Stock Investing Part 2
The investor needs to decide on which type of broker to use
The Role of the Stock Broker
A stock broker is required to buy or sell stocks on the stock market, and they are commonly referred to as a Broker.
The stock broker's first role is to forward your trade order on to a stock exchange or to an ECN (Electronic Communication Network) so that your order can be filled:
Stock Brokers first role:
- When stocks are purchased - they are bought from someone who is selling them (which can be an investor, a trader or a market maker).
- When stocks are sold - they are sold to someone who wants to buy the stock (which can be an investor, a trader or a market maker).
The stock broker's second role is to settle your stock:
Stock Brokers second role:
- For a stock purchase - the stock broker will arrange for the stock ownership to be transferred into your name and will forward the payment to the stock seller's account.
- For a stock sale - the stock broker will arrange for your stock to be transferred across to the stock buyer's account and will deposit the payment received into your stock trading account.
Types of Stock Brokers
Stock brokers charge a commission for these two services and the fees vary depending on which of the three main types of stock brokers is used.
- Full Service Brokers: they are the oldest stock broker type. They provide an additional service of monitoring their client's stock portfolios, however this comes at a significant premium in the commissions charged. They are often criticized for influencing their client's to trade unnecessarily in order to generate additional commissions, but they are still used nowadays primarily by stock investors who do not have the time or desire to conduct their own research.
- Online Brokers: these are stock brokers that are accessed via the internet and they are relatively cheap to use. Their popularity has increased dramatically over the years. They do not provide a portfolio monitoring service, but they generally provide access to company research reports, financial news and fundamental data via their websites. This allows the stock investor to make their own informed decision on any proposed stock purchases or sales.
- Direct Access Brokers: they are also stock brokers that are accessed via the internet, but with this type of stock broker, trade orders are always placed directly onto the order book and the client can decide which exchange or ECN their order is directed too. They are generally the cheapest stock brokers to use, but are intended for the more experienced and active stock investor. Their research information is generally the same as the online stock brokers.
Selecting a Stock Broker
The decision as too which type of stock broker to use largely depends on the following factors;
- Whether the stock investor is comfortable with the process of selecting which stocks to buy or sell? Stock Investors who are educated in the basics of the stock market tend to prefer to make their own decisions.
- How frequently the stock investor or trader buys or sells stocks. Once the trading frequency increases, commission charges start to become quite significant.
- The typical position size per order placed. Generally all stock brokers have a minimum brokerage charge. For very small orders the minimum commission can be a large percentage of the trade order. For example, a $10 minimum brokerage to buy $100 worth of stock represents an effective commission of 10%.
- How long the stock investor holds their stocks before selling, if sold at all? With long-term stock holdings, the gains are significant and therefore the commission charge becomes less of an issue. With the more active short-term stock investors and especially stock traders, the gains are quite small and as such the commission charges need to be carefully considered.
The decision as to which type of stock broker to use is one that needs to be made by the individual stock investor.
Also, a stock investor can use more than one type stock broker and they can change the type of stock broker used at any time.
The more experienced active stock investors and especially stock traders tend to prefer direct access to the order books and hence will use a direct access broker.
Stock investors and traders starting out tend to prefer online brokers as they tend to be more user friendly.
Full service brokers tend to be more popular with those stock investors who prefer not to have any direct involvement with the stock market.
Building an Investment Portfolio
This is where the investing begins
The Investment Portfolio
A portfolio is simply a term used to describe the fact that an investor owns stocks and/or funds. Any stocks or funds that have been sold are not considered part of the portfolio, it is only the stocks or funds currently held.
Beginner stock investors are faced with the task of building their portfolio of stocks and/or funds and at first this seems like a difficult task as the beginner has minimal knowledge or experience.
To make this task easier some beginner stock investors use model portfolios where the stocks are pre-selected for them.
It is generally advisable for the beginner stock investor to only allocate a portion of their available capital to start with; this is because most beginners who study the stock market and educate themselves will fairly quickly improve their knowledge and will then want to make their own stock selections, which they can do if there is capital remaining.
So how many stocks should a beginner stock investor hold? Generally around 5 to 10 stocks to start with.
Holding too few stocks will hit the investor's portfolio hard if any one particular stock declines significantly in price.
Holding too many stocks involves a lot of work monitoring your portfolio without any real diversification benefits.
Example: Let's say a beginner stock investor has $20,000 to invest; they could start to invest say 25% and invest the rest as their knowledge and experience increases. Thus with $5,000 to begin with, the beginner stock investor could buy $1,000 worth in 5 stocks or $500 worth in 10 stocks.
As the beginner stock investors knowledge and experience increases, the remaining capital can then be progressively allocated to the stock market.
