Investing in Stocks for Beginners
Why is Investing Important
As the years go by most adults will end up purchasing a house or some other accommodation to live in and for a lot of adults this will be their only asset of significant value. It's an asset that generally appreciates in value over the years - so it's worth more and more as time goes on. However the family home is not considered an investment as it's not able to provide a future income.
Most adults spend their lives working - either for an employee or running their own business and most adults will try to enjoy life outside of work. For some this may involve eating out regularly while for others it may involve a leisurely sport like playing tennis or skiing. Whilst these recreational pastimes involve an expense - this is not an issue whilst they are still working. In other words the adult can afford to finance their chosen lifestyle.
But as humans, people have not evolved to the stage were they can continue to work as they age past a certain point - at some point they will either not be capable to work or younger people will be seen as being more desirable for an employer and replace the aging worker.
Now this creates an issue - if the adult stops working then they stop receiving their income which was used to finance their lifestyle. This means the adult can no longer finance their lifestyle
Sure there will be some token pension benefits but this will generally only be a fraction of the income they received whilst working.
So is there anything the aging worker can do to continue financing their lifestyle after they retire form work.
The answer is YES - it is to put some money aside regularly whilst they are working. A small amount of money regularly put away adds up to a considerable amount of money over the years. This is further compounded when invested.
Let's look at some figures to illustrate this:
Investing for the Future
Someone working puts away $1000 per month.
1. Investing in bonds earning around 2.5% p.a. amounts to a little over $300,000 in twenty-years time.
2. Investing in stocks earning around 10% p.a. including dividends amounts to around $750,000 in twenty-years time.
As can be seen from the above figures, money put away regularly over time adds up to a nice nest egg in the future. This is money that can help finance your lifestyle when you retire in the future.
The total amount of money invested in the above example is $240,000 over twenty years.
1. Bonds. The capital increase is $60,000 for the investment in bonds at 2.5%.
2. Stocks. The capital increase is $510,000 for the investment in bonds at 2.5%.
Yes Stocks generally return more than Bonds but they are also considerably more volatile. This means that the year to year returns fluctuate considerably with some years giving negative returns. As a general rule stocks are best held over the long-term.
1. Bonds. They will provide an income in the future at the future rate (currently 2.5%). On $300,000 the annual income received amounts to $7,500.
2. Stocks. Large-cap stocks also provide an income in the form of a dividend at around 2% which gives an annual income of $15,000 in twenty years time.
A twenty-year investment period means that the person starts investing whilst they are 45-years old assuming they retire when 65-years old.
Starting to invest earlier whilst 35-years old means the investment period increases to thirty years. This has a profound effect on the investment value when retiring
30-year Investment Period
1. Bonds. At 2.5 they will be worth $540,000 with an annual income in 30-years of $13,500 with the total amount invested being $360,000.
2. Stocks. At 10% Large-cap stocks will be worth $2.2 million with an annual dividend income in 30-years of $44,000 with the total amount invested being $360,000.
Whilst not everyone can start investing whilst in their thirties or younger, as the above figures illustrate the younger you start then the much more the retirement investment nest egg will be worth.
The main purpose of investing is to provide future wealth - this enables you to hopefully maintain your lifestyle - or at least provide a significantly better lifestyle than what a pension on its own could provide when you retire.
After thirty years investing a total of $360,000 in stocks actually gave a massive increase of $1,840,000 to give a total worth around $2.2 million. As a bonus there's an annual income from dividends of $44,000.
Investing generates future wealth through the principle of compounding interest. There are two factors that affect the returns.
Two factors that affect the returns
1. The higher the annual percentage return then the more the investment will be worth in the future.
2. The longer the investment period then the more the investment will be worth in the future.
Stock returns are usually higher than the returns from Bonds which provides a larger best egg, but stocks are considerably more volatile than bonds - especially in short to medium-term.
Therefore it's best to take a long-term view with stocks and to accept that there will be some really bad years with negative returns. The trick to investing in stocks over the long-term is not to panic and sell when returns are bad. In other words, don't take a short-term view with a long-term investment.
For those investors who find the short-term volatility of stocks to much to bear, a popular strategy is to combine stocks with bonds in the one portfolio. There is a tendency for bond values to move in opposite direction to stock values, thereby one helps to offset the other which lowers the volatility but also lowers the long-term returns.
The Silly Things Investors Say
Investors come up with all sorts of explanations why stocks behave the way they do. They feel that this is why something happened, they say "that's the reason why!". However there's usually some other reason why it happened. The following is a list of some of the silly things investors say.
1. The stock price is as low as it can go
This is a common statement from investors, but there is no absolute rule that tells you how low a stocks price can fall. The stock price could fall to one cent. How far it will actually fall is dependant on the supply and demand for that stock.
The book value tends to hold for the most part - this is evident by the fact that its difficult to find stocks below book value nowadays, but book value is certainly no guarantee. Bear markets can see many stocks drop below book value.
The whole issue of how far a price can fall comes about from investors buying at a certain price drop level and then expecting that to be the bottom. They buy with the expectation that prices will raise after they have bought. However, the stock price usually drops some more after they bought and they then sell. Their selling applies even more downward pressure on the stock price.
