificates

At one time, stocks were traded as actual paper certificates. The evolution in database technology and connectivity have rendered physical stock certificates largely obsolete, although some companies may still offer certificates by special request (for example, a parent might want to present a child with a paper certificate as a concrete illustration of equity ownership). Most equity shares, like other securitized assets, are now held in in book entry from with a registered brokerage firm, with your virtual ownership of the asset listed in electronically. Most shareholders today never even see a physical stock certificate.

Equities are a popular investment choice for savers, retirees and anyone who seeks growth of capital and income generation.

Historical data show that over the long run—say, periods of five to 10 years or longer—stocks generally outperform other investments, while typically keeping pace with inflation better than cash deposits. That’s why most investment professionals recommend investing in stocks as part of a diversified portfolio, along with bonds, cash and other assets, aimed at building wealth over time.

A key benefit of stocks is that they typically are liquid assets that can be bought and sold relatively easily. This gives the investor a great deal of flexibility, since you can adjust your investing positions with ease and at a relatively low cost.

With stock ownership, your liability for losses as a partial owner of the company is limited to the size of your investment. In the event of a company’s bankruptcy or a market downturn, you will only lose the money you’ve put into purchasing equity shares. So while the potential upside growth of the equity’s value is theoretically unlimited, there is a downside limit to how much you can potentially lose in a worst-case scenario.

As traditional defined-benefit retirement plans (i.e., pensions) have been replaced by defined-contribution plans, like 401(k) plans and Individual Retirement Accounts (IRA), investors must be more self-directed in planning and financing their post-work lives. Understanding the role that equities can play in building a diversified retirement portfolio is vital to long-term investing success.

Before investing in equities, do your research to learn about how these assets work. Then you should talk to a financial professional, who can help you craft an investment strategy that meets your long-term goals. Finally, review your portfolio on a regular basis, and assess your investment strategy, to ensure your performance tracks with your objectives, risk tolerance and income needs.

The two classes of securities most familiar to average investors are equities, or stocks, and debt, or bonds. What’s the difference between stocks and bonds?

As noted above, equities are securities that represent shares of ownership in a business. Investors buy equities with the hope that they will appreciate in value over the time they hold the securities.

Bonds, on the other hand, are securities that represent debt obligations.  They work like an I.O.U., while generating regular fixed income payments for the investor. When you purchase a bond, you are lending money to the issuer of the bond. That issuer could be a corporation, state, city or federal government, a federal agency or other entity. In return, the issuer pays you a specified rate of interest over the life of the bond and will repay the face value of the bond (the principal) when it reaches maturity — that is, the date the bond comes due.

(For more information on bonds, check out the Project Invested page on “Bond Basics,” which explains how these debt securities work in greater detail).

Public corporations typically offer two classes of equities: preferred stock and common stock. Preferred stock has characteristics of both debt and equity securities, and is less frequently traded by average investors. This primer will focus on common stock, since that is the class of equity most retail investors will deal with.

Stocks and bonds both have their own unique advantages and disadvantages as investment vehicles. Careful investors will typically arrange to hold a variety of securities in a diversified portfolio as a strategy to manage risk.

As equity owners of a company, every shareholder has the right to vote on the company’s management and direction—as a part-owner of the company, each shareholder have a say.

Each share of stock affords the shareholder one vote on key issues presented by the company’s leadership at the annual meeting. These can include decisions on who sits on the board of directors, executive compensation, corporate social responsibility, stock options, issuance of additional shares of stock and other critical issues. These are not small matters, and shareholder votes have a powerful impact on a company’s management direction.

You are not required to physically attend the annual meeting to make your voice heard, thanks to proxy voting. As an investor, you will receive a proxy card with a listing of the ballot issues to be decided at the annual meeting. You can vote by returning the card (many companies also allow proxy voting online or by telephone), which allows you to have an influence on the company’s future direction without being physically present.

For a more detailed look at how the proxy voting process empowers investors, check out Project Invested’s primer on proxy voting.

It’s helpful to understand how equity shares in a public company are generated. That requires an understanding for the initial public offering (IPO) process.

