Ask any investor why he or she owns a particular stock, and you may hear about how it feels to own a piece of a well-known company or receive regular dividends. But how can stocks benefit your portfolio? Let’s take a closer look.
The Case for Owning Equities
Equities can add diversification and serve as a growth engine to help build value over time:
Higher growth potential – Equities serve as a cornerstone for most portfolios because of their potential for growth. In the chart below, you can see that stocks have a long track record of providing higher returns than bonds or cash alternatives. In fact, large domestic stocks have provided an average annualized return of 10.6%.
But remember – you need to balance reward with risk. Generally, stocks with higher potential return come with a higher level of risk. Investing in equities involves risks. The value of your shares will fluctuate, and you may lose principal.
The power of compounding – Compounding can work to your advantage as a long-term investor. When you reinvest dividends or capital gains, you can earn future returns on that money in addition to the original amount invested.
Let’s say you purchase $10,000 worth of stock. In the first year, your investment appreciates by 5%, or a gain of $500. If you simply collected the $500 in profit each year for 20 years, you would have accumulated an additional $10,000. However, by allowing your profits to stay invested, a 5% annualized return would grow to $26,533 after 20 years due to the power of compounding.1
Dividend income – Many companies choose to pay dividends on a regular basis, most often quarterly. Dividends can be used to supplement one’s income or may be reinvested to buy additional shares:
- If you’re using this money as a regular income stream, consider staggering your stocks’ dividend payments dates.
- If you reinvest your dividends and buy additional shares of stock, your money has the potential to grow faster.
Keep in mind that dividends can be increased, decreased or eliminated at any point without notice.
Purchasing power protection – Inflation reduces how much you can buy because the cost of goods and services rises over time. Equities offer two key weapons in the battle against inflation: growth of principal and rising income. Stocks that increase their dividends on a regular basis give you a pay raise to help balance the higher costs of living over time.
In addition, stocks that provide growing dividends have historically provided a much greater total return to shareholders, as shown below.
How Edward Jones Can Help
Before your financial advisor recommends a stock to you, it must pass Edward Jones’ disciplined analysis. We look at factors including balance sheet strength and management’s track record to assess a company’s quality. We spend time thinking about past, present and future opportunities and challenges for each sector to identify the companies we believe have sustainable competitive advantages for the long term.
Then we apply strict valuation analysis and consider any specific risks to determine a fair price for the stock. This is how we determine a Buy, Hold or Sell recommendation. Our team of Certified Financial Analysts and investment professionals challenge one another throughout the process to make thoughtful, well-informed decisions.
Our guidance can be summed up in three points:
1. Focus on quality.
We filter stocks based on geography, longevity, financial risk and a company’s size before applying fundamental and valuation analysis.
Narrowing the Selection
Country – We consider companies primarily based in the U.S., Canada and Europe that follow familiar accounting standards and reporting requirements.
Longevity – The companies we follow need a solid track record – typically 10 years or more of operating history. This means the company has likely faced at least one economic downturn and management has experience with adversity as well as success.
Financial health – We seek to exclude those companies that have below-investment-grade credit quality and weak financial strength.
Size – Larger companies usually possess a longer track record of success, a broader base of customers and sales, as well as management depth. We consider companies with at least $2.5 billion in market value and at least $1 billion in annual revenue for coverage.
Fundamental analysis – Once companies meet the above criteria; our analysts perform a deep dive of a company’s financial and operating history and project future earnings, cash flow and a fair value of the company.
We believe paying dividends is one important measure of a quality stock. A company’s ability to consistently raise dividends can demonstrate profitability. Companies that have excess cash flow and strong financial positions often choose to pay dividends to attract and reward their shareholders. As a result, they’re often less volatile than stocks that don’t pay dividends.
But beware of reaching for high yields. A higher-yielding stock could be a signal that investors are concerned whether the company can continue to pay its dividend. We’ve found these stocks are most at risk of cutting their dividends.
2. Diversify your stock positions.
Diversifying your investment portfolio can help protect against market fluctuation. Look at the following factors when you’re planning to diversify:
Asset allocation – Your portfolio’s asset class mix is one of the most important factors in determining performance. Look at the size of a company (or its market capitalization) and its geographical market – U.S., developed international or emerging market.
We recommend that, when owning individual securities, you consider a diversified portfolio of domestic large-cap and mid-cap stocks. For the more volatile international, emerging-market and small-cap stocks, we favor a mutual fund to help manage risk. Remember, while diversification cannot guarantee a profit or prevent a loss, it can help smooth out performance over time.
Sector allocation – Once you’ve diversified by asset class, we recommend going deeper with diversification across the major market sectors and then industry sub-sectors. This is because economic cycles and market shocks can impact industries very differently.
Price movement – To help understand the risk you’re taking, consider a stock price’s tendency to move up or down relative to the market. We suggest owning a balanced mix to help smooth performance over time.
Investment concentration risk – At minimum, we recommend owning 15 individual stocks to limit overconcentration in any single stock or sector. If you’re using individual stocks as the primary way to gain large-cap equity exposure for your portfolio, then up to 30 stocks may be necessary.
3. Invest for the long term.
While investing with a long-term view sounds simple enough, sticking to this principle requires discipline. We believe you should buy investments with the intention of owning them through good and bad markets. We base our investment guidance on a long-term view. For our stock recommendations, we typically use a three- to five-year outlook.
Market declines can be unnerving. But bull markets historically have lasted much longer and have provided positive returns that offset the declines.3 Also, market declines often represent a good opportunity to invest. Strategies such as dollar cost averaging and dividend reinvestment can help take the emotion out of your investing decisions.4
As the chart below illustrates, we believe no one can accurately “time” the market. An investor who missed the 10 best days of the market experienced significantly lower returns than someone who stayed invested during the entire period, including periods of market volatility. We recommend staying invested with a strategy that aligns with your financial goals.
Time to sell – From time to time, you may need to sell a stock to help maintain proper diversification among sectors or limit overconcentration in a stock position. Significant changes in a company’s fundamentals or a stock’s overvaluation may also be reasons to sell. And as your portfolio’s objective changes over time, the types of stocks you own may need to change to meet income needs or match your risk tolerance.
Now that you’ve learned about stocks and how Edward Jones can help, it’s time to take action. Discuss your options with your financial advisor to find out what stock ownership can do for you.
Owning Individual Stocks
With thousands of stocks to choose from, what is the best way for you to invest? Your financial advisor looks at the following:
- Your financial goals
- How much money you plan to invest
- Your risk tolerance
- Your desired level of involvement
- The type of account
You can own stocks individually or through actively managed mutual funds, index funds or exchange-traded funds (ETFs). Take into account the following before you purchase individual stocks:
Tax control advantages2 – With individual stocks, you control when to buy and sell. Individual stock ownership may reduce your tax burden.
Cost efficiency – If you intend to hold your equity investment for a long time, buying individual stocks may be very cost effective. Ask your financial advisor for more information on the types of accounts and costs available at Edward Jones.
Customization and transparency – If you want to be involved in the decision-making process, individual stock ownership may suit you. Individual stocks offer the customization and transparency that mutual funds, index funds and ETFs generally do not. Your financial advisor can work with you to build a stock portfolio with only those companies you want to own.
Potential for higher risks – Be sure to consider the trade-offs before investing in individual stocks. The risk of losses and price volatility may be higher, especially if your portfolio is not properly diversified.