Selecting Stocks for a Portfolio
So what types of companies should the beginner stock investor include in their portfolio? There are several considerations here;
- It is advisable for the beginner stock investor to only consider large companies with a solid history of being profitable. The list of stocks in the S&P 100 index is a good place to start. These are the largest 100 stocks in the S&P 500 index.
- The beginner stock investor should consider whether the income from dividends is important to them. Generally, large companies that pay good dividends are companies with minimal growth prospects and large "growth" companies typically pay little or no dividends.
- Beginner stock Investors should make sure their portfolio is diversified, which means to buy a range of stocks in different industry groups. This means do not buy only banks or only buy software companies.
As the beginner stock investor increases their knowledge and experience, further capital can be allocated progressively over time.
The number of stocks in the portfolio can be increased up to about 20 stocks. However, adding more than 20 stocks does little to increase diversification and has the disadvantage of increasing the amount of time taken to monitor a portfolio.
The exception is a portfolio that largely consists of buy and hold stocks as the on going monitoring is minimal since in this case the stocks are generally never sold.
Including Funds in a Portfolio
The beginner stock investor does not need to restrict their portfolio to only buying stocks.
Funds such as mutual funds, closed-end funds or exchange traded funds (ETFs) can be included in the beginner stock investor's portfolio in exactly the same manor as buying stocks directly.
In fact, a beginner stock investor's portfolio could consist of a couple of mutual funds, a couple of closed-end funds and a couple of ETFs and some stocks.
Utilizing funds in a portfolio is a particular good strategy if the beginner stock investor's capital is limited.
The secret to building long-term wealth
Making Regular Contributions
The basis for Dollar Cost Averaging is to accumulate shares in a company over time at fixed time intervals for a fixed dollar amount.
The time interval can be anything from one month to one year (for example buy $100 of stock in company XYZ every three months).
Dollar Cost Averaging is effectively the process of making regular contributions to an investment portfolio.
It must be stressed that this tactic is only suited to long-term investing in financially sound companies and works best with value investing or dividend investing strategies that use a buy and hold approach.
Alternatively it can be used for long-term investing in funds such as mutual funds or exchange traded funds (ETFs).
Dollar Cost Averaging is generally not suited to stock trading, although some speculative stock investing strategies make use of it.
Also, Dollar Cost Averaging is generally not suited to companies that are not financially sound as the stock's price could potentially drop way below its tangible book value and may even drop close to zero.
The idea of using a fixed dollar amount is so that the number of shares that can be purchased reduces as the stock price increases. This means that when the stock price peaks and then subsequently falls, the least amount of stock was purchased at the highest price and the maximum amount of stock is purchased when the stock price has fallen to its lowest level.
Now when the stock price bounces back up again, the stock investor has bought more stock at the low prices than stock bought at the high prices. This includes stock bought at the very bottom, which of course is every stock investors dream.
This tactic works extremely well for long-term investing in financially sound companies using value investing or dividend investing buy and hold strategies, but it does have advantages and disadvantages.
The advantage is that the lower the stock price is, the more stock that was bought at these low prices, and hence the more profitable the investment becomes over the long-term.
The disadvantage is that brokerage costs can become an issue for small stock purchases. One solution is to increase the time interval to say one year thus providing a higher dollar amount to purchase stock.
Dollar cost averaging works extremely well
with financially sound stocks
A variation on the Dollar Cost Averaging tactic is to reinvest the dividends received.
This tactic is extremely popular and can be conducted directly through the dividend paying company with a process known as DRIP, which stands for dividend reinvestment plan and most DRIPs have no fees.
Buying while Stock Prices are falling
A common misconception with Dollar Cost Averaging is that it will eliminate capital losses when stock prices have fallen.
This is not the case, as capital losses continue to increase with falling stock prices; however when the stock price finally rebounds and starts to climb again, the capital gains increase quicker on the way up than they fell on the way down.
This is because a higher proportion of stock was purchased at those lower prices which are contributing more to the increase in capital gains.
Many beginner stock investors are not comfortable with the idea of buying more stock when the stock's price is falling, but what needs to be taken into account is that a fundamentally sound company has a practical limit as to how far the stock's price will fall below what it is worth and these stocks will sooner or later rebound back up again.
Dollar Cost Averaging gives the stock investor an opportunity to buy stock at the very bottom of a decline before the stock price rebounds.
Working within the stock market industry
Industry insiders include market makers, stock brokers, stock analysts and institutional investors which are large organizations such as banks, mutual funds, insurance companies etc.
Industry insiders are employees within the stock market industry and work in a range of industries.
They typically start off their career as a junior while working under the guidance of a senior who acts as their mentor, thus enabling the junior to learn and become proficient in their chosen field.