This does not mean that the stock price will not rebound and go higher in the future - price can go way above where it is now and this is generally what happens with good quality investment stocks over the long-term.
Just don't expect it to happen in the short-term. When buying a falling stock price you must accept that the price can fall further. Most investors when buying a falling stock price wrongly assume that that price fall is the bottom and the price will magically go up as soon as they buy.
Companies with strong fundamentals will very likely see their long-term stock price eventually go up in line with their fundamentals - but in the short-term (one year) and even over the medium-term (five years) the stock price may well be lower than the price is now.
Companies with poor fundamentals may never see their stock price go above where the price is now - even after ten years (assuming the company even lasts that long).
There is no rule that says the stock price must go up - even over the long-term - it's just more likely with companies with strong fundamentals.
2. You know when the stock price has bottomed
While this may seem the same as with the above where the stock price is as low as it can go - the difference is that with this statement investors use some form of analyses to determine that a stock's price has bottomed, whereas with the above statement investors just assume that when they've bought then that's the bottom.
Even with some form of analysis there's still no absolute way to know the stock price has hit the bottom.
Even when using chart patterns or chart indicators, this still requires the investor to wait for a rebound to confirm that a bottom has occurred. Even then chart patterns and indicators are nowhere near 100% accurate at determining bottoms - even allowing for the time delay.
Chart patterns and indicators really do no more than giving the investor some cues to the possibility that a bottom has occurred. The best the investor can say is that the stock price is now cheaper than it was.
For the shorter term investors and speculators it's generally better to wait for a rebound before buying. In other words, it's generally a bad idea to buy a stock while the price is falling.
For the long-term investors there is nothing wrong with buying a fundamentally sound stock with a falling stock price - just don't expect that you have bought the bottom of the price fall. Investors may have to wait a considerable amount of time for the stock price to recover and there is always the possibility that it never recovers.
When buying fundamentally poor stocks with a falling stock price - don't expect the stock price to recover as it very well may never recover even over the long-term.
3. The stock price is so high, it can't go any higher
There is no arbitrary limit to how high a stock's price can go. Fundamentals give some insight to how expensive a stock's price might be, but the fundamentals gives no indication of how high the price can go.
Stock prices keep climbing because there's an imbalance with the Supply and Demand. The demand for that stock keeps exceeding supply. That is, there are more broker orders placed to buy the stock than there are broker orders placed to sell the stock. For the buy orders to fill they have no choice but to bid higher prices to attract the required quantity of sell orders - which results in the price rising.
Rising stock prices attracts the attention of the speculators who track the price increase. These speculators become short-term buyers which fuel the price increase. They buy which increases the demand for the stock and then shortly after they become sellers which provides supply at the higher prices.
Strong price rises create strong upward trends which attract a large volume of trading activity from the general public. A significant portion of the stock market is speculative - their decision to buy and sell is based solely on a stock's price increasing with no regard to the company's merits.
These speculators include not only the professionals but also the general public which includes position traders, swing traders and day traders. All this trading activity increases the stock's liquidity which makes it easier for the public traders to enter and exit their positions. It makes it easier to buy and sell (especially with market orders) as spreads become tight which means less slippage (the difference between the Bid and Ask price).
Another source of demand comes from investors (with no trading interest) who see a stock's price continue to climb and buy on fear of missing out.
Another source of supply comes from investors who already own the stock and see its price climb higher and higher and start to panic - but what if this is the top, I will miss out on the maximum profit - so they convince themselves this is the top and thereby sell. So the investor sold out of fear of missing the top. The investor convinced themselves that this was as high as the price could go, but they usually just simply end up selling into a continuing uptrend. Typically the stock price continues to climb higher after they've sold.
Investors selling based on the notion that the stock price can't go any higher is a silly reason to sell - a decision which at some future date they usually regret. Investors who sell their stock early with strong price gains generally always miss out on making the strong returns over the long-term.
4. The stock price is under $5, I can't lose much
A lot of investors (mainly new investors) have this view. The notion is that a really low stock price means a small dollar investment so if the stock flops then only a small amount is lost
The problem with this philosophy is that with the American stock market most stocks trading under $5 have terrible fundamentals - most don't make a profit at all and a lot have deteriorating balance sheets - quite a few don't even generate any revenue at all.
These low priced stocks are mostly highly speculative with high bankruptcy risks. While they are cheap, investors mostly lose money buying these speculative stocks. Most speculative stocks (but not all) are high risk and not suitable for investing.
While it's true that buying low priced speculative stocks won't lose much money - the investor mostly loses buying these. While the loss per stock might be small, a lot of small losses adds up.
While buying speculative stocks is usually a bad investment, they can with selective picking make good speculative trades. The difference here is that with speculative trading the speculator knows the stock is a fundamental piece of junk - they use technical analysis techniques with includes trade management. The speculative stocks are evaluated for their risk and potential reward (how much they could lose compared to how much they could make based on probability).