A company that is growing rapidly or seeking to achieve a larger scale or liquidity for investors and employees may elect to become a publicly traded corporation, so its equity shares can be traded on stock exchanges like the New York Stock Exchange (NYSE) or NASDAQ.

When a company “goes public,” it registers stock with the Securities and Exchange Commission (SEC) to make an IPO. The IPO is typically underwritten by a large investment bank, which coordinates the initial sale of shares to accredited investors and large institutional investors (like pension and mutual funds). If demand is strong and the first offering of equity shares sells out quickly, a greenshoe option gives the underwriter the right to sell these investors more shares than originally planned. On IPO day, the initial round of equity shares will be created and sold directly to investors through what is known as the “primary market,” where original issuances are sold.

The IPO is a significant step in the growth of many businesses, as the process provides access to a larger pool of funding through the public capital market, where the company can secure additional financing through the sale of equity securities to fuel growth. In addition, an IPO can increase the company’s profile and lend the company greater credibility with banks, creditors and customers.

However, going public also subjects a corporation to a wider array of federal regulatory and reporting requirements. These can be costly and carry significant implications for management flexibility and long-term decision-making. Thus, the decision to go public is one no company takes lightly.

Once a company completes the IPO process, its equity shares begin trading on the secondary market. The “secondary market,” where investors trade previously issued securities among themselves, is where most daily trading of stocks takes place; large public exchanges, like the aforementioned NYSE and NASDAQ, are examples of secondary market exchanges.

So when an investor purchases shares of, say, Facebook stock from a brokerage firm, she’s not buying those securities directly from the company—she’s trading existing shares on the secondary market. While the company’s management may be pleased to see the price of its stock rising on the exchange, note that the company does not receive any additional financing from trading on the open market after the IPO process is complete. If the company needs to raise additional funds, it can issue additional stock, borrow money or pursue other funding strategies.

You’ve probably heard the old investor’s adage: “Buy low, sell high.” If you check the price of a company’s stock online, via mobile device or by asking a financial professional, you’ll find the price fluctuates over time. The price of a particular equity may shift significantly within a few hours or even minutes. What determines the price of a particular equity at any given time?

Equity valuation is a highly technical undertaking, but in a nutshell the initial price of a company’s stock is determined at the time of the IPO. Analysts at the investment bank that underwrites the offering will use complex formulas and calculations to determine the underlying current value of the company and its long-term performance potential. Based on those calculations, a target price is assigned to the stock when it’s issued.

After that point, supply and demand plays a critical role in driving price changes, since there are at any given time a limited number of outstanding shares available. If there’s strong demand for shares on IPO day, as the company hopes, the price will rise; weak demand means prices will fall.

After the IPO, once shares are trading on the secondary market, changes to a stock’s price are disseminated electronically on a continuous basis, again reflecting changes in supply and demand throughout the trading day. Any number of events—for example, a better (or worse) than expected quarterly earnings report, a change in corporate leadership, or an adverse legal or regulatory outcome, as well as broader economic or market conditions unrelated to the company’s performance—can affect consumer sentiment and cause swings in a stock’s price over time.

Equity prices are also affected by changes in the number of available shares; if a company elects to adjust the number of outstanding shares that too will affect the market price.

One common strategy to adjust the number of shares available is a stock split, an accounting procedure in which the company “splits” its existing outstanding shares to create a larger pool. So for example, if a company with 100,000 shares outstanding, trading at $50 per share, declares a “2-for-1” split, the number of shares available will double to 200,000, while the price will adjust to $25 per share. Note that this doesn’t change the actual value of the company, and if you’re a shareholder, the overall value of your shares remains the same as before. However, a split can create more trading volume, as more investors may seek to purchase the stock at the revised lower price, which may lead to a price increase.

Conversely, a company may choose to retire shares by purchasing them back on the secondary market. A company may choose to retire shares when they don’t see suitable opportunities for investing earnings in further expansion, mergers and acquisitions or paying out dividends. Reducing the number of shares outstanding through a stock buyback will increase the value of those shares that remain outstanding.

