Stock Investing Part 1
The Stock Market
The American Stock Market
The American stock market actually consists of two major stock exchanges and several electronic communications networks (ECNs).
The first major exchange is the New York Stock Exchange (NYSE) which dates back to 1792 and is the world's largest stock exchange.
The second major exchange is the National Association of Securities Dealers Automated Quotations (NASDAQ) which was the world's first electronic stock market formed in 1971.
Public companies are listed on an exchange such as the NYSE or NASDAQ and stock investors can buy and sell shares of these companies.
The share ownership of these public companies is commonly referred to as stock. When a stock investor owns shares in a public company they are referred to as stockholders'.
When a new company is listed on an exchange the process is called an initial public offering (IPO). This is when the public companies shares are available for the first time.
The number of shares issued by a public company is known as the shares outstanding and this can vary over time as the company can buy back its own shares and it can also issue more shares.
The float refers to the number of shares available for stock investors to buy and may be less than the number of shares outstanding, which is due to some of the shares being owned by other companies rather than by stock investors.
Public companies may change the number of shares outstanding and generally do this to alter the stock price.
For example, a company that wants to lower its stock price because it may be perceived to be too expensive can issue a 2-for-1 stock split which effectively doubles the number of shares each stock investor owns, however the stock price will halve.
The net result is that there is no change in the value of stock owned by the investor. The investor now owns twice as much stock that's worth half as much.
Generally it's only the large organizations such as mutual funds that transact on the two exchanges.
Nowadays when a stock investor places an order to buy or sell stock with their online broker the order will probably go to one of several electronic communications networks (ECNs).
These ECNs where specifically setup to handle the huge increase in online stock transactions and are a convenient and cheap way for investors to buy and sell their stock.
Designated market makers work on the trading floor of the NYSE and their role is to match the buy and sell orders received from stock brokers. These orders are usually quite large and nowadays mostly come from institutions such as mutual funds. The NYSE designated market makers used to be referred to as specialists.
The NASDAQ also has market makers who are participating firms registered with NASDAQ and they provide quotes. Nowadays NASDAQ mainly deals with the larger orders from institutions such as mutual funds rather than small orders that typically come from most stock investors.
The Trading Volume reported includes all the trade orders that were executed on the two exchanges and on all of the ECNs for each trading day. Also included are any orders that were filled off market by the stock brokers such as block trades which are typically very large orders.
Listed Public Companies
The stock market makes it easy for investors to be part owners of companies
Companies can be either privately owned or publicly owned and both have shares.
Private companies typically only have a couple of shares and there are a lot of owner operated businesses which have only one share (these businesses are usually referred to as sole traders).
Public companies can be listed or unlisted and typically have a large number of shares which are for sale to the general public. The reference to Public company means that the general public owns the company - it does not mean government owned.
The reference to Listed means that the shares can be bought and sold on a stock exchange through a stock broker. The reference to Unlisted means that the company is not listed and the shares can only be bought and sold through a business broker (which is not the same as a stock broker).
Unlisted companies are generally much smaller in size than listed companies and have fewer shares, but the share price for an unlisted company is generally much higher than that of a listed company.
Unlisted companies are generally aimed at businessmen, businesswomen and the wealthy, even though any member of the general public can buy a share in them. Whereas listed companies are specifically aimed at the general public and this is why the share size of a listed company is smaller with a corresponding lower share price - this makes it more attractive to small investors.
Both listed and unlisted public companies must publicly disclose any information to U.S. Securities and Investment Commission (SEC).
This is a disadvantage for public companies since its competitors know exactly what they are doing.
This is to the advantage of the private company as there is no requirement for them to publicly disclose their business operations.
Companies can also be listed in more than one country - which means they have stockholders from two or more countries. This tends to occur when the company was formed in a country which has a relatively small stock exchange and for the company to expand they seek out a larger market (with the U.S. stock markets being the largest in the world).