5. If the stock price drops, it will come back up if I wait long enough
This situation arises when investors buy a stock and the price then drops leaving the investor with a paper loss. This makes most new investors extremely uncomfortable and even some experienced investors - the natural reaction is that the investor wants the stock price to recover and trade above their purchase price.
After all, investing is a long-term endeavor and you say to yourself I'll just wait and the stock price will recover.
The problem here is that the stock price may never go back above the purchase price. Investors will usually lose patience and sell the stock because they were expecting the price to recover.
Selling stocks that are below their purchase price is common with investors with a short to medium-term view.
A lot of the higher quality stocks do tend to recover (especially over the long-term) but the investor had already sold them. Investors are notorious for selling a profitable stock for a loss.
However with the lower quality stocks a lot of these stocks never recover. If the investor waits for a recovery it may never come.
Investors must expect that while some stocks do go up in price straight away and never go down, others go down and recover and some go down and never recover.
The investor will never know in advance as to which stock will be the one to go down and never recover.
6. The stock market's gone up for so long; it'll just keep going up
Bull markets with rising stock prices leads to complacency. As the stock market climbs higher and higher investors assume this will continue. Most investors are fairly new and have no idea of market cycles yet alone what a bear market is. These investors simply see stock prices climb higher and higher and assume that this is the way the stock market is.
Their philosophy is that a stock with an increasing stock price must be a good investment. Because the stock market has gone up for so long they expect their stock purchases to continue going up and during the bull market many stocks do just that.
Any suggestion that this may be a bubble is dismissed by the investors as they reassure themselves that this in not a bubble - it's a good investment.
There investors buy stock which creates buying pressure and this creates an imbalance in the supply/demand for stocks which creates upwards pressure on stock prices. New investors come along seeing the rising value and they want a piece of the action so they buy.
This whole process continues along merely, but sooner or later this all comes to an end. Stock prices now start to fall - a lot of these investors (mainly new investors) sell their stocks into the declining market - which in turn creates an excess in supply which further drives the market lower.
Unknowingly these investors bought into the latter stage of a Bull market cycle and sold into a Bear market cycle.
The market never just keeps going up - never - it cycles through Bull market phases and Bear market phases. The Bull market phase usually last for many years even a decade. The Bear market phase is usually much shorter and can last for a year or two and sometimes less than a year.
Unfortunately for the investor who sold into a Bear market cycle they are usually quite short in duration and the investor often sell towards the bottom of the cycle.
The lessen here is that investors must realize that the market does not just go up but that it cycles and works its way higher over the decades with ups and downs - that's why a long-term approach is best.
Words of Wisdom
The following words of wisdom are based on investing over the long-term. This does not reflect the short-term view from speculation or trading.
Words of Wisdom
- Investing in a long-term process.
- Over the years quality (fundamentally sound) stocks generally increase in value.
- Long-term means 10 to 20 years - not one or two years.
- Don't confuse investing with speculation or trading (which is short-term in nature).
- The financial media can influence the short-term direction of the market but has no influence over the long-term. Economics and company fundamentals dictate the long-term.
- Sometime in the future the stock market will decline - a bear Market will develop.
- Stock market declines provide great opportunities to buy fundamentally sound stocks.
- Trying to predict the level that the stock market will be at in a year's time is impossible. It's only through pure luck if you get it right.
- In 10 years time the market will likely be higher than it is now.
- In 20 years time the market will almost certainly be higher than it is now.
- The direction in one year's time is unknown.
- To invest profitably you do not need to pick every winning stock. There will always be some losing stocks in your portfolio.
- The really big winners are never the ones that you thought would be.
- Tomorrow's next new blue-chip is not known until tomorrow.
- Different categories of stocks have different risks and rewards.
- You can achieve good solid returns from ordinary stocks if you hold them for long enough.
- A stock that has given good returns in the past may not do so in the future.
- A company that has made strong profits in the past may not do so in the future.
- Stock prices may well move in opposite directions to what the fundamentals suggest in the short-term, but long-term stock prices generally do follow the fundamentals.
- A company that is doing poorly fundamentally can do even worse in the future.
- A stock price that has gone down can still go down even further.
- A falling stock price can only fall to just above. You cannot sell a stock for a negative sum of money nor can you buy a stock for less than zero or even for zero.
- A raising stock price in the short-term does not mean you were right. In the short-term you are only right if you sold for more than you paid.
- A falling stock price in the short-term does not mean you were wrong. In the short-term you are only wrong if you sold for less than you paid.
- Over the long-term, short-term price declines are only important if you want to buy more. If you want to sell now then you are not long-term.
- Long-term price advances are irrelevant if you have already sold that stock.
- Buying a fundamentally poor stock just because it's cheap is a loser's game.
- Selling a fundamentally sound stock just because the stock price has declined in the short-term is not a good long-term investing reason to sell.
- Buying a fundamentally poor stock just because the stock price has increased in the short-term is not a good long-term investing reason to buy.
- There is a reason why a company is growing.
- Growing companies do not grow for ever.
- Most investors cannot own every growing company and if even if they could it is not necessary.
- If a stock goes bankrupt you lose the same amount whether you paid $200 or $20 or $2 - you lose the amount you invested.
