This article outlines some of the typical methods used to invest in stock market. The investor may choose from among many different types of securities, but this discussion will be limited to the purchase of common stocks.
Market timing
One of the first issues facing the investor is deciding when to invest in the stock market. It is apparent that stock prices commonly rise or fall for extended periods. These fluctuations mean that the investor who is able to predict broad market movements can earn superior returns relative to a buy-and-hold strategy by purchasing stocks before the market rises and converting these holdings to cash (liquid interest-earning assets such as treasury bills) before the market falls. While some analysts do attempt to predict market movements either through economic forecasts or the analysis of stock price trends, investors are seldom totally convinced that the future direction of the market can be known in advance. Consequently, most equity investors keep part of their portfolio invested in the market at all times and keep the remainder in cash. When the market is expected to fall they decrease the proportion invested in equities, and when it is expected to rise they increase the proportion.
Industry grouping
As economic conditions change, stocks in the same industry group tend to behave in a similar fashion. For example, in a recessionary period the earnings of all firms will tend to decline but the earnings of construction firms as a group may fall further than the earnings of merchandising firms.
An investor who is unable to predict which industry will provide the best future return will likely allocate funds among the industries in roughly the same proportions as the composite index. This strategy should capture any upward movement in the market. On the other hand, the investor who feels able to pick those industries that will be able to exhibit superior performance can be expected to give more weight to those industries in making up a portfolio. Two of the more common methods of choosing the industry weights for a portfolio are based on business cycles and movements in interest rates.
Cyclical stocks
Cyclical stocks are stocks of firms with economic prospects that change noticeably with each phase of the business cycle. When there is a recession, the profits of cyclical stocks, such as metals, forest products, housing and automobiles, decline quite dramatically, whereas the profits of non-cyclical stocks, sometimes called "defensive stocks," such as food, medical care, nursing homes, publishers, and breweries, tend to resist decline. This resistance to decline generally occurs because the firms represent essential services or products that continue to be consumed at a relatively steady pace regardless of the state of the economy. Conversely, when the economy is expanding, cyclical stocks tend to outperform non-cyclical stocks.
Interest-sensitive stocks
Interest-sensitive stocks are stocks of those firms with profits that are highly dependent on the level of and direction of change in interest rates. These firms usually have a high proportion of debt in their capital structure, an above-average dividend payout rate and a reasonably stable growth in revenues. Utilities are typical interest-sensitive stocks. If interest rates rise, the cost of carrying the heavy debt load rises and, since revenues are regulated, it takes some time before cost increases can be passed on to the consumer. In the meantime profits decline. As a result of this phenomenon, the price of an interest-sensitive stock falls in periods of rising interest rates, whereas in a period of falling interest rates the price of an interest-sensitive stock rises.
