STOCK MARKET BASICS

Stocks, or equity securities, are simply shares of ownership in a corporation that are available for purchase by the public. The price of a company's stock changes from day to day, reflecting the company's performance and marketplace demand for the stock. Stocks are generally considered to be relatively risky investments because their value can increase or decrease significantly in a very short period of time.

Over the long term, however, stocks have historically outperformed other investments, such as bank deposits, CDs, bonds, and real estate, as illustrated by the chart below.

Types of Stocks
There are several categories of stocks, each with different characteristics.

Blue chip stocks are those issued by large companies with a good earnings track record. Because the companies are well established, with somewhat predictable earnings, their stock prices tend to fluctuate less than other equities and have relatively stable prices. These companies often pay steady dividends, giving the investor income in addition to the potential for capital appreciation. Dividends often increase as the company’s earnings grow.

Growth stocks are those issued by companies with fast-growing profits. They are generally riskier than blue chips because stock growth could plateau or fall, especially if the rise in company earnings is interrupted. For example, a pharmaceutical company whose revenues are inflated by sales of new, highly desirable drug might be in a growth mode until that drug is proven to be ineffective or to have dire side-effects. Over the long term, growth stocks generally outperform blue chips.

Small company stocks usually hold the greatest growth potential. A small company stock may be relatively new to the marketplace, so its price has a lot of room to grow if the company succeeds. But with the increased potential for long-term price appreciation, there is also a bigger risk of a price drop. These companies don’t have the proven viability or the financial strength of large corporations.

Stock Market Price Cycles
As surely as tides surge and ebb, stock prices rise and fall. Many factors influence stock performance—the economy, interest rate movements, government actions (such as taxation, spending and industry regulation), the returns available in the bond market and other alternative investments, as well as human emotion. Changing technology, the time of year and new domestic and overseas markets also play important roles.

For example, rapid inflation can turn investors bearish on stocks. When inflation increases, the Federal Reserve Board usually raises interest rates to cut back on borrowing and slow rising prices. Inflation raises the cost of borrowing money—and of most other things—which cuts into corporate profits.

Generally, the stock market cycle and the economic cycle run the same pattern—but not simultaneously. Stocks tend to reach their low points before the economy hits the bottom of its cycle. With prices low, investors begin buying stocks again in anticipation of higher prices later, when the economy begins to recover. In the next phase, the early bull market, stocks increase further as their upward momentum and an improving economy bring more buyers into the market. At the top of the bull market, stock prices level off before the economy peaks. Stocks then begin to decline in anticipation of an economic slowdown.

Be aware, though, that market cycle theory and reality are often different. Stock market cycles are like the weather—you can never predict exactly what’s going to happen. The next bull market is not going to be just like the last one. Also, certain stocks buck the trend. Some perform poorly in bull markets while others may climb in declining