- If a stock bought on 50% margin deposit then halves - you lose halve of the total purchase value, not just halve of the margin deposit.
- Be careful rotating stocks in your portfolio based on earnings results. You may end up with a portfolio of yesterday's winners.
- Be careful rotating stocks in your portfolio based on price gains. You may again end up with a portfolio of yesterday's winners.
- Buy and Hold is not a dirty word, even if Wall Street says it is!
- Dollar Cost Averaging is not a dirty word, even if Wall Street says it is!
- Dividend investing is not a dirty word, even if Wall Street says it is!
- When fundamentally sound stocks you own become cheaper - consider buying some more.
- You won't improve your returns by replacing good quality stocks that have gained significantly and replace them with poorer quality stocks that are cheap.
- Invest some time in understanding the stock market.
- Enjoy your life. Don't spend all your time worrying about the stock market or the value of your portfolio.
- Creating wealth is a long-term process.
Your ownership type is determined by your investing status
Most stock investors are under the impression that when they buy a stock that their name will appear on the company's books as a registered owner of those shares. This may or may not be the case, as it depends on the method that use used to acquire those shares.
There are actually three methods that are used to record the ownership of a company's shares and they are Physical Certificate, Brokerage Firm Registration and Direct Registration.
With this method, the investor's name is recorded on the company's books as a stockholder. This is the oldest and original method used. When an investor places an order to buy stock with their broker and that order is filled, the stock purchase is settled three days later and the investor's name is listed on the company's books and the investor receives a certificate of ownership for that stock. The same applies if stock is acquired directly from the company through a stock purchase plan.
The investor will receive company reports such as annual reports mailed directly to them and dividends will be paid to the investor directly from the company. The investor is also responsible for notifying the company of any change of address.
If the investor wants to sell their stock, they first need to send their certificate to the stock broker who sights this as evidence that the investor actually owns the stock. Thus, the investor can not immediately sell their stock as it takes time for the broker to receive the certificate.
Brokerage Firm Registration
This is the modern method used by online brokers, although non-online brokers may also use this method of stockholder registration. With this method, when an investor buys stock, it is actually settled in the broker's name, not the investor's name. Thus it is the broker's name that appears on the company's books as the registered stockholder, not the investor. The investor's name only appears on the brokers books as the owner of those shares. As a broker can have many investors owning stock on their books in the same company, the broker must keep track of the individual investors who actually own those particular shares.
Most retail investors will own their stock
with Brokerage Firm Registration
The investor will not receive any company reports or any other communication directly from the company as the company is not aware of the investor. Instead the company sends any communications directly to the broker. In turn the broker relays this information to the investors that are on the broker's books for that stock.
Dividends are actually paid to the broker as they are on the company's books as a stockholder. The broker in turn allocates the per share dividend payment to each investor's account.
If the investor wants to sell their stock, they simply need to instruct their broker to place a sell order which can be done by phone or over the internet if using an online broker. There is no certificate proof of ownership issues to content with and there is no time delay in placing a sell order place.
Direct Registration System
This is basically a combination of the physical certificate method and the broker firm registration method.
With the direct registration system (DRS) the investor's shares are directly recorded on the company's books using an electronic system. No physical certificate is issued, but the investor still receives direct communications from the company such as annual reports. Also, dividends are paid directly to the investor by the company.
If the investor decides to sell their stock, the investor instructs their broker who electronically transfers the shares from the company's books across to the broker's books. Once the broker has confirmation that it has received those shares, the broker will place the order to sell those shares.
It should be noted that a broker will only place an order to sell shares when the broker has physically confirmed that those shares actually exist. Hence the need to transfer the shares across to the broker.
The difference with DRS and the physical certificate method is that DRS transfers the shares electronically rather than having to hand the broker a paper certificate.
The investor does not necessarily have a chose in which stock registration method to use as this depends on the stock broker. Generally, it is the institutional investors and high net wealth investors that tend to favor the physical certificate or DRS methods.
For the typical stock investor, the broker registration method is often the only choice if using an online broker and for the most part this method is the most appropriate as the investor can immediately place a sell order and the investor need not worry about keeping the contact details up to date.
Stock buybacks can increase shareholder value
Management may also pay some of the profit via a dividend and retain the remainder on its balance sheet. The dividend payout ratio is the proportion of the profit that is paid as a dividend.
Any profit that is not paid out as a dividend is recorded on the balance sheet under the stockholders' equity section as retained earnings. The retained earnings can accumulate over the years and the company can use this money for other purposes such as to acquire other companies, to reduce debt or to buy back its own shares.
Companies often reduce the amount of retained earnings when they become too large. This is to make the company less attractive as a take over target - since companies with lots of cash on balance sheet are prime takeover targets.
When a company buys back its own shares, the company can either cancel those shares or hold them for future reissue. When a company holds these shares rather than canceling them, those shares are referred to as treasury stock and they still exist but they are not owned by anyone.
When a company initially floated as a public company (known as an Initial Public Offering or IPO), the company issued a set number of shares. These initial shares are referred to as Shares issued. After the company buys back some of its Shares issued, the remaining shares are referred to as Shares outstanding.
