An Introduction to Stock Investing
Part 1. Stocks are Companies
Why should you Invest in Stocks
The idea of investing has been around for a long time and people invest for a variety of reasons.
The main reason people invest in the stock market is to increase their wealth, but there are other reasons such as;
Reasons for investing:
- Providing a sufficient nest egg for retirement.
- Saving for their kids' college education.
- Investing to provide a more comfortable lifestyle.
- Invest to obtain a better return on bank account savings.
The reason for investing is in itself not important, but the reason does dictate which approach to investing would be the most appropriate.
The simplest approach to investing is to invest in something like a certificate of deposit and this suits some people, but the returns are relatively small.
Simply saving spare money will provide a future cash benefit and investing this will provide an additional return.
There are numerous approaches to investing, all with varying risk levels. The basic rule is that the higher the return, the higher the risk level associated. Also, the time frame needs to increase as the risk increases.
The stock market is probably the most popular investment choice with long-term averages of around 10% per year for the conservative investor.
Beginner investors can be reluctant to venture into the stock market for fear of the perceived market risks involved.
While any investment involves a degree of risk, most of the risk associated with the stock market is in not understanding what the stock market actually is and/or utilizing inappropriate investing strategies for their investment goals - this is referred to as investor risk.
Broadly, when you invest in the stock market, you invest in the future of the economy. Over the last century the economy has grown substantially and thus you are investing in the wealth of the nation.
Investing in the Stock Market
The stock market can seem like a daunting place for the beginner stock investor and simply understanding the stock market can seem like an insurmountable task.
Financial publications such as books, magazines and the newspapers all tend to be aimed at those investors that already have a basic understanding of the stock market.
Even a lot of introductory material tends to assume a basic knowledge of the stock market. So where does that leave the beginner stock investor?
The irony is that stock market is fairly straight forward and quite easy and quick to learn when using a structured systematic approach.
So in this introduction, let's simplify it right down to the essential basics to get you started.
A share is a part ownership of a company that is listed on a stock exchange. These companies typically have millions of shares and investors can purchase as many shares as they desire.
The term stocks is an accounting term and in the stock market stock is used in the same context as share and these terms are used interchangeably.
In the U.S. the term stocks is commonly used when referring to a part ownership of a company. Other countries like England and Australia like to use the term share.
To keep it simple, companies can be classified as either private or public and both have shares.
A private company can have several owners, let's say 4 owners each of equal share. Now say this company was worth $100,000, this makes each owner's share worth $25,000.
A public company is usually much larger, say $100,000,000. Thus with only 4 owners, each owner would need $25,000,000 to be a part owner. Needless to say most investors could not purchase a stake in this company.
So to get around this financial problem, the concept of public companies was developed.
With a public company the ownership portions are split up into very small parcels, say 1,000,000 shares. Now with the $100,000,000 company, each share is only $100. Thus most investors can afford the buy a stake in this company. Further more, they can buy as many shares as they can afford. For example, buying 10 shares at $100 would cost only $1,000.
Public companies are listed on a stock exchange, hence the term listed. Generally when referring to listed companies within the context of the stock market, they as simply called companies. The term listed is implied and they are public because they are listed on a stock exchange so that the public can purchase shares in these companies.
Stock exchanges provide two primary services. The first service is to list a company and make the initial offering of the company's shares to the public, which is done through a stock broker.
These initial shares are referred to as an IPO which stands for initial public offering.
The second service is to provide a means by which those initial stock investors can sell their shares and thereby allowing other stock investors to buy the shares from them. Hence the term stock exchange.
There are two main stock exchanges in the U.S. The New York Stock Exchange (NYSE) which is the world's largest stock exchange and the NASDAQ which stands for National Association of Securities Dealers Automated Quotations and is the world's second largest stock exchange.
A stock broker is required to buy shares in a company. They place your order on the stock market and purchase them from someone who is selling their shares, which is also done through the stock broker. Thus the stock broker acts as an agent for buyers as well as sellers.
Part 2. Investing in Stocks
Companies that make a profit can redistribute some of that profit back to their stockholders. This accounting process is known as paying a dividend. Some companies pay a large portion of their profits as dividends while other"s pay no dividend at all.
The DOW refers to the DOW Jones Industrial Average and is an index that measures the performance of the stock market. The DOW index consists of the 30 largest companies listed on NYSE and NASDAQ.
If the DOW increases in value, this means that the average stock price of the 30 largest companies has increased and visa versa if the DOW decreases.
Bull and Bear Markets
The stock market has two main cycles, a bull market cycle where stock prices are broadly increasing over a period of around three to five years which can extend well beyond a decade, and a bear market cycle where stock prices are broadly declining for one to two years.
The stock market over the long term trends higher in line with economic growth. Since 1950 till 2012 the DOW index has averaged around 10% per year and can average around 20% per year during periods of strong economic growth.
