Pop Quiz: Can You Profit When Stocks Fall?

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You might be surprised by how much -- or how little -- you know about investing in stocks. See how you fare on this quick quiz.

Stock market investing can play a crucial role in life, especially if you’ll be depending on savings to keep you afloat during your retirement years.

The longer we live, the more money we’re going to need, and stocks, while risky, can provide better returns than other types of investments. Yet many of us don’t understand the basics of stock investing.

“By and large, people are pretty clueless,” Olivia Mitchell, executive director of the Pension Research Council at the University of Pennsylvania, told the Los Angeles Times after she and a colleague studied Americans’ financial literacy.

Test your investing smarts

Is your knowledge better or worse than the average person on the street? Money Talks News founder Stacy Johnson recently stopped a person outside the New York Stock Exchange and asked if she’d be willing to test her stock market savvy. You can see how she did, and how your answers compare, by watching this video.

How’d you do? Don’t feel bad if you didn’t score 100 percent. The person Stacy stopped got only half of the answers correct. Here’s another look at the questions, along with more detailed answers.

True or false: Stocks outperform other investments over the short term 

This is a tricky question. While stocks outperform many other investments in the long run, say, over 10 years, the shorter the time horizon, the more unpredictable, and thus risky, stocks become. So the answer to this question is false.

Day trading and other forms of short-term investing are far too risky for the average investor and are not a good strategy for your retirement savings.

For a vivid illustration, look at the S&P 500 stock market index’s recent history in this About.com chart. In 2007, your investments might have been cooking along nicely. The next year, though, the market fell 37 percent, taking with it many years’ gains.

Collectively, the losses in 401(k) plans and IRAs totaled $2.8 trillion as of early December 2008, according to the Pittsburgh Post-Gazette.

Over the long term, however, stocks outperform most other investments. “Stocks have historically provided the highest returns of any asset class, close to 10 percent over the long term,” says CNN Money.

True or false: When companies pay shareholders, it’s called interest

The answer is: False. Payments made to shareholders are typically called dividends, not interest.

When you invest in a stock, you become part-owner of a company. When you buy a bond or put money in a bank account, you’re loaning money. Dividends are payments made to owners. Interest is a payment made to lenders.

Some companies never pay dividends, using the money instead to grow the company. While dividends should never be the sole determinant when buying a stock, they can be a great perk.

Referring to his online portfolio, Stacy Johnson offers an example of how dividends and stock investing can be a hedge against inflation:

About five years ago, I bought oil company ConocoPhillips for $31 a share. When I bought it, it was paying an annual dividend of $1.88 a share, which means I was earning about 6 percent on my $31 investment. That’s a pretty nice return. But over the five years since, the company has increased its annual dividend to today’s $2.92 a share. That means I’m now earning more than 9 percent. Even better, the stock has more than doubled.

Interest, as mentioned above, is money earned by lending money to a bank, company or government agency. Here are four common ways to earn interest on your savings:

  • Money market deposit accounts. They’re available from banks and credit unions, but don’t expect interest rates above 1 percent. Your money is insured up to $250,000 by the Federal Deposit Insurance Corp. (Money market mutual funds are a different product and are not federally insured.)
  • Savings accounts. Bank and credit union savings accounts are insured, and yields (interest rates) are running as high as 1 percent.
  • Certificates of deposit. CDs tie up your money for a period (called a maturity), usually from three months to five years. The longer you’re willing to invest in the CD, the more interest it pays.
  • Bonds. When a corporation, nation, state or local government borrows, it issues bonds. Like CDs, you agree to lend for a certain period of time, typically from one to 30 years, and in return you receive periodic interest and the return of your principal when the bond matures. Because the federal government has the authority to print money, its bonds are typically considered the safest. But rates are low, currently less than 2.5 percent on a U.S. 10-year bond.

True or false: You can make money in stocks even when they go down 

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