A word about market indexes

In addition to the prices of individual stocks, another potentially useful data point for evaluating the state of the overall market is a market index. A market index is a weighted selection of equities that collectively serves as a benchmark for the movements of the market as a whole or for specific market segments.

The most commonly cited index is the Dow Jones Industrial Average, which is composed of the 30 U.S. publicly listed companies with the largest market capitalizations. Other common market indexes are the Standard & Poor’s 500 Index (S&P 500), the NASDAQ Composite and the Russell 2000 Index, all of which sample a larger number of company stocks to provide a snapshot of the market’s performance at a given point in time.

Market indexes are a useful shorthand tool for reporting on and discussing the overall state of the market. But they are only one tool, and they do not always reflect total market conditions.

If you’re considering investing in equities, there are a number of factors to take into consideration.

Risk

Equities as a class have shown sustained growth over time, but recognize that investing in any security entails risk. Stocks tend to be relatively volatile compared to other types of securities, and can be subject to rapid and unforeseen changes in value.

It’s possible you’ll purchase stock of a company that over time faces difficult times—for example, a loss of market share to competitors, a failed product, bad decisions by management, poor timing in introducing a new product, legal or liability challenges, or an unfavorable economic environment.  In such a case, the value of your shares may decline, and they may end up being worth less than what you originally invested.

At that point, you’ll have to determine if you’re better off selling the shares at a loss, or holding the investment in hopes of a turnaround. In a worst-case scenario, the company could go bankrupt, and the investment would be worth zero.

Keep in mind that equity investments are not only subject to risk at the level of the individual firm’s stock. The value of your equities may fall in the event of a large-scale decline in the total market. This market risk, which is often tied to the vicissitudes of larger economic cycles, is rarely predictable, and can lead to substantial declines in the value of individual securities and in the size of your portfolio. Even if a downward market cycle is followed by upward swings, it can take months or years for the market to regain its previous heights.

So when you invest in equities, think carefully about your own risk tolerance. If you have a higher tolerance for risk, or if you have a longer investing time frame that will allow you time to recover from potential losses, you may prefer to accept a higher level of investment risk in the hopes of achieving a higher return.

Even the smartest, most successful investors will admit they have had plenty of failures in their portfolio—investing success is a matter of having more winners and fewer losers over the course of your portfolio’s life. Bear in mind that assets with a higher risk profile will offer potential greater returns, but also carry the risk of potentially greater losses.

Price. Every equity listed on an exchange is priced individually according to a wide range of variables (discussed below), and those prices fluctuate in response to changing conditions. Prices are a valuable market signal, but you can’t tell much about a particular stock based on price alone.

Is Stock A trading for hundreds of dollars per share at its peak, or does it still have the potential to grow? Is low-priced Stock B undervalued based on the company’s outlook, or does it reflect the company’s weak prospects for future earnings? Learning how to conduct a fundamental analysis of a company’s earnings and growth potential (see below), and tracking stocks and market conditions over time, can help to determine if the current price accurately reflects a stock’s value as an investment.

Diversification and allocation. Diversification refers to the process of dedicating portions of your portfolio to different types of investments as a way to manage your overall risk of losses—it’s a way of “not putting all your eggs in one basket,” so to speak. That way, if a particular investment or asset class within the portfolio should decline in value, the loss may be offset by gains in another part of the portfolio.

One common tactic is to diversify by asset class. For example, many investors will strive to hold a mix of equity and debt instruments (stocks and bonds), along with cash) with different characteristics as a hedge against risk.

Investors also commonly diversify within asset classes. For example, instead of investing in a single stock, an investor will hold a variety of stocks from different companies, industries and economic sectors; instead of investing in a single bond, an investor will hold a variety of bonds of different types and with different maturity dates.

In addition, investors may choose to diversify assets according to their age or risk tolerance, and how the investor allocates the proportions of investments within their portfolio is likely to change over time.

So for example, an older investor nearing retirement may devote a greater percentage of his portfolio toward less volatile investments, like bonds and income-generating equities; a younger investor with a longer time frame may elect to take on additional risk in hopes of generating greater returns for her portfolio over a longer time horizon.

