Investment Basics: Understand the principles

Some people may think of investing as a hobby, but these days successful investing is a necessity. As you struggle with the dismal earnings and reimbursement picture, you need to invest wisely to fill in the gaps in your income and prepare for your future. This is where we come in-you've asked us to give you more information about the fundamentals of investing. So beginning with this issue, we'll supplement our regular financial coverage with a series we're calling Investment Basics.

This primer is designed to answer questions that a beginning investor might have. Even if you already have a portfolio and are working towards your financial goals, you'll find useful pointers in each article. Use them as a quick financial reality check. In upcoming articles, we'll be covering mutual funds, stocks, bonds, retirement funds, college savings, financial advisers, and financial records.

But first, you need a well-designed investment plan that lets you reap the benefits when the markets are up and minimize losses when they're down. Here are the elements to consider when constructing your plan.

If you're investing for the long term, you need carefully selected stocks or stock funds in your portfolio. Stocks go up and down daily and there are bad years as well as good. Historically, however, they outperform bonds, money-market instruments, bank accounts, and nearly every other investment class.

Say you have a choice of two stocks that you expect to produce a total return* (stock price appreciation plus dividends) of 9 percent. One is a solid blue chip company and the other is an exciting new firm. You're better off getting your 9 percent from the blue chip, because you're getting the same return for less risk.

If you have the choice of a market darling that's been reaching new highs or a solid but underperforming stock that's priced below its apparent value, which one is a better investment? Go with the underpriced stock, known as a value stock. Two reasons: First, high expectations are built into the price of the market darling, and you'll pay a premium for that. Then, the slightest bad news will knock the price down. Second, since long-term capital accumulation is your goal, you can wait for the market to recognize the true value of the underpriced stock. Its price should rise accordingly.

If you're like many doctors, however, you don't have the time to evaluate the risk factors for a large number of stocks. Many physicians want a portfolio of well-chosen stocks without the time and work involved in choosing them. For them, mutual funds work well instead. "We always recommend mutual funds because it's tough for an investor to own enough individual stocks in the proper proportions to diversify effectively," says financial planner Sherman L. Doll.