These employees deal with the stock market on a day to day basis and as such are tuned into the tactics that can be used to invest and trade profitably.
For example, the financial press reports on a company whose revenue is down and the general investing public will typically sell their stockholdings, thereby pushing the stock's price down (usually way below what it is worth).
These industry insiders know how the stock market works.
They know that the sell off is over done and that the stock's price will rebound off from the bottom. The stock's price may only rebound up half way to were it was, but it still provides for a profitable trade.
Beginner stock investors can learn a lot by studying their approaches and tactics, some of which can be readily incorporated into the stock investors own strategies.
Within the context of insider trading, an insider refers to a company's officer such as a CEO, CFO or a director.
Also, any investor or another company that owns 10% or more of the companies stock is considered an insider.
There is legal and there is illegal insider trading.
Legal insider trading occurs when the company's officers or other insiders buy or sell their company's stock when the general investing public has the same information that the company's officers have.
Insider trading is only illegal when the company's officers or other insiders have information that the general investing public does not have and these insiders buy or sell their company's stock based on that information.
Insiders must by law report their trading activities to the SEC (Securities and Exchange Commission) and this information is made public.
These insider trades may give some insight into their company as these insiders are directly involved with the inner workings of the company.
These company key employees know their company best, so if they buy more of their company's stock then they think it's a good investment or at least that the stock price is likely to increase in the short-term.
As an example, a company may have disclosed information that its profits will be declining and thus the stock price will typically decline, but the insider trading reports show that there is a significant amount of stock purchases by these insiders, then there is a very good chance that this profit decline is only temporary as the insiders are confident enough to buy more of their own companies stock.
The Art of Stock Picking
The professional stock investors secret - financial intuition
Successful Stock Picking
Successful stock picking is as much an art as it is a technical skill. It involves using a smorgasbord of tactics and tricks, and the reference to "The Art" is that it also involves a certain degree of intuition.
Stock pickers adapt to current market conditions and use a variety of investing strategies. Stock pickers are very open minded.
Beginner stock investors will naturally ask the question "why not just use the buy/sell recommendations that are so readily available".
While this is a common approach, beginner stock investors who do not educate themselves have no real knowledge or financial skills in the stock market.
It's fine to use these recommendations as part of one's stock picking strategy, but it's a mistake to exclusively rely on them without any knowledge of the driving forces behind the stock market.
So the big question running through the minds of beginner stock investors is how does someone learn stock picking skills? Basically, it involves learning how the stock market works, by reading, studying and analyzing the forces that drive the market.
Stock Picking Skills
Stock picking uses all and any means necessary to find a suitable and profitable investment or trading opportunity. It may include:
- Fundamental analysis to determine a company's worth and potential.
- Risk Management to manage the investment risks.
- Market analysis to determine whether or not to consider taking a position.
To the beginner stock investor this may seen like there is a lot to learn, however learning the basics is quite simple and easy to achieve, especially if they focus on the important concepts.
The beginner stock investor's knowledge increases dramatically and this reflects back through their increased success and profitability.
Stock picking skills allow stock investors and stock traders to analyze market conditions and to select an appropriate strategy to capitalize on an opportunity.
Beginner stock investors once they start to acquire a knowledge base, tend to become passionate and treat their continuing education as a hobby.
There is an immense amount of satisfaction in investing and trading with the ebb and flow of the stock market.
Financial knowledge is a natural way to controlling market risk
Dealing with Market risk
Market risk is a natural concern for many new investors to the stock market.
After all, the stock market is a new endeavor for most people and to make things worse, the new aspiring stock investor has no real knowledge of what the stock market is or how it really works. The stock market is a never-ending sequence of bull markets and bear markets.
On the one hand they are exposed to the financial press which presents an image of the stock market as a glamorous world with exciting prospects of significantly increasing ones wealth with relatively ease.
On other hand, seemly concerned fellow work colleagues and well meaning friends are providing conflicting views that the stock market is risky.
Most of these new aspiring stock investors would have heard of stories of people who had lost a significant amount of money in a short period of time in the stock market.
So the beginner stock investor in their mind has to sort out this apparent conflict. The mere fact that you are reading this article means that you are searching for some rational explanation.
Stock Investors losing money
The stories of stock investors that lost money generally did so because they had no real understanding of the stock market. There are numerous reasons why they lost money - with some of the most common reasons being:
Common reasons investors lose money:
- They may have purchased stocks that should never have been considered as an investment. They end up holding shares in companies that are near worthless rather than financially sound companies. Some of these companies may even end up in bankruptcy.
- They may have purchased shares in good quality companies but at an over inflated price and when the stock price corrected back down to its fair value they proceeded to sell those stocks at a loss.
- They may have decided to trade stocks, that is to buy stocks with the view to sell them soon after for a quick profit, but find that it is considerable more difficult to trade profitably than they had anticipated.