The key lesson when it comes to diversification and allocation is that everyone’s situation is different, and there’s no single “right” answer to how one should diversify and allocate his or her portfolio. That’s why it’s important to have a clearly articulated investment strategy, which is where a licensed financial professional can be very helpful.

Fees. Keep in mind that investing in stocks entails transaction costs beyond the price of the shares. A brokerage will charge fees or commissions for any purchases or sales of stocks; in most cases, these will be reasonable service charges, but keep an eye on your portfolio to ensure that fees or commissions paid do not cut too deeply into your returns. Even small fees can add up over time, and more frequent trading will, predictably enough, trigger additional transaction charges.

Depending upon your relationship with your broker or financial advisor, you may also incur additional fees for expert advice or portfolio management. Make sure you understand in advance what fees you will pay and how they may affect the overall return on your portfolio.

Taxes. If you hold a stock for a period of time and it appreciates in value, you can expect to pay taxes on your profit when you sell your shares. (But you pay no taxes on the appreciation in value as long as you continue to hold the stock). The tax laws distinguish between short-term and long-term capital gains. If you hold a stock for less than a year, the short-term gains will be taxed at your same tax rate on other types of income. Conversely, if you hold a stock for more than a year, your tax liability on the long-term gain will be less than for short-term gains.  If you sell the stock at a capital loss, you will typically be able to claim the loss on your tax return to reduce your tax liability for capital gains and sometimes against other types of income.

Either way, be aware that selling shares is likely to have tax implications, and be sure to consider how taxes, like fees, will affect the performance of your portfolio.

Note also that any gain or loss will be calculated based on the “cost basis,” that is, what you paid to purchase the shares. The capital gain or loss will be calculated based upon the difference between the cost basis at the time of purchase and the market value at the time of sale (with adjustments for stock splits and dividends). So be sure to maintain careful records of when you buy and sell shares to ensure accurate tax reporting. (A caveat: If you hold securities in a tax-deferred retirement account, different tax rules may apply, so talk to an investment professional or accountant about how taxes may affect your retirement portfolio.)

Inflation. The point of investing in equities or any other asset class, for the vast majority of people, is to build wealth and ensure purchasing power for the future. Inflation, the macroeconomic dynamic of rising costs for goods and services, can erode your purchasing power over time.

While the inflation rate will generally not be a top concern for most investors’ day to day decision-making, you should strive to ensure the overall returns on your investing portfolio outpace inflation over time. Investors who are concerned about inflation may choose to seek out the stocks of companies with the ability to adjust their prices and profits in response to changing economic conditions.

A word about bears and bulls

You’ve likely encountered the terms “bear market” and “bull market” in the media. These are colloquial shorthand terms used to describe overall market conditions.

It’s said that the terms are based on how the respective animals attack adversaries. An attacking bull thrusts his horns upward, while the bear swipes his paw downward to strike. So in a bull market stocks are rising, and investors are making money; in a bear market, stock prices are falling, and investors are losing money. These market descriptions often correspond to broader economic conditions.

An additional income generation opportunity appreciated by many equity investors is the dividend payment made to shareholders. A dividend is a payment made by a company to its equity shareholders, usually on a quarterly basis, from profits or cash reserves. Essentially, it’s the cut of the earnings you’re entitled to as a partial owner of the company. (For a more in-depth introduction to how dividends work, read the Project Invested primer on dividends).

Profits that are not distributed to shareholders as dividends are known as “retained earnings.” Retained earnings may be used to finance expansion, mergers, acquisitions or other types of investment aimed at growing the company. As a general rule, larger, more established firms are more likely to pay dividends to investors, since they have fewer viable opportunities for expansion; younger start-up firms that are still on the grow are more likely to forego dividend payments in favor of reinvesting earnings to expand the company.

The most common types of dividends are cash dividends, which means investors get a cash payment based on the number of shares they hold, and stock dividends, whereby a company issues investors additional shares of stock.

