The stock markets are a means to buy and sell, but they are a market place: when, what, and how often and how much one buys, accumulates or sells is NOT the province of the market: that is the province of the field of investment which is covered elsewhere. Investment in general is a rich and complex field as it serves all kinds of investors, government, corporations, services, groups and individuals: each investor has her own objective, her own access to capital which to invest. Indeed, the subject of investing can well be approached from the investors point of view. Given that I am writing this here in a wiki, an information forum open to and created by the community of the world, it might be appropriate to direct this summary to the individual small investor, who invests as part of a long term and life long plan of savings for herself, her family and heirs. Again, the market is a place where one trades (buys and sells) financial instruments, such as stock, bonds and the many forms of these instruments, and is not itself concerned with investing, ie, the strategy for making a profit under many many varied desires and circumstances. This section under the stock market should be dry, technical and thorough, and should serve as a reference. However, to understand the vehicles, form a coherent view of ones own objectives and the appropriate vehicles: stocks (common, preferred) bonds (convertible or not) one should start with an introduction to investing, and most likely, focusing at first on individual investing, which should be the most straight forward and the most useful.
Traditionally the US stock exchange has given an annual average return of seven percent after adjusting for inflation. This makes it one of the most lucrative investments available. Granted, there is no guarantee that the market will behave in the future as it has in the past, but it has been consistent in some respects over its 70+ year history.
The challenge and lure of Investing come from the fact that it is an inexact science. In physics, there are a few laws which govern a large variety of physical phenomena. In Investing, there are no such comparable laws. Investing is all about predicting the future. Since, there are a large number of factors influencing the future price of a stock, there is always a degree of uncertainty with any position.
Stocks are just one kind of financial instruments. The field is complicated by the fact that there are mutual funds, Exchange Traded Funds (ETFs), Real Estate Investment Trusts (REITs), options, futures , bonds and several other kind of financial instruments. It takes almost a year to just familiarize oneself with the jargon of the field.
Finding a broker
There are several options to consider when finding a broker. These include but are not limited to the following: Full service brokers, discount brokers, and financial advisors. Each have their advantages and disadvantages. Transaction cost, experience, history and strategy are all factors to consider when hiring a broker.
A full service broker is a broker that will generally come with the highest up front costs. These costs are probably the full service broker's biggest disadvantage. However, the broker history plays a large role in the weight of this disadvantage. If the full service broker proves to have a history of high returns, they may be worth the initial fee, with the assumption they may be able to make you more than your average expected return after the fees are paid. When choosing a full service broker, one should interview several brokers. This serves as a good way to view their history, ask about their experience, costs and finally their strategy. Their strategy is what stocks and funds they are most familiar with and their justification as to why they pick the stocks they do. If one is adverse to larger transaction costs and doesn't mind using a more hands on approach, then he may want to look at more cost effective methods, such as a discount broker. Generally these brokers will be cheaper than their full service cousins (hence the name 'discount'), but they may require more interaction from the user.
Ameritrade, Brown & Co, and Interactive Brokers are some of the most cost effective brokers around. Barron's and Forbes periodically compare these brokers.
Understanding Stock Fundamentals
Stock market prices fluctuate everyday, and no stock is completely safe. However, there are certain things that you can look at to try to determine the best stocks. The price of stocks is based on two things: hype, and the fundamental value of the company. You must be careful about stocks with lots of hype that lack strong fundamentals, because they have strong potential to lose much of their value rather quickly.
When looking at a company, you will first notice its price. The listed price is generally taken as the most recent trade price on an open market. If you multiply the total shares outstanding by the price per share, you get the market capitilization (abbreviated market cap), which reflects the current market value of the company. The book value is the value of the various assets that make up the company. Many companys' market values are many times the book value, which reflects non-tangible assets like customer relationships.
What really drives the prices, however, is earnings. The earnings are the money made, which is the sales or revenue minus the costs of doing business, among other things. Earnings are analyzed in relation to price by a value called the P/E or price to earnings ratio. The primary way to use the P/E ratio is in a relative valuation. That means, how cheap is this company/stock compared to similar companies. If company A and B are equally profitable, have similar levels of assets and debt, and are growing at similar rates, then the stock with the lower P/E would appear to be a "better deal" or is possibly undervalued. The major pitfall in this approach comes when both companies A and B are presently overvalued, which could precede a drop in the stock price. There were numerous examples of this during the dot-com "bubble" and it's subsequent "burst".