Shares outstanding = Shares issued - Share buyback
As an example, a company issued 10,000,000 shares and bought back 1,000,000 shares but did not cancel those shares.
Shares outstanding = 10,000,000 - 1,000,000 = 9,000,000 shares
Treasury stock = 1,000,000 shares
If the company cancels the shares it bought then the treasury stock will be zero.
If the company has treasury stock, this is shown on the balance sheet as a negative dollar value in the stockholders' equity section. The negative value reflects the dollar amount the company paid for those shares. If the company cancels the shares it bought then the retained earnings is reduced by the amount paid for those shares.
Treasury stock does not receive dividends as a company cannot pay itself a dividend. Should the company pay a dividend, the dividend pool is divided up amongst the shares outstanding - which effectively increase the dividend paid per share. Also treasury stock does not carry any voting rights as they are not owned by anyone.
Treasury stock can also arise during the IPO as companies may not sell of the Shares issued. The company can keep a certain number of issued shares and in the future if the company needs to raise extra cash they can simply sell the remaining issued shares. Otherwise the company would have to issue new stock in the future which will incur additional costs. Thus having treasury stock is a cost effective way to raise capital in the future if needed.
The main purpose of a company buying back its own shares is to reduce the number of shares outstanding. The effect this has is to increase the dividends per share and the earnings per share since for the same profit there are fewer shares.
Share buybacks are a tax effective way to boost the stock price since the stock price generally follows the earnings per share rather than the profit.
When the stock price is undervalued, the company may offer a premium above the current stock price. This sends a signal to investors that management considers the stock price too cheap and that the stock is worth more than what the market is currently is paying. This is a cost efficient way of reducing the shares outstanding.
Companies that buy back their shares when the stock price is high can provide investors with confidence that stock price still has further to climb.
While stock repurchases benefit the dividends per share and the earnings per share, they have no effect on the company's book value (stockholders' equity). This is because cash is used from the retained earnings to pay for the shares - while there are fewer shares outstanding, the net assets is also reduced. This is best illustrated with an example.
As an example, a company has Net assets of $100,000,000, Earnings of $10,000,000, Shares outstanding 10,000,000. The company buys back 1,000,000 shares at $10 a shares.
Before stock repurchase
Book value = 100,000,000 / 10,000,000 = $10.00
EPS = 10,000,000 / 10,000,000 = $1.00
After stock repurchase
Buyback cost = 1,000,000 x 10 = $10,000,000
Shares outstanding = 10,000,000 - 1,000,000 = 9,000,000
Net assets = 100,000,000 - 10,000,000 = $90,000,000
Book value = 90,000,000 / 9,000,000 = $10.00
EPS = 10,000,000 / 9,000,000 = $1.11
Thus buying back 10% of the issued shares increases the earnings per share by 11% but the book value remains unchanged.
Another consideration with shares outstanding is when a company has convertible instruments such as convertible bonds or company issued stock options. Should these be exercised then the number of shares outstanding is increased. The term 'diluted shares outstanding' is used to allow for the maximum number of shares outstanding if all the convertible instruments were exercised.
Portfolio size and Brokerage costs
Investors should be aware that brokerage costs affects their portfolio's performance
Investors new to the stock market can start with any dollar amount they like in building their investment portfolio (the dollar amount is known as capital). The only consideration is with respect to the cost of brokerage, which can be relatively expensive for purchasing small quantities of stock. While the amount of money that investors start with varies considerably, for the purpose of this article they will be categorized into three levels as follows:
Small investment:The investor starts with $1,000
Medium investment:The investor starts with $10,000
Large investment:The investor starts with $100,000
Most beginner investors who open a stock brokerage account will nowadays typically open an account with an online broker. The brokerage costs are generally around $7 to $10 per order.
While it is generally better not to invest all of the initial investing capital at once (as the beginner will probably make some less than ideal investment decisions to begin with), with only $1,000 this is small enough that even if the investor made the wrong decision based on a lack of experience, any mistake is not going to be financially disastrous. In this case, the investor might as well invest the full $1,000 to start with.
The investor needs to make a decision as whether to buy stocks or funds.
With stocks it is generally better to diversify and buy around 10 stocks. However, with a $1,000 to start with this means the investor can only buy $100 worth of each stock. The problem here is that the brokerage for each stock is going to be around $10, which means that the upfront cost per stock is 10%, which is extremely high. This is not to say that the investor cannot buy stocks, but it is extremely expensive to start with, however there are no ongoing costs.
Another approach for the investor to consider is to buy a fund or two rather than stocks. The funds can be mutual funds, closed-end funds or an exchange traded fund (ETF).
Mutual funds have a minimum initial investment which varies from fund to fund, but there are funds that have minimums of only a few hundred dollars. The investor will however be paying an annual management fee which again varies considerably, but can be as low as around 1%. A lot of funds will charge entry fees, but there are mutual funds that do not.
Thus, with a mutual fund there is an ongoing annual fee that the investor must pay (which usually is deducted from the dividends due). Compare this to stocks with the upfront 10%; the mutual fund will have an ongoing fee of say 1% per year (which adds up over the years). The investor will either pay the costs upfront as with stocks or pay the costs over the years as with funds. It should be noted that with both stocks and funds, the investor will receive any dividends due.