Many investors opt to reinvest their dividends to purchase additional shares of stock, which enhances the likelihood their portfolio will grow over time through the power of compounding. In cases where the quarterly dividend payment is less than the price of a share of stock, the investor can be issued fractional shares, which gradually increase their ownership stake and generates further dividend payments. Some companies have established Dividend Reinvestment Plans (DRIP) for small retail investors seeking to boost their returns through this innovative means of growth investing.

Do note, however, that dividend payments are taxable as income and you will need to declare total annual dividend receipts on your annual tax return. For tax reporting purposes, your broker or financial institution will mail you an annual IRS Form 1099-DIV statement listing the total dividends you were paid over the course of the year.

In the popular imagination, the pathway to investing success may lie in getting hot stock tips, or in reading the headlines in financial media sources to find new opportunities, or in having a “gut feeling” that the price of a particular stock will skyrocket.

But a more reliable approach to success is to develop and hone essential skills in analyzing a business, based on a careful evaluation of empirical factors, in order to assess the company’s potential for long-term growth. For beginning investors, here are a few basic things to know about researching and analyzing a company to determine if the stock is a good buy.

Get to know the company and the industry. An important first step in analyzing a stock is to develop a deeper understanding of the company and its place in the industry. What are the company’s products or services? Who runs the company? What’s their business plan? Who are their primary customers? How do they make money? What are their assets and liabilities? Who are their competitors? What are the potential risks to the business’s long-term health?

One way to get a snapshot of a company’s current standing is to study its annual 10K report, quarterly earnings statements and other recent public documents. Be aware that some corporate communications may highlight positive news and downplay potentially negative news, so learn to read with a skeptical eye and to focus on key facts like earnings, revenue, and business risks. Check out Project Invested’s guide to reading corporate reports for more.

Listen to quarterly earnings calls. Publicly listed corporations are required to file quarterly earnings statements. Most companies will also hold a quarterly conference call in which executives will discuss the recent performance and take questions from analysts. These calls are open to the public, and can be a good way to learn more about the strengths and weaknesses of a company. Check out the Project Invested guide to listening to quarterly earnings calls for more.

Learn to interpret financial statements. Developing fundamental skills in reading a company’s balance sheet and income statement can give you a useful overview of how the company is doing right now. You don’t have to be an accountant to understand a company’s assets, liabilities, revenues and profit, but you’ll want to do your homework to know what to look for. Learning to compare financial statements over time may help you to spot trends in company performance that will shine a light on whether the stock is a good long-term bet.

Calculating earnings per share and the price/earnings (P/E) ratio. One way to begin developing a more evidence-based approach to assessing equities is to learn some basic calculations related to valuation, based on publicly available information.

Earnings per share (EPS) is a useful metric for getting a quick understanding of a company’s actual performance. It essentially asks the question, is this company making money? To calculate EPS, look to the company’s income statement to find the after-tax profit and divide that number by the average number of outstanding shares. Since the number of outstanding shares may change over time, many calculations use a weighted average of shares outstanding over the reporting period. Or to make it even easier, type the company’s name and “earnings per share” into any online search engine. Various market exchanges and financial firms provide reports and charts on company variables like EPS that make it easy to assess performance over time.

With the EPS, you can readily calculate the company’s price-earnings (P/E) ratio. The P/E ratio is determined by dividing the current stock price by the EPS, and it can help you determine if a stock is overvalued or undervalued by comparing it to other companies’ P/E ratio. The higher the P/E ratio, the more an investor is willing to pay to purchase the stock.

The EPS and P/E ratio won’t tell you everything you need to know about a company or if the stock is a good investment. But at the very least, learning how to determine these variables for yourself can be your starting point in learning to think more carefully about the potential of any given equity investment based upon the company’s reported performance.

Recognizing these analytical tools are only the tip of the iceberg. There’s a vast amount of literature on fundamental and technical analysis of equities, and banks, financial institutions and institutional investors have armies of skilled professional analysts who examine companies in granular detail to determine their growth potential. It can be tough to outperform the professionals.