Thus the foreign companies listed on NYSE and NASDAQ are typically dual listed and the American depositary receipts (ADRs) are a convenient method for the foreign company to issue new shares.
The size of companies varies considerably, with private companies generally being the smallest and listed public companies being the largest.
The following gives an idea of the capitalization of various companies:
Capitalization of various companies:
- An owner operator may have a business worth $100,000 and since they are a sole trader their businesses share price is $100,000.
- A Private company may have 4 owners each of equal share. If this company was worth $1,000,000, this makes each owner's share worth $250,000.
- An unlisted public company may have 1,000 shares and the business is worth $10,000,000 which makes each share worth $10,000.
- A listed public company may have 1,000,000 shares and the business is worth $100,000,000 which makes each share worth $100.
Receive an income - there is more to stock investing than just capital gains
Stock Dividends are Cash Payments
Stock dividends are cash payments that are made to the stockholders of a company. The dividend is the stockholder's share of the company's profit and is paid on a per share basis
Not all companies pay dividends and there are two main reasons for this.
Firstly, companies that are continually making a loss cannot pay a dividend since by definition the dividend is a distribution of a company's profit.
Secondly, many growth stocks while continually making a profit, choose not to distribute the profits back to their stockholders via a dividend payment, but instead choose to reinvest those profits back into the company.
Reinvesting dividends is typically done to either finance further expansion of the company thus increasing its value and hence stock price or to reduce financing costs by reducing the company's loan interest costs thus increasing its net profit.
Also a company may only payout a portion of its profit as dividends.
Important Dividend Dates
There are 4 dates of importance for receiving a dividend payment and they are as follows.
1. Declaration date
2. Ex dividend date
3. Record date
4. Payment date
The declaration date is the date when a company announced that it is paying a dividend; they state what the payment amount is and what the record date is.
In order for a stockholder to be entitled to receive a dividend payment, they must be on the dividend paying company's share registry, also known as being on the company's "books".
To be on the company's books, a stock investor who is buying shares must have those shares settled on or before the record date.
The settlement of share transactions takes place 3 business days after the day that the share purchase or sale is made. This is known as T+3 settlements (T+3 is short for trade date plus three days).
This means that the stock purchase must be made at least three business days before the record date.
Stock brokers generally provide stock investors with the ex-dividend date.
For stock investors to be on the company's books, the share purchase needs to done at latest one business day before the ex-dividend date. If shares are purchased on the ex-dividend date, those shares are not entitled to the dividend payment.
The payment date is simply the date on which the stock investor actually receives the dividend payment.
The latest date on which to purchase stock may seem a little confusing at first, but will clarify them as shown in the example below.
Let's assume a company has declared that it will pay a dividend with a record date 13-Jul.
- 10-Jul Tue: Stock must be purchased by this date
- 11-Jul Wed: Ex dividend date. Stock purchased on this date does not receive the dividend
- 12-Jul Thu:
- 13-Jul Fri: Record date. Stock purchased must settle by this date
On the ex-dividend date the stock is no longer entitled to receive the dividend payment and as such the stock's price will typically open for trading at a lower price than the price that it closed at on the prior day.
The amount that the stock's price drops is the amount of the dividend payment and this is known as the ex-dividend gap.
So for example if a stock pays a dividend of $1.00 and closed at $50.00 on the day before the ex-dividend date, then the stock will probably open for trading on the ex-divided day at $49.00.
Stock investors determine the attractiveness of a stock's dividend by using a simple ratio calculation known as the dividend yield, which is calculated by adding up all the dividends received over the last 12 months and dividing the result by the latest stock price. This is then divided by 100 to express it as a percentage.
Dividend yields vary widely and some stock investors specifically seek out stocks that pay good dividend yields and this strategy is known as dividend investing (also known as Income investing). These investors build a fixed income portfolio and may also include bonds.
Investors have a choice of common stock or preferred stock
Stocks are generally classified as either common stock or preferred stock.
Common stock is the class of stock that's most commonly issued, hence the term common. Unless stated otherwise, when the term stocks is used, it specifically means ommon stock.
