Market Strategies

During most of the 20th century, investors could earn more by investing in stocks than in other types of financial investments — provided they were willing to hold stocks for the long term.

In the short term, stock prices can be quite volatile, and impatient investors who sell during periods of market decline eas­ily can suffer losses. Peter Lynch, a renowned former manager of one of America's largest stock mutual funds, noted in 1998, for instance, that U.S. stocks had lost value in 20 of the previ­ous 72 years. According to Lynch, investors had to wait 15 years after the stock market crash of 1929 to see their holdings regain their lost value. But people who held their stock 20 years or more never lost money. In an analysis prepared for the U.S. Con­gress, the federal government's General Accounting Office said that in the worst 20-year period since 1926, stock prices increased 3 percent. In the best two decades, they rose 17 per­cent. By contrast, 20-year bond returns, a common investment alternative to stocks, ranged between 1 percent and 10 percent.

Economists conclude from analyses like these that small investors fare best if they can put their money into a diversified portfolio of stocks and hold them for the long term. But some investors are willing to take risks in hopes of realizing bigger gains in the short term. And they have devised a number of strategies for doing this.

Buying on Margin. Americans buy many things on cred­it, and stocks are no exception. Investors who qualify can buy "on margin," making a stock purchase by paying 50 percent down and getting a loan from their brokers for the remainder. If the price of stock bought on margin rises, these investors can sell the stock, repay their brokers the borrowed amount plus interest and commissions, and still make a profit. If the price goes down, however, brokers issue "margin calls," forcing the investors to pay additional money into their accounts so that their loans still equal no more than half of the value of the stock. If an owner cannot produce cash, the broker can sell some of the stock — at the investor's loss — to cover the debt.

Buying stock on margin is one kind of leveraged trading. It gives speculators — traders willing to gamble on high-risk situations — a chance to buy more shares. If their investment decisions are correct, speculators can make a greater profit, but if they misjudge the market, they can suffer bigger losses.

The Federal Reserve Board (frequently called "the Fed"), the U.S. government's central bank, sets the minimum margin requirements specifying how much cash investors must put down when they buy stock. The Fed can vary margins. If it wishes to stimulate the market, it can set low margins. If it sees a need to curb speculative enthusiasm, it sets high margins. In some years, the Fed has required a full 100 percent payment, but for much of the time during the last decades of the 20th centu­ry, it left the margin rate at 50 percent.

Selling Short. Another group of speculators are known as "short sellers." They expect the price of a particular stock to fall, so they sell shares borrowed from their broker, hoping to piof-it by replacing the stocks later with shares purchased on ihe open market at a lower price. While this approach offers an opportunity for gains in a bear market, it is one of the riskiest ways to trade stocks. If a short seller guesses wrong, the price of stock he or she has sold short may rise sharply, hitting ihe investor with large losses.

Options. Another way to leverage a relatively small outay of cash is to buy "call" options to purchase a particular stock ker at close to its current price. If the market price rises, the trailer can exercise the option, making a big profit by then selling he shares at the higher market price (alternatively, the trader can fill the option itself, which will have risen in value as the price of the underlying stock has gone up). An option to sell stock caled a "put" option, works in the opposite direction, committing he trader to sell a particular stock later at close to its current prte. Much like short selling, put options enable traders to profit fnm a declining market. But investors also can lose a lot of mone' if stock prices do not move as they hope.