Question #3: I want to buy Apple, but the stock costs several hundred
dollars per share, and I don’t have enough money to buy 100 shares. Should I
stick to cheaper stocks?
Answer: This question requires two answers. First, regarding the issue
of purchasing 100 shares. A couple of decades ago, buying shares in round
lots of 100 mattered. Brokers didn’t like dealing with smaller trades, and in
many cases they charged lower commissions for round lots. Some fullservice brokers still prefer to deal in round lots, but with securities trading
electronically and discount brokers charging a fixed rate for most trades,
today you can buy 87 shares of Stock A and 42 shares of Stock B, and
nobody will give you a hard time.
The financial world has evolved, and dollar-based investing has become
popular. Dollar-based investing focuses on the size of the stock position in
dollars, not shares. Suppose you have $25,000 to invest and wish to
purchase 10 stocks. Consider putting $2,500 in each stock, which equates to
50 shares of a $50 stock, 83 shares of a $30 stock, or 29 shares of an $80
stock. Holding equal dollar amounts of all your stocks not only reduces the
risk inherent in lopsided portfolios (if your biggest holding falls, it causes a
disproportionate decline in the value of your entire portfolio), but also
makes it easier to assess how each of your stocks are performing. If you
start out with equal-dollar positions, you can tell at a glance which stocks
have risen and which have fallen.
The second answer addresses the issue of cheap stocks. Many investors,
particularly those who began buying stocks during the days when everyone
purchased shares in round lots, still view a $100 stock as more expensive
than a $50 stock. However, professionals value stocks relative to earnings,
cash flows, or sales, and so should you.
For example, a stock that trades for $100 per share and earns $10 per
share has a price/earnings ratio of 10, while a $50 stock that earns $2.50
per share trades at 20 times earnings—and the $50 stock looks more
expensive than the $100 stock.
Whether you purchase 50 shares of the $50 stock or 25 shares of the
$100 stock, a 10% rise in the stock’s price will have the same effect—
boosting your holdings in that stock to $2,750 from $2,500.
Question #4: Which should I buy, stocks or bonds?
Answer: For most investors, the smart answer is both. Both stocks and
bonds play an important role in a portfolio. While stocks offer superior
growth potential during good years (as well as a lot more downside
potential during bad years), bonds provide greater income and steadier
overall returns (though they can’t match stocks for potential upside).
While not all stocks trace the same path, they do tend to move in similar
directions. If the S&P 500 Index has returned 15% in a given year, for
example, most stocks—even those outside of the index—have probably
posted positive returns. Some tread more quickly than others, of course.
Bonds also tend to move in the same direction as other bonds, though
different classes within the bond group (such as long-term corporate bonds,
Treasury bills, high-yield bonds, etc.) will see their returns diverge.
While both bonds and stocks tend to run in loose packs, a fact investors
should exploit to reduce volatility is that those packs don’t often run
together. So, how much should you put in stocks versus bonds? There’s no
single right answer that applies to everyone. But you can start with this
longtime industry rule of thumb: Subtract your age from 110, and you have
a good baseline for stock exposure. The equation suggests a 30-year-old
should hold 80% stocks and 20% bonds, while an 80-year-old should hold
30% stocks and 70% bonds. Of course, many other factors beyond age
contribute to this decision, as discussed in Chapter 11.
Basic Knowledge You Should Know About Investment part 2.