Investing in the stock market is best approached with a long-term view as there is a chance of a negative return in the short-term. Long-term refers to a decade or more and short-term refers to a year or less.
Bull and Bear Symbols
The symbolic use of animals to describe a market cycle (such as a bull and a bear) dates back to the early days of the stock market.
When the stock market is rising, investors feel confident that this will continue; reference is then made to a bull as it is an animal that is known for its ability to charge forward with strength and power (as in a bull fight).
When the stock market is a declining cycle, investors feel angry and they tend to complain about the stock prices declining; reference is then made to a bear as it is an animal that is known for its nature of being defensively grizzly and growls when threatened.
Market capitalization is usually referred to as market-cap is simply the share price of a company multiplied by the number of shares.
Larger companies tend to have more shares and higher share prices which gives them higher market-cap values than the smaller companies. Hence market-cap is a broad measure of the relative size of a company.
There are numerous investing styles to choose from, some of the popular ones are:
- Growth Investing: Focuses on companies with sales and profits that are increasing at an above average rate.
- Value Investing: Focuses on companies where the current stock price is less than what the company is worth.
- Dividend Investing: Focuses on companies that pay reliable dividends. This style of investing is also known as Income Investing.
- Blue-chip Investing: Focuses on the largest companies by market-cap, especially those in the DOW index.
- Small-cap Investing: Focuses on the smaller companies by market-cap that have significant growth potential.
Mutual funds have a fund manager that manages the funds portfolio. The mutual fund may need to purchase more shares for the portfolio with the money received from new members.
They may also need to sell shares from the portfolio when members leave the fund in order to pay out their portion.
Fund managers charge annual fees for their service and can also charge entry and exit fees.
At first it may seem easier to simply use a mutual fund, however the decision on when to enter and exit the fund is left up to the investor, and the investor still has to choose from a large selection of mutual funds available which utilize a wide variety of investing styles and tactics.
Stocks or Funds
Should the beginner investor buy stocks or funds. This is a personal decision and depends on the individual investor's preference.
Mutual funds are convenient for the beginner investor as they make all the decisions as to which stocks the fund holds.
On the other hand, buying stocks directly gives an immense amount of satisfaction that only direct ownership of a corporation can bring.
The following is a quick summary:
Buying Mutual Funds:
- All stock buy and sell decisions are made by the fund manager.
- The beginner investor only needs to determine when to enter and exit the fund.
- There are over 1000 funds, so the beginner investor still needs to choose which funds to enter.
- The minimum investment is generally only a few hundred dollars.
- Mutual funds have annual fees and often also have entry and exit fees.
Direct Stock Ownership:
- Personal satisfaction in directly owning a corporation.
- Potential for greater returns due to the small quantity of stock required by investors compared to the large quantities of stock that funds must purchase.
- Many stock investors utilize online or direct access brokers which provide cheap brokerage fees thus minimizing costs and maximizing returns.
- For beginner stock investors, the relative brokerage costs are high if only a very small quantity of stock is purchased.
The decision whether to buy stocks direct or to buy into mutual funds is dependant on each individual investor's personal circumstances.
It should be noted that an investor can own both stocks and mutual funds together.
Part 3. Beware of Market Cycles
The Beginner Investor Trap
For over the last 100 years beginner stock investors have been attracted to the stock market during prosperous times when the stock market has been increasing in value year after year.
These new stock investors have the impression that the market simply heads upwards in a straight line and this provides them with the confidence to participate. This is illustrated in Figure 1.
Graph 1. Investors buy their stocks
The stock market may continue upwards for a short time, but then reverses direction and heads downward with the current stock prices now being less than what these new stock investors had paid.
Their investments are now worth less than when they started. To make things worse, the stock market continues to fall some more and these beginner stock investors are seeing loses in their portfolios increasing at an alarming rate.
After a year or two they have had enough, realizing that they had made a terrible mistake they sell their entire stock portfolio at a significant loss vowing never to return to the stock market ever again. This is illustrated in Figure 2.
Graph 2. Investors now sell their stocks
To rub salt into the wound, the stock market then reverses its downward decline and heads upwards again reaching the same level where those beginner stock investors entered the stock market in the first place.
Needless to say that these beginner stock investors are now disgruntled, too see that if they had not exited at a large lose when they did, they would at least now have made their money back. This is illustrated in Figure 3.
Graph 3. Investors now regret selling their stocks
If the previous advance in the stock market wasn't bad enough, the real killer is that the stock market now continues to climb higher and higher and it seems like nothing could stop its relentless climb upwards.
Those beginner stock investors who sold their stocks back in Figure 2 are now totally gob smacked. They wish that they had only known more about the stock market in order to realize that they had merely entered the market near the top of a bull market, which in itself is not that bad.
Their mistake was that they subsequently sold their stocks into a bear market and ended up with a loss rather than a profit. This is illustrated in Figure 4.
Graph 4. Investors cannot believe what has happened
Beginner stock investors typically expect immediate gains and continuous gains; however the stock market trades in cycles of bull and bear markets.