Preferred stock is less common and has preference to dividends and preference to any remaining funds in the event of liquidation.
However, preferred stock generally does not have any voting rights and may not appreciate in price as much as common stock.
Preferred stock generally receives a higher dividend than common stock, which is typically a fixed percentage.
Preferred stock receives the dividend first and any remaining dividends if any are distributed to the common stock. In the event of bankruptcy, Preferred stock receives any remaining funds before common stock.
Some companies issue several classifications of common stock in order to assign different voting rights to each classification of common stock. They are usually distinguished by referring to them as Class A stock and Class B stock.
The number of votes assigned to each class varies between companies, but typically one class will have one vote per share and the other class will have more than one vote per share. The class with one vote can be either Class A or Class B.
While there are other classes of stock, the above mentioned classes are the most common classes encountered on the stock market.
The risk is less with the larger market capitalized stocks
Market capitalization (usually referred to as market cap) is simply the stock price of a company's shares multiplied by the number of shares outstanding.
The shares outstanding are the shares that are currently owned by the stockholders. Some companies repurchase shares using the company's profits to pay for them, and they do this rather than pay a dividend.
Stock repurchases reduce the number of shares available, thus increasing the company's equity per share for the remaining stockholders.
Thus the number of shares outstanding is equal to the original shares issued when the company was first floated less the shares that were repurchased.
Larger companies tend to have more shares outstanding and higher stock prices which gives them higher market capitalization values than the smaller companies.
Hence market capitalization is a broad measure of the relative size of a company as currently determined by the market.
A variation to Market Capitalization is the enterprise value which adds the company's debt to the market capitalization.
The market capitalization for a company will fluctuate considerably over time in line with the fluctuations in the stock's price.
Market capitalization is not a reliable indicator of a company's fundamental value as the stock's price can be driven substantially higher or lower than its business valuation, but is useful as a general guide to a company's size relative to the market in general.
The market capitalization of a stock
can vary significantly over time
The market capitalization ranges widely from the largest companies down to the smallest companies.
The largest blue chip companies in the DOW index have market capitalizations over $200 billion, while the smallest companies listed have market capitalizations less than $50 million and some are only a couple of million dollars.
Market Cap Categories
The following is a general guide as to the market capitalization ranges for various categories of company sizes commonly referred to in the stock market.
- Blue chips- Over $200 billion
- Large cap- Over $10 billion
- Mid cap- $2 billion to $10 billion
- Small cap- $250 million to $2 billion
- Micro cap- Less than $250 million
Generally the larger market capitalization companies are financially stable and tend to have been in business for a considerable amount of time.
The small and micro capitalization companies tend to be newer companies with a limited track record and quite often have poor fundamentals, however there are numerous exceptions.
Measure the markets performance
Stock market indices provide a means by which to measure the performance of stock markets and are essentially a group of stocks that are selected to represent the U.S. economy.
There are numerous stock market indices, some of which cover the entire economy while others cover a specific sector or industry within the overall economy.
The DOW is by far the most popular index reported by the financial press and is also the original index which started back in the late 1800s by Charles Dow.
There are several DOW indices, however when the financial press reports on the DOW, they are specifically referring to the Dow Jones Industrial Average index which consists of the 30 largest companies in the US economy.
Most stock investors are familiar with the DOW index which is actually the DOW Industrials average.
There's also the DOW Transport average and the DOW Composite average which includes all three Dow averages.
The S&P 500 is the second most popular index reported by the financial press and dates back to 1950. The calculations are done by Standard and Poor's and the index consists of the 500 largest companies in the US economy.
The two most widely followed indices in the world
are the DOW Industrials and the S&P 500
Index Calculation Methods
There are two methods used to calculate the value of an index, price weighted and market cap weighted.
Price weighted indices are calculated by adding up the change in prices of all the stocks that make up the index and then add that result to the previous index value to arrive at the new index value.