The basic analytical tools introduced here won’t tell you which stocks will thrive in the future—you’ll still need to develop a sense of judgment, honed by experience, to make solid decisions. However, understanding the fundamentals of analyzing a company can be a good place to start in developing a more sophisticated approach to investing in equities based on evidence and reasoning, rather than guessing and hoping.

A word about market bubbles

A market “bubble” refers the idea that assets have grown collectively overpriced relative to their actual value, and investors come to believe the market can only continue to go higher. In that case, the market is likely to “correct” itself when the bubble pops and assets decline to lower values.

In a well-known recent example, the stock values of many Internet-based firms in the last 1990s were pushed to surprising heights based on investor enthusiasm and strong demand, creating a bubble. When that bubble popped, many investors lost a substantial amount of money, and many of the companies were liquidated.

It’s not always easy to tell the difference between a vibrant, growing market and a bubble, and timing the market is difficult. But experience in watching the market and researching companies may make you better attuned to the signs of a possible bubble so you can steer clear of investing in overpriced assets.

One challenge for both beginning and experienced investors is selecting which equities to buy for their portfolio. Any experienced investment professional will advise assembling a diversified portfolio that reflects a variety of asset classes (including equities, bonds and cash), with a mix of securities representing different industries and economic sectors.

There are a wide variety of different investing styles and strategies, and each investor needs to consider what type of approach is right for his or her goals. Beginning investors will want to consider if they prefer to pursue an active or a passive strategy.

Some individuals prefer an active investing approach, in which they play a hands-on role in researching, selecting and trading stocks on a regular basis. An active trading approach can generate higher returns—but it can also generate greater losses, since the approach often entails greater levels of risk. In addition, a higher trading volume will trigger additional transaction costs in the form of more fees and taxes, so be aware of the effect these costs can have on your overall portfolio.

Conversely, many people prefer a passive investing approach, which requires less hands-on attention but still allows them to enjoy the benefits of long-term growth in the market. These investors may prefer to practice strategies like buying and holding stocks for a longer period, or dollar-cost averaging to build a larger equity position over time. Like all investing, passive strategies come with risk, and you’ll still need to pay attention to your portfolio to ensure appropriate diversification and allocation.

Many investors practice hybrid forms of active and passive investing. Again, there’s no “one size fits all” answer, which is why it’s important to have a clear sense of your investing goals and strategy.

In addition, there are a variety of different types of investing vehicles that allow you to purchase equities in ways that help to manage risk.

Investing through a broker. An investor can always select individual stocks based upon his or her own research or the advice of a financial professional. To invest in equities this way, you’ll need to form a relationship with a broker-dealer who will act as your intermediary in purchasing equities on an exchange.

Decades ago, that required direct contact with a broker, either by an office visit or phone call. Today’s investors have more options. If you simply want to purchase stocks with a minimum of professional support, you can create an account with any online brokerage service and start trading almost immediately.

Investors who want higher levels of guidance and support may elect to open an account with a full-service brokerage firm. You will likely pay additional fees, but many investors are open to higher costs in exchange for higher levels of service.

Keep in mind that picking winners is hard, even for experienced investors. If you plan to invest in individual stocks, pay careful attention to diversification and allocation, as an investment portfolio made up of a smaller number of individual equities will likely magnify the risks of stock ownership.

Investing through Direct Stock Purchase Plans (DSPP). Many public companies offer DSPPs that allow investors to buy equity shares directly, typically with low or no fees. These plans will often be administered by a transfer agent, usually a bank, trust or financial institution that manages and tracks the ownership of shares. DSPPs allow companies to issue new shares and acquire additional capital funding by selling directly to investors.

These plans can be an attractive option for those who practice a “buy and hold” investing strategy, since they are frequently set up to allow an investor to purchase additional shares on a regular basis over a longer term at a low cost. Dividend reinvestment plans, as discussed in the “What are dividends?” section above, are a type of direct purchase plan.