Bull market cycles typically range from three to seven years. Bear market cycles tend to last around a year or maybe two before the bull market resumes.
To put this into perspective, the stock market spends more time going up than it does going down.
The end result is that over the long-term the stock market broadly goes up. To demonstrate this, in the year 1915 the DOW index was around 60, nowadays (Aug 2019) the DOW is over 26,000.
Part 4. Building a Portfolio
A portfolio is simply a term used to describe the fact that an investor owns stocks and/or mutual funds. Any stocks or mutual funds that have been sold are not considered part of the portfolio, it is only the stocks or mutual funds currently held.
Diversification simply means owing stocks in a variety of industries rather than merely buying stocks in only one or two industry groups.
The reasoning for this is that if one particular industry group performs extremely poorly, then the overall impact on the portfolio is reduced compared to if only stocks in the poorly performing group were held.
For example, if a stock investor only bought bank stocks and banks then performed poorly while other industries such as technology and mining perform well, then the stock investor is missing out on the good performance from these industries.
Dollar Cost Averaging
This is an extremely popular stock investing tactic which involves investing the same amount of money at regular time intervals. Monthly, quarterly and yearly are common time intervals used by stock investors.
The main advantage of Dollar Cost Averaging is that fewer shares are bought when stock prices are high and more shares are bought when stock prices are low.
This has the benefit of smoothing out the gains as the impact of a bear market is dramatically reduced since only a few shares are bought at the peak of a bull market and the maximum shares are bought at the bottom of the bear market.
It is buying this larger quantity of shares at the bottom of a bear market that really boosts the portfolios returns when the subsequent bull market resumes.
Stocks can be bought using a loan to pay for a percentage of the purchase cost, typically 50% which is set by the Federal Reserve Bank for U.S. stocks.
With a 50% margin this means the stock investor can effectively buy twice as much stock for the same money. The stock is used as collateral for the loan.
After the stock is purchased the stock broker imposes their maximum margin requirement - typically 25% which is governed by regulation.
As the stock is used as collateral for the loan, if the stock's price drops below a level that would provide insufficient collateral, then the stock broker will sell some of the investor's stock in order to reduce the loan amount so that the equity to collateral ratio is back to the set level - which is typically 25%.
Generally, most professional investor's would advise the beginner stock investor not to buy stocks or mutual funds on margin until they gain more experience and understanding of the stock market.
Penny stocks are usually very small companies listed on the NYSE or NASDAQ exchanges with stock prices less than $5 or they are listed on NASDAQ's Bulletin Board or Pink Sheet and trade over the counter.
Penny stocks are usually companies that make no profit and are high risk (even though there are exceptions). Most professional investor's would advise the beginner stock investor not to buy these stocks.
Experience stock investors can make good returns from these penny stocks (Microsoft used to be a penny stock) but it is high risk and requires a through understanding of the stock market.
These are similar to penny stocks and may be the same.
The primary difference is that penny stocks are either not listed on an exchange or if they are, their stock price is very low, whereas speculative stocks are small companies that are generally not making a profit, but have the potential to significantly improve their financial position.
For example, a small biotech company may not be operating profitably but this is due to them financing the development of a new drug that may cure Alzheimer's disease. Needless to say, if this drug were successfully developed, then the company's stock price would go through the roof and the stock investors would make a fortune.
Buying speculative stocks is a high risk strategy that can also be extremely profitable, but it is only suited to experienced investors.
Again, most professional investor's would advise the beginner stock investor not to buy these stocks.
Where to now
The reason that the topics on margin loans, penny stocks and speculative stocks were covered here in this Introduction section is that beginner stock investors are easily swayed into buying these stocks or using margin loans.
At least the beginner stock investor is made away of the benefits and the risks. Once the beginner stock investor has gained sufficient experience and knowledge, these higher risk tactics could then be incorporated into their investing strategies.
For a beginner stock investor who does not wish to pursue their knowledge any further and/or wants to invest in the stock market right now, then generally the safest way for them to invest is to either buy mutual funds or buy large blue-chip stocks and hold them for the long term, which is 10+ years.
Also, most professional investors would advise the beginner stock investor to only invest a portion of their capital to start with. This allows the beginner stock investor time to increase their knowledge and understanding of the stock market before committing any further finances to it.
Ideally, beginner stock investors should not buy any stocks or put any money into mutual funds until they have a better understanding of the stock market. The investor looking to get started now can read the series of articles on How to Invest in the Stock Market.
While the stock market is quite straight forward, there are numerous traps that catch the beginner stock investor off guard. These include buying speculative stocks, margin leading, trading and buying mutual funds with high fees.
Beginner stock investors who are impatient and invest without at least a reasonable understanding of the stock market tend to have a bad habit of losing money.
In addition to the membership content there's a significant amount of free material in the investing basics section. These articles will increase the beginner investor's knowledge of the stock market thereby helping them to invest more wisely and profitably.