The DOW index is calculated using this approach. So the index value of the DOW today is simply the sum of the stock price changes from yesterday, added to yesterday's index value.
Market cap weighted indices are calculated by adding up the change in market cap of all the stocks that make up the index and then add that result to the previous index value to arrive at the new index value.
The S&P 500 index is calculated using this approach. So the index value of the S&P 500 today is simply the sum of the market cap changes from yesterday, added to yesterday's index value.
Other Common Indices
Other indices frequently mentioned by the financial press include:
NYSE composite which is calculated by NYSE and consists of over 2000 companies listed on NYSE.
NASDAQ 100 which is calculated by NASDAQ and consists of the largest 100 companies listed on NASDAQ.
NASDAQ composite which is calculated by NASDAQ and consists of over 3000 companies listed on NASDAQ.
Unlike the DOW and S&P 500, the indices provided by NYSE and NASDAQ include non-US companies listed on their exchanges. Both NYSE and NASDAQ calculate their indices using market cap weighting.
Indices should only be used as a guide to the performance of a stock investment portfolio as individual stock investors' portfolios do not consist of all of the stocks in the index.
This means that while an index may go up say 10%, the stock investor's portfolio may go up much more than 10% or only go up a couple of percent.
Stock Market Cycles
The ups and downs
Beginner and novice stock investors typically expect immediate gains and continuous gains; however the stock market trades in cycles.
The two market cycles are, the bull Market cycle where stock prices are broadly increasing year after year and the bear Market cycle where stock prices are broadly declining for a year or so
At the extremes, bull markets can be as short as two years and as long as seven years, and bear markets can be as short as six months and as long as two years long before the bull market resumes.
The Market Cycle
In bull markets, confidence is high amongst stock investors who are exposed to multitude of positive financial press coverage. This reinforces their confidence that these seemingly endless stock price increases will continue forever into the future.
This over confidence leads stock investors to pay increasingly higher prices for their stocks, quite often for companies that are only worth a fraction of the prices they are happily paying.
At some stage in the future, this seemingly endless increase in stock prices comes to a halt, and stock prices now start heading downward, shaking the confidence of these once bullish stock investors.
These stock investors now see the value of their portfolio decreasing, along with their own confidence.
The stock investor is now exposed to a multitude of negative financial press coverage and their once exuberant confidence is now replaced with outright pessimism.
At some stage further into the future, stock prices start to increase again, financial press reports become positive again and the pessimistic view that stock investors had been displaying is once again replaced with enthusiasm and confidence.
Thus, the next bull market has begun and so the cycle repeats again.
Stock Prices during Bear Markets
New stock investors wonder whether the value of the stock market could drop to zero in a bear market.
The answer is quite simply no. The stock market is tracked using an index such as the DOW or the S&P 500. An index is quite simply a collection of companies and their stock prices are used to calculate an index value.
An index is therefore a collection of income producing assets which even if none of these companies were making any recent profits, they still have the value of their assets.
To put this simply, if stock prices of these listed companies were to drop to zero, other companies will mount a takeover bid in order to just buy these listed companies for their assets and then subsequently sell these assets netting them a pure profit as the cost of these assets were next to free?
Stock Prices during Bull Markets
The stock price increases achieved in bull markets is typically much greater than the stock price declines experienced in bear markets. In other words, more money is made in bull markets than is lost in bear markets, and bull markets last longer than bear markets.
The long-term nature of the stock market is upwards, but is interrupted by bear markets. The stock market itself is a collection of companies that produce a product or service and is an integral part of the economy.
The long-term expansion of the economy requires a continuing increase in products and services, which in turn increases the value of the companies that provide those products and services.
Stock prices in bull markets do not generally increase consistently, but rather have short periods of price increases followed by short periods of price declines.
These micro cycles of increasing/declining prices continue to repeat within a bull market. Similarly, bear markets have the same micro cycle characteristics.
There have been numerous market theories which attempt to explain this phenomenon.