The investor might also consider buying an ETF. While there is still a brokerage cost of say $10, it is for the purchase of $1,000 of an ETF, thus the effective upfront cost is only 1% instead of 10% for the stocks. The investor still has the annual management fee for the ETF, but this is generally cheaper than with mutual funds and may be less than 0.5% for an index tracking fund.
The investor with $10,000 to start with might considerer not to invest the entire amount to begin with, but rather start with only a portion of the total and build up their portfolio over a period of time. This is entirely up to the investor and whether the investor plans on contributing more funds on an ongoing basis. The main point here is that investing is a skill that is developed with experience and knowledge and as the investor's experience increases they will typically want to buy more stocks (which they cannot do if there are no funds remaining).
Investors often feel that they must invest their
entire account when they first start investing
The medium sized investor is in a better position as far as relative brokerage costs are concerned. Let's assume that the investor decides to start with $5,000 for now and decides to buy a diversified portfolio of 10 stocks.
Each stock purchase will be $500 and with a brokerage of $10 gives an upfront cost of 2%. This is quite respectable and the investor has no ongoing costs and will receive any dividends due.
The investor still has the option of buying mutual funds. The investor might consider buying a closed-end fund or an ETF. Buying $5,000 of a fund with a $10 brokerage gives an effective upfront cost of only 0.2%. However, it is probably better to buy several funds rather than put all the capital into only one fund. That way the investor could buy a growth investing fund and an index fund for example.
The investor starting with $100,000 is probably keen and enthusiastic about making money from the stock market. They are well capitalized and inexperienced, and this is a dangerous combination.
If the small investor loses 20%, their portfolio is only down $200. However, the large investor's portfolio will be worth $20,000 less, which is now financially really noticeable. This puts the large investor under considerable financial pressure and due to their inexperience they will likely make all sorts of silly and illogical decisions in an attempt to try and recoup the lost value in their portfolio. Making investment decisions while emotionally distressed is self destructive and is a fantastic way of totally destroying the value in ones portfolio.
Most professional stock investors would indeed recommend that the large investor start off with only a portion of their available capital. Many of these professional stock investors are talking from bitter experience and the mistakes they made in their early days of investing.
The large investor might consider starting with only 25% invested in stocks and over the coming months or even years gradually increase their stock portfolio size. Investors tend to gain experience fairly quickly as capital gains are a great motivator for increasing their knowledge base. This increased knowledge leads to wiser investment decisions, which in turn leads to further capital gains. Thus, knowledge and experience, and profits are all interconnected.
The large investor might start with $25,000 and buy 10 stocks. Each stock purchase would be $2,500 and with a brokerage of $10 gives an upfront cost of only 0.4%. This is very cost effective and the investor has no ongoing costs and will also receive any dividends due.
Of course the large investor can also consider buying funds. Some stock investors will buy stocks and funds, especially index funds, foreign stock market funds or bond funds. Investors with a large amount of capital can more readily and economically spread their investments across various markets.
While investment capital is not a barrier to investing in the stock market, the investor needs to consider their available capital and decide on the most appropriate approach to take.
Order Types and Features
The variety of order types and features available to investors continues to increase as technology advances. Long gone are the days where the only order types available were a Market order or a Limit order.
Nowadays investors can effortlessly place complex order setups directly to an electronic exchange and all that is needed is an internet connection. In fact the investor does not even need to use their computer as they can simply use their smart phone.
As the order types and features continue to increase it is a good idea that investors keep up with the latest that's on offer.
While not all brokers will offer all of the order types and features listed in this article and some brokers have different names for the order types and features, the following provides an overview on what the brokers are generally offering investors these days.
This is an order type where the investor can easily break up a larger order into a sequence of smaller orders. Rather entering a sequence of smaller orders one after the other, the investor can essentially set the order system to periodically enter small orders at a set interval. For this order type Accumulate means to buy stock and Distribute means to sell stock.
As an example, the investor may wish to buy (accumulate) 1,000 shares in a fairly illiquid stock that does not have that share quantity immediately available. The investor can set the order system so that it places a limit order for say 100 shares. When this 100 share order is filled, the system can be set to wait a specified time such as 5 minutes before the next 100 share limit order is placed. The order system will continue to this automatically until the 1,000 share order is completely filled.
All or None (AON)
The All or None (AON) is an attribute that can be added to a limit order. Most investors who use limit orders will at some stage have had their order only partially filled. The AON feature eliminates partial order fills. The order is only executed if the order share quantity can be completely filled, otherwise the order remains inactive.
This order type can have numerous different names and is simply a combination of orders - an entry order combined with a stop-loss order and a profit target order.
After placing a Bracket buy order that has filled the order system automatically:
- Places a stop-loss sell order at a preset offset amount below the current market price
- Places a profit target limit sell order at a preset offset amount above the current market price.
The offset amount is specified at the time the Bracket order is placed.
This feature allows the investor to add conditions that must be satisfied before the order can be executed.