- They may simply have bought near the top of a bull market and proceeded to sell their stocks during the bear market at a loss - this is one of the biggest beginner investor traps.
Most beginner stock investors tend to be caught off guard by market cycles, both short-and long-term cycles.
They tend to purchase shares in the wrong companies and/or purchase stocks at wrong time.
The outcome is almost always the same and generally results in a financial loss.
The irony is that the stock market is fairly simple and straight forward. The key to success is knowledge and experience.
The key to success is knowledge and experience:
- Knowledge is easily obtained by reading and studying educational material relating to the stock market.
- A satisfactory level of experience can be obtained in a fairly short period of time when combined with reading and studying.
Thus it is possible for a new aspiring stock investor to become quite proficient in the stock market in a matter of months rather than years.
This level of proficiency will continue to increase over time and helps keep them out of the higher risk purchases that plaque the unknowledgeable newcomer.
Stock Investor Risk
The beginner investor trap, Bought High and Sold Low
Tracking the Stock Price Daily
Beginner stock investor's typically buy shares in companies were the stock price continues to increase.
This gives the beginner stock investor confidence as the seemingly continuous increase in the stock's price gives the illusion that the price increase will continue unabated.
After all, the stock's price has been going up and as such beginner stock investor's see no reason why this should not continue.
The beginner stock investor having purchased their shares, now start tracking the companies stock price on a daily basis.
At some stage - usually sooner than later - the stock price drops below the price originally paid.
This naturally causes some anxiety and the beginner stock investor starts to wonder if they made the right decision in purchasing these stocks.
At this stage, most people will naturally seek answers and the financial press is a means of providing information.
The beginner stock investor now reads articles related to the stocks purchased and since the stock price is declining, the financial news is most likely going to be negative.
When stock prices fall, beginner
investors focus on all the negatives
Losing Confidence in the Stock
This shakes the confidence of an already anxious stock investor. At this stage, people naturally focus on the negatives and ignore any positives.
Psychologists refer to this phenomenon as Tunnel Vision and it is a major problem with stock investors.
It becomes a compounding effect, the further the stock's price drops below their purchase price, the more focused the stock investor becomes on any negative coverage by the financial press.
This causes considerable psychological pain and in the stock investor's mind, the only why to make this pain go away is to remove the source and that is to sell the stock.
So what is the problem?
Simply put, beginner stock investors have not yet learnt how the Stock Market works and as such will always fall victim to this all too common phenomenon, which happens to most stock investors sooner or later.
So what is the solution?
Basically beginner stock investors need to learn how the Stock Market works and the way to do that is by studying and learning.
The quickest and easiest way for the investor to increase their financial knowledge is to read educational articles such as the articles found on this website.
Stock Trading vs. Stock Investing
The debate over trading vs. investing has been going on forever
What's the Difference
While both stock investing and stock trading seeks to obtain a capital gain from an increase in the companies share price there are a number of differences between these two broad styles of participating in the stock market.
Stock investing is concerned with the growth of a company's profits in the years to come.
As a company's profit increases, so does its business valuation and hence its stock price will tend to be higher.
Since this process typically takes years, stock investing tends to be a long-term process.
With investing it is prudent to determine a basic valuation for the company in question so as to gauge its investing potential.
A stock price that is significantly higher than its valuation needs to be questioned whether there is any realistic gain left or is it just going to get hammered in the first market correction that comes along.
This leads the investor to wonder if there is another tactic that could be used to perhaps capitalize on the above mentioned company's strong upward price momentum on a short-term basis, such as stock trading.
Stock trading is concerned with the short-term cyclical gyrations and as such long-term earnings growth is not that important nor is it concerned with how over priced the stock is.
What's important are the forces that drive these short-term gyrations which includes market sentiment and company specific events.
The time frame for stock trading is generally quite short and ranges from days to weeks for swing trading and ranges from weeks to months for position trading.
There are some longer term speculative trading styles which can last up to a year or more.
While stock trading can be conducted without the use of a stock price chart, it tends to be more efficient to use charts in order to visualize these short-term gyrations or swings as they are commonly known.
Stock price charts tend to show how a company is perceived by stock investors and other stock traders, especially when combined with a basic valuation of that company, which gives the stock price a reference line.
The Difference between the Two
The difference between stock investing and stock trading is essentially the time frame that the stocks are held and can be summarized as follows;
- Stock Investing - seeks a capital gain from the future growth of the company's profit which typically takes years.
- Stock Trading - seeks a capital gain from the short-term fluctuations in the stock's price which ranges from days to months.
Stock Investors can also trade stocks and stock traders can also invest in stocks. This dual approach is a common strategy utilized amongst the professionals.