The Bull Market
Stock exchanges monitor the number stocks that increase in price (known as advances) and the number of stocks that drop in prices (known as Declines).
Together these two produce an indicator known as the Advance/Decline and is reported by the Stock Exchanges.
Typically in bull markets the number of advances is more than the declines and visa versa for bear markets. The Advance/Decline is also referred to as the Breath Index and is plotted on a chart to highlight any trending behavior.
Another ratio used is the Bull-Bear ratio which tracks the number of analysts that are bullish on the market compared to the number of analysts that are bearish on the market.
In a bull market the upward surge in stock prices is generally referred to as a market rally and the downward period is known as a pullback or a correction.
The Bear Market
In a bear market the downward decline has no unanimous term but is sometimes referred to as either a downturn, a market sell off or a market decline.
The upward surge in stock prices is unanimously referred to as a bear market rally.
The term stock market crash is generally used when the downward correction is severe and dramatic.
Bear markets generally decline by 20% or more of the bull market gains, but this has varied dramatically with each bear market since the stock market index DOW started in the late 1800s.
A general rule is that the greater the bull market gains are, then the greater the bear market decline is as measured from the top of the bull market.
Some minor bear markets only recorded declines of 10%.
The one thing most bear markets have in common is that the bottom of the bear market finished above the bottom of the proceeding bull market.
Mutual Funds vs. Stocks
Buying Mutual Funds
Mutual funds tend to be popular with investors who are new to stocks and have no real knowledge of the stock market.
They have the perception that mutual funds are an easy and safe way to invest as the fund does all the work for them.
While this is true to a certain extent, the decision as to when to enter the fund and when to exit the fund is still left up to the investor, as is the decision as which type of fund to invest in.
This creates a problem for investors without any stock market knowledge, as a market correction typically sees them exit their fund, usually at a loss.
Direct purchasing of stocks is popular amongst stock investors who have a strong desire to learn and understand the stock market and these investors may also incorporate funds into their portfolio.
Key Features of Mutual Funds and Stock
The following is a quick summary outlining the key features of investing in mutual funds and the key features of direct stock ownership:
Buying Mutual Funds:
- All stock buy and sell decisions are made by the fund manager, who continuously monitors and adjusts the funds portfolio.
- The beginner investor merely needs to determine when to enter and exit the fund; however this requires a sound knowledge of stock market cycles. Investors entering and exiting at the wrong times is the number one reason for investors losing money.
- There are over 10000 funds, so the beginner investor still needs to choose which funds to enter. Funds utilize a variety of investing styles which have a wide range of performance returns throughout various market cycles. That is, the returns are not constant from year to year.
- The minimum investment is generally only a few hundred dollars, which allows an investor to make small monthly or quarterly contributions (the dollar cost averaging approach).
- Mutual funds have annual fees and often also have entry and exit fees. This is where an investor needs to determine whether these additional fees are worth it based on the returns received.
Direct stock ownership:
- Buying Stocks directly gives an immense amount of satisfaction that only direct ownership of a corporation can bring. It is normal for the new investor to a little nervous when buying their first stock as this is something new to them.
- Background research is done by the stock investor. Most stock investors who buy stock directly tend to make the research and the learning into a hobby. After all, how many hobbies actually pay you money?
- Potential for greater returns. Fund managers can very easily move a stock's price due to the large quantity of stock they purchase. This allows a stock investor who only requires a small quantity of stock to easily fill their order without affecting the stock's price, thus obtaining a price advantage over the fund manager.
- Stock investors often use online brokers which provide cheap brokerages compared to full-service brokers. These low fees lower the transaction costs and increase the net returns.
- Some experienced stock investors utilize direct access brokers which provide extremely cheap brokerage fees thus minimizing costs and maximizing returns. While direct access brokers typically have a monthly account fee, these are usually small and are waived if the monthly brokerage exceeds the monthly fee.