Investing through mutual funds. A mutual fund is a collective investment vehicle that pools money from a large number of investors to purchase a portfolio of equities, bonds or other securities. If you have a personal retirement account like a 401(K) or an IRA, you are likely invested in one or more mutual funds. In recent decades, mutual funds have grown rapidly in popularity, since they allow an investor to purchase a wide range of securities at one time without having to research each of the companies in individual detail. It’s a form of instant diversification.

There are mutual funds centered around virtually every industry, market sector or investing strategy, so research the options to find a fund vehicle that reflects your investing goals and risk tolerance.

Two particular types of mutual funds that have grown in popularity among investors are index funds and life-cycle funds. An index fund is a mutual fund that is designed to track with a major stock index. For example, an S&P 500 Index fund would invest in shares all of the companies listed on the S&P 500. So if that index goes up, so does the value of your investment. Index funds are a form of passive investing, and one of the principal advantages of these funds is that they typically have relatively low expense ratios and lower fees.

A life-cycle fund automatically adjusts the allocation of securities from a position of higher risk to one of lower risk as the investor ages. So, for example, if an investor purchases shares in a life-cycle fund at age 25, her portfolio allocation will be weighted more heavily toward equities, which have a higher risk profile. As she nears retirement, her portfolio composition will automatically adjust to reflect a smaller proportion of stocks and a larger proportion of bonds and cash, which typically carry less risk. Life-cycle funds have grown in favor with investors seeking to manage their portfolio risk without having to worry about reallocating the assets their portfolio on a regular basis.

Do recognize that the standard warnings about risk apply to mutual funds—you can lose money investing in a mutual fund just as in any equity investment—and keep a close eye on transaction fees that may reduce the value of your investment. Moreover, since mutual funds don’t trade on the open market, they can’t be bought and sold as quickly as an exchange-traded stock, so they are somewhat less flexible as investments.

Investing in Exchange Traded Funds (ETF). ETFs stake out a middle ground between individual stock investing and mutual funds. Like a mutual fund, an ETF is a collective investment vehicle that invests in a selection of equities, typically with lower fees. However, ETF shares are traded on the exchange like markets, and can be bought and sold throughout the trading day.

A word about short selling

Short selling is a form of trading in which an investor, believing a particular stock to be overvalued, essentially bets against the asset by contracting to “borrow” shares from a broker, for a fee, then sell those shares. If the stock declines in price, the short seller can make a profit by purchasing shares at the lower price to replace the loaned shares.

There’s a downside, though: should the stock increase in price, you’ll have to buy the stock back at the higher price—a situation in which you’ll actually lose more than you’ve invested. The risk of short-selling is theoretically infinite because there is no limit on the growth of the stock’s price the investor will have to pay to replace the “borrowed” shares, but the investor’s potential gains are limited to the amount that the stock’s price can fall (which will not go below zero).  That’s why short selling can be risky, and is an investing strategy best left to those with a deep understanding of the market and the financial ability to withstand potential losses.

Short selling strategies can be controversial, but they actually make a valuable contribution by serving to identify overpriced assets in the market. The ability to make substantial profits by getting a short sale right can be a compelling incentive for investors who know what they’re doing.

It’s easier than ever to get started building a diversified portfolio, simply by creating and signing into an online account with a brokerage firm.

However, if you’re uncertain of how to move forward, a talk with a broker, investment advisor or other financial professional can help you to articulate and clarify your goals. Many financial professionals are happy to meet for an initial consultation at no charge, but even if you incur a fee for professional consulting, this approach may save you from making costly errors that may hurt your long-term returns.

Once you find a broker or advisor you’re comfortable working with, discuss with him or her which investments are most appropriate for your goals. If you invest in equities, be sure to request detailed information about the specific stocks in which you are interested before investing.

Always keep in mind when investing in any asset: past performance does not guarantee future results. This reality is certainly true for equity investing. It’s possible a company that’s been highly successful for a long period of time will experience slower than expected growth. A company may face setbacks due to poor decision-making, changes in consumer preferences, increased competition or a shift in market conditions. In such cases, the value of your investment could fall, creating a capital loss.