As an example, an investor is looking to buy a breakout from a trading range but only wants to do so if the S&P 500 index is trading above a certain amount and the price of Crude Oil is trading above a certain amount.
With this feature the investor can specify the conditions that need to be satisfied before the buy order can be executed.
A Discretionary order is an attribute that is added to a limit order to increase the price range that the order can be executed.
As an example, in a fast moving market a stock might have an asking price of 30.50. The investor places a limit buy order for 30.50 but due to the fast moving market the Ask price may increase again by the time the investor clicks the send button. The discretionary attribute is a feature that adds a preset amount to the limit price (say 0.10) which means that the limit price is increased to 30.60 when it reaches the exchange. If the Ask price is less than or equal to 30.60 then the order is filled. If the Ask price has risen above 30.60 then the order is placed in the order book at the original limit price of 30.50.
Fill or Kill (FOK)
The Fill or Kill (FOK) attribute is a time feature for limit orders where if the order cannot be immediately executed then the order is canceled.
The FOK attribute is similar to the All or None (AON) attribute but they are not the same.
Once the investor submits an FOK limit buy order, if the share quantity cannot be immediately filled then the order is canceled. With the AON attribute the order remains inactive at the exchange and is not canceled.
Good after Time/Date (GAT)
This is a time attribute that can be added to an order. Essentially this feature delays the activation of the order until the specified start time and date.
An investor might place a market order to buy stock before they go to work at say 8:00 AM EST. Some investors do not want their orders executing at the market open due to the wide Bid/Ask spreads. By specifying the start time and date then the order will not execute until that time and date. The investor can specify a start time of say 10:30 AM EST and a start date of Today.
Good til Time/Date (GTD)
This is a time attribute that can be added to an order. Essentially this feature terminates an unfilled order after the specified start time and date.
This attribute allows an investor to set a time and date at which the order will be canceled - even if the order is only partially filled.
For example an investor may wish to sell a stock with a limit price but the stock is going ex-dividend. If the investor cannot sell their stock at the limit price before the ex-dividend date, then the investor wants the order canceled. The Good til Date can be set as the day before the ex-dividend date and time can be left blank - which will default to the market close.
Good til Canceled (GTC)
This time attribute is commonly used nowadays which allows the order to continue working beyond the day that the order is placed.
A lot of brokers now offer an option as to whether the order is a day only order or not. The GTC attribute is used if the investor wants to be sure that the order continues working past the day it was entered.
Immediate or Cancel (IOC)
The Immediate or Cancel (IOC) attribute can be attached to a limit order. Any portion of the order that is not immediately filled when the order is placed will be canceled.
As an example, if the investor places a limit buy order for 100 shares and only 60 shares fill immediately at the limit price, the order for the remaining 40 shares is canceled.
Limit if Touched (LIT)
The Limit if Touched (LIT) order is essentially a limit order with a trigger price attribute.
When an investor uses a LIT buy order, they set the limit price as normal and they set a trigger price which is below the current Ask price. The trigger price must be above the limit price.
As an example, an investor places a LIT buy order with a limit price of 20.00 and a trigger price of 20.10 when the Ask is 20.50. The limit order is only placed in the order book if the Asking price drops down to 20.10 (otherwise the limit order is not placed).
Limit on Close (LOC)
The Limit on Close (LOC) is a limit order that is only activated at the market close.
A LOC buy order will only fill if the Asking price at the close is at or lower than the limit price. Any unfilled quantity is canceled.
This order type is useful for trading strategies that use the closing price.
Limit on Open (LOO)
The Limit on Open (LOO) is a limit order that is only activated at the market open.
A LOO buy order will only fill if the Asking price at the open is at or lower than the limit price. Any unfilled quantity is immediately canceled. The order does not remain active after the open.
Market on Close (MOC)
The Market on Close (MOC) is a market order that is only activated at the market close. The investor is not guaranteed to receive the exact same price as the last price before their order was submitted. The investor's order may have created a new closing price but with actively traded stocks this is likely to be only a few cents difference.
This order type is useful for trading strategies that use the closing price.
Market on Open (MOO)
The Market on Open (MOO) is a market order that is only activated at the market open. The investor is not guaranteed to receive the exact same price as the open price. The investor's order might take the next ask price available. The MOO may give a price that is different from the open price or the MOO may create the open price with the investor's own order. At least the investor will have their order filled at the open.
One Cancels All (OCA)
The One Cancels All (OCA) is actually a group of orders linked together. When one order in the group is filled then the other orders are canceled.
This order grouping is frequently used when an investor is looking at say three stocks to buy on the day but only has funds to buy one stock. The investor can place an OCA group with a limit order for all three stocks. When the first limit order is filled then the other two limit orders are canceled.
When the market participants lock in a quick profit
The term 'Profit taking' is frequently mentioned in the financial press and it may seem fairly obvious as to what they are referring to. It's usually mentioned whenever a stock, commodity or currency has had a quick gain and prices then pullback. The presumption is that market participants are now selling in order to lock in a profit from the quick price gain.