- For beginner stock investors, the relative brokerage costs are high if only a small quantity of stock is purchased. This due to the minimum brokerage fee. One way around this is to save up to purchase a larger quantity of stock. The other is as soon as the beginner stock investor has gained some experience they can utilize a direct access broker.
Irrespectively of whether a stock investor directly owns stock or has bought into a mutual fund or both, the investor is still subject to the benefits and the pitfalls of the stock market and a lack of knowledge here can prove to be very costly.
Investors have a choice
Most investors that are new to the stock market are under the impression that there is only one type of Fund that is managed, broadly known as mutual funds.
Actually, there are three types of funds that are managed. These are as follows:
Mutual Fund types:
- Mutual Funds: also known as open-end funds, are the fund type that most investors that are new to the stock market will be familiar with. In fact, if no other reference is made to the fund type, then the reference is to a mutual fund. The investor buys shares in a mutual fund directly from the fund provider.
- Closed-end Funds: these are similar to mutual funds except that the fund is listed on the stock exchange and investors actually buy shares in the fund just like buying shares in any other stock listed on the stock exchange. That is, the stock investor buys the shares from another investor who is selling their shares in the fund.
- Exchange Traded Funds: these are usually referred to as ETFs and are similar to closed-end funds in that they are also listed on a stock exchange, however exchange traded funds are not actively managed and their portfolios generally consist of stocks that make up an index, and as such are primarily used to mirror a stock indices performance.
All funds utilize a pooled source of capital that is provided by investors and the fund manager allocates that money by purchasing stocks for the portfolio in accordance with the funds prospectus.
This pooled source of capital is split up into units referred to as shares.
With a fund, the term share refers to the investors share of the fund, whereas with a listed company a share refers to a share of the company.
Thus with a fund, the investor buys a share of the fund, not a share of the company that owns the fund.
The traditional mutual funds and the closed-end funds both have a portfolio of stocks and a fund manager who actively managers the fund.
The fund manager's role includes monitoring the financial state of the companies in the portfolio and selling stock that no longer meets the funds criteria.
ETFs are very similar to mutual funds and closed-end funds, but primarily have a portfolio that is designed to track an index.
An ETF is only passively managed with the portfolio only amended when the underlying index it is tracking is amended.
Shares in a mutual fund are bought directly from the fund provider and the investor does not need to have a stock brokerage account. Shares in mutual funds can also be bought through financial advisors and some stock brokers.
Closed-end funds and ETFs are listed on a stock exchange and their shares are bought and sold through a stock broker.
When buying a closed-end fund or ETF, the investor needs to have a stock brokerage account.
The investor is simple buying someone else's share of the fund from the stock market and the fund is included in their stock brokerage account just like any other stock.
Investors should be aware that
all funds charge fees
All fund types charge annual fees for their service and Mutual funds may also charge entry and exit fees.
Mutual funds may incur higher operating costs than closed-end funds as the investor can sell their fund shares back to the mutual fund at any time.
Also any of these fund types can be held in a tax advantaged account such as an individual retirement account (IRA or Roth IRA) which may be suit investors, but they should take into account their own personal tax considerations.
Closed-end funds have higher operating costs than ETFs. This is due to closed-end funds being actively managed, whereas ETFs only need to purchase shares to start their portfolio with the ongoing management only requiring a portfolio rebalance if the underlying index it tracks alters, thus the operating costs and hence the annual fees for ETFs are lower than that of Closed-end funds.
Closed-end funds and ETFs do not charge entry and exit fees, however normal stock trading brokerage is payable, but this is generally lower than the mutual funds entry and exit fees when an online broker is used (especially if a direct access broker is used).
Funds for Stock Investors
Mutual funds tend to be popular with investors that do not wish to be actively involved with the stock market and not requiring a stock brokerage account makes it very easy for them to participate in the stock market.
In contrast, both closed-end funds and ETFs tend to be popular with stock investors who are actively involved and have a good understanding of the stock market. They use these fund types in a similar manner to investing directly in stocks, using various investing strategies to capitalize on the prevailing market conditions.