Remember: careful investing is not guessing, and it’s not gambling. It’s an exercise in saving and long-term decision-making in an environment of incomplete information. Your job as an investor is to work to understand the market and make informed judgments as to how to best allocate your savings in a diversified portfolio that will achieve solid returns over the course of your investing life. Working closely with a financial professional can help you toward that goal.

Allocation. Assigning percentages to different asset classes within an investment portfolio to manage risk.

Bear market. A market in which share prices are declining.

Bonds. Securities that represent debt obligations. Bond investors receive regular fixed income payments over the life of the investment, and are repaid the face value of the bond upon maturity.

Book entry. A method of recording and transferring ownership of securities electronically, eliminating the need for physical certificates.

Bubble. A market dynamic in which trading of assets drives up prices to levels that exceed their intrinsic value, often based on speculation and/or crowd psychology.

Bull market. A market in which share prices are rising.

Capital gain (or capital loss). When a stock is sold for a profit, the capital gain is the difference between the net sales price of the securities and their net cost, or original basis. If a stock is sold below cost, the difference is a capital loss.

Cost basis. The original value of an asset as reported for tax purposes. The cost basis is used to calculate the capital gain or loss on an investment.

Direct Stock Purchase Plan (DSPP). A plan that allows investors to purchase equity shares directly from the issuing corporation, rather than through a financial intermediary, often at a lower cost.

Diversification. The process of dedicating portions of a portfolio to different types of investments to reduce the overall risk of losses.

Dividend Reinvestment Plan (DRIP). A type of Direct Stock Purchase Plan in which dividends paid to an equity shareholder are automatically directed toward the purchase of additional shares of stock.

Dividend. A regular payment made by a company to its equity shareholders, usually on a quarterly basis, from profits or cash reserves, typically in the form of cash or additional shares of stock.

Earnings per share (EPS). A company’s profit divided by its number of outstanding common shares. EPS is a simple indicator of a company’s profitability.

Equities. Tradable financial securities that represent a share of ownership in a corporation. More commonly known as “stocks.”

Exchange-traded fund. A type of fund that is an exchange-traded security, experiencing price changes throughout the day as they are bought and sold. ETFs are composed of underlying assets that typically track an index.

Index fund. An investment mutual fund designed to track the returns of a designated market index.

Initial public offering (IPO). The first offering of a company’s equity shares on a public market exchange. A company undergoing an IPO is said to be “going public.”

Life-cycle fund. An investment mutual fund that automatically adjusts allocations of assets to reflect changing risk profiles as the investor ages.

Liquidity. A measure of the relative ease and speed with which a security can be purchased or sold in a secondary market.

Market indexes. A weighted composite of equities that collectively serves as a benchmark for the movements of the market as a whole.

Mutual fund. An investment vehicle that invests pooled cash of many investors to meet the fund’s stated investment objective.

Offering document (Official Statement or Prospectus). The disclosure document prepared by the issuer that gives detailed security and financial information about the issuer and the securities being issued.

Over-the-counter market. A decentralized market where geographically dispersed dealers are linked by telephones and computers. The market is for securities not listed on a stock or derivatives exchange.

Price/Earnings (P/E) ratio. The current stock price divided by the earnings per share.

Primary market. The market for new issuances of assets.

Proxy vote. An “absentee ballot” for a shareholder who is unable to attend an annual company meeting to vote on corporate ballot issues. The shareholder indicates their voting preferences and delegates to management the responsibility to vote their shares as directed.

Retained earnings. Earnings not paid out as dividends and held by the firm for reinvestment in the company’s operations.

Risk. The chance that an actual return on an investment will be higher or lower than expected, including a loss of some or all of the original investment.

Secondary market. Market for previously issued securities.

Securities. Financial instruments that can be traded by buyers and sellers in capital markets. Debt securities (bonds) and equity securities (stocks) are among the most commonly traded financial instruments.

Stocks. See equities.

Transfer agent. A business entity, usually a bank, trust or other financial institution, that manages and tracks a public company’s stock or bond issues.

U.S. Securities and Exchange Commission (SEC). Federal government agency responsible for enforcing securities laws and regulating the securities industry and capital markets.