In reality Profit taking occurs all of the time and also occurs from short sellers when market prices have a quick decline - which the financial press never refers to as 'short selling profit taking'?
Short-term traders, speculators and investors are taking profits all the time, which includes selling into a rally with a profit target. This especially occurs when market participants use chart patterns with profit targets and they place limit sell orders.
In fact there are always buyers and sellers present in the market place - after all, it's the buyers who buy stock from the sellers (if nobody is selling then a buyer cannot buy).
The general implication (by the financial press) is that profit taking is something that only occurs after a price increase and the subsequent pullback is only temporary.
The market price is a never ending sequence of short-term rallies and short-term pullbacks and follows the principle of supply and demand. During a rally there is more demand form buyers than there is supply from sellers. The opposite occurs during a pullback where there is less demand form buyers than there is supply from sellers. Thus any pullback can be though of as profit taking from long sided market participants.
Profit taking is only a temporary decline and after the pullback is completed the stock then rallies again. If the rally continues above the high of the previous rally then the trend is still upwards. However if the next rally falls short and does not reach the previous rally's high before selling off again and trades below previous pullback's low, then the trend may have reversed and a new downtrend started. A second lower pullback is not called Profit taking as it is only the first pullback that is called profit taking.
Profit taking can lead to a trend reversal,
due to fear that prices may have peaked
So why are these market participants taking profits? Basically any market participant who has an open profit and they are concerned that the price advance has peaked will likely be a seller. The reasons for their concern are wide and varied and actually do not matter. If a market participant is worried that they will lose their open profit they will probably sell to lock in that profit rather than risk losing it. Greed and fear is what drives the market.
When the price advance is only minor then it's mostly the short-term participants such as swing traders and position traders who are profit taking - usually the price has reached their profit target or when prices pullback then their trailing stop-loss is triggered.
If the price has made a more significant advance, then the speculative traders become more active with profit taking. While the short-term traders are also active they tend to sell their entire position, but the speculative traders and investors tend to only sell a portion of their holdings so as to lock in some profit just in case the last rally proved to be the top of the uptrend.
Annualized vs. Average Rate of Return
It's easy to get confused
In the financial markets it is common practice to state the returns from an investment as a percentage per year.
For example, the S&P 500 index returned 22% a year over the last four years. As another example, the S&P 500 index achieved an annualized return of 17% during the last four years.
In both cases the same S&P 500 values were used (850 to 1590 over four years) but yet there are two different percentage figures for the returns. The reason for this is that there are two different methods of calculating the annual percentage returns.
- Annualized rate of return: A formula is used to calculate the percentage figure for the gain over the number of years. With this method the percentage gain is the same for each year and the dollar amount increases each year. This method is also known as the Compounding rate of return.
- Average rate of return: The total gain over the number of years is dividend by the number of years. With this method the dollar amount gained each year is assumed to be the same which means that the percentage return declines each year. This is a simplistic method which ignores the Compounding effect on the return and this method is frequently used to calculate historical returns.
These two methods are best illustrated with a simple example as shown below in Table 1.
Table 1. Annualized vs. Average rate of return
From Table 1. above, both methods start with $10,000 and end with $20,000 over a ten year period.
The annualized return is 7.18% per year and is calculated as follows.
Annualized rate of return = (($20,000/$10,000) ^ (1/10yrs) - 1) x 100% = 7.18% per year
The average rate of return is 10% per year and is calculated as follows.
Percentage gain = ($20,000 - $10,000) / $10,000 x 100% = 100%
Average rate of return = 100% / 10 yrs = 10% per year
The average rate of return is an easy calculation to perform and is a common method for stating the annual percentage returns. In fact if no other reference is made to the returns, then assume the returns were calculated using the average rate of return method.
The average rate of return method in effect calculates an average percentage gain and applies that percentage to work out the dollar gain for the first year (which for the above example is $1,000 based on 10%). This dollar amount is then simply added to each year (which leads to a declining percentage gain per year).
This is in contrast to the annualized method which adds a fixed percentage to each year, thus the dollar amount gained each year actually increases. Over the long-term, the stock market actually follows a compounding return rather than a fixed annual dollar gain such as obtained with the average rate of return - it's just that it is easier to calculate the percentage for the Simple rate of return.
The long-term effect can be readily observed with very long-term line charts (20 years and more). With a linear price scale the plotted data tends to bow upwards rather than showing a straight line. This is referred to as an exponential graph and is the reason why charting packages provide a Log scale feature - which is intended for long-term charts.
The example for the Annualized and Average rate of returns shown in Table 1. are plotted on a graph as shown below.
Graph 1. Annualized vs. Average rate of return
As can be seen from the above graph, the average rate of return plots as a straight line and the annualized return plots as an exponential curve.
For the same capital gain the average rate of return is always a higher percentage figure, which in this example is 10% (the annualized return is 7.18%).
The annualized method is normally used when the long-term compounding effect needs to be taken into account. Over the shorter term there is little difference between the two methods. As the time frame increases the difference becomes more noticeable. In reality, the average rate of return is frequently used as it is a quick and easy calculation to perform, while calculating the annualized return requires either a financial calculator or a spreadsheet application.