Again, as a warning, it is imperative to note that one of the major conditions for determining relative value using P/E ratios is the growth rate of a company. If company A has a higher P/E ratio than company B, it is highly likely that the higher ratio is justified by a higher growth rate of company A's earnings.
Research stocks over the Internet
Many free websites can help you learn more about stocks. Here are just a few:
- Yahoo Finance
- Google Finance
Understanding Stock Technicals
Some people give lots of importance to the price/volume behavior of stocks. The price and volume of a stock can be charted against time. A good thing about the price/volume history is that it does not lie.
Also, you will read the disclaimer in several places that past performance does not predict the future. If the past performance, does not mean anything to future, why even study it? No amount of chart reading would have predicted the Enron Collapse.
The rationale for looking at the charts is that it helps you identify the patterns and/or trends. Fundamental analysis tells you what to buy and technical analysis is supposed to tell you when to buy.
The first thing to remember is that stocks are risky, and even the least risky stock can on occasion go down in value or even bankrupt. You can find out about companies from all over, but before buying you should thoroughly research the company. Also, keep in mind that many people including so-called professionals are often wrong. Over 80% of actively managed mutual funds do not generate better returns (after they take their fees) than the major indexes.
A well known investor named Warren Buffett claims that "Rule number one" is, "don't lose money." This is easier said than done and if you can not tolerate modest, near term, temporary losses, simply buy new issue Treasury Bonds, hold them to maturity and do not expect much income (that will be taxed like wages, at higher rates), after inflation. Historically, stocks have generally provided better returns albeit with added risk. The older you are the less risk you should be willing tolerate.
Warnings aside, the first thing to consider is risk. How much debt does the company have? Are they earning money, and will they continue earning money. Read their annual report, and look at their business, and think about what could happen that could hurt their business. Listening to conference calls is a rarely used but great way to assess the company's management. You can hear if the presentation of results and predicitons made sound honest and realistic. Risky stocks may be a good investment, but you should always be aware of the risks beforehand, and decide what you are going to do if the worst comes to pass.
After taking a hard look at the risks, you also have to look at the potential for the company, and the likelihood that it will happen. For example a solar cell company, may have huge potential if the government mandated solar cells on top of every building, but that is very unlikely to happen.
Look at the current price/earnings(P/E) ratio and what it would be in the future with various levels of growth. Also, look and see if the company pays dividends. Often, the earning number is inflated through accounting tricks, but the dividend is what the company paid stockholders last year. If the company has a good dividend, you can make a bit every year while continuing to hold the stock.
While the fundamentals, and how much money the company makes will affect it over the long term, other factors often dominate the markets in the short term. During the late 90's tech stocks got bid up, because they were hyped up in the media. After September 11, investors worried about terrorism, and stocks were priced accordingly. The market has day-to-day fluctuations, but usually there are certain themes from the media that hype something, that over-values or under-values certain stocks and segments of the market. However, when the theme goes away--often rather quickly--those stocks will correct (go up or down to their intrinsic or fundamental value). One short-term strategy would be to try to ride the themes, and profit, but it can at times be quite difficult, and mistakes often result in heavy losses. If you are going to buy a stock that you think will go up on hype use extreme caution. A more sensible approach is to try to buy things that are fundamentally undervalued before you think a cycle will start hyping that particular area of the market.
The value of a share of stock is based on many things but how much the "market" thinks the company will make in the future is the usually the biggest factor in what dicatates the current selling price.
Anticipating price movements will generally give much better results than reacting to them, in both the short and long term. It is important to recognize that the past does not dictate the future, but it can give some insight. Stocks with long histories of increasing value (including dividends when applicable) are more likely to continue appreciating than those with an erratic past.
Recognize that the sector a company is in can be as or even more important to the share price as the company's fundamental future earnings expectations. Chasing after stocks with significant recent price appreciation may work but more likely buying an already over priced stock will cause losses. An important truism is that, "The wise man(woman) does first what a foolish one does last." Ask anyone who waited until late 1999 to buy tech stocks because they decided, "everyone is getting rich except me."
Consider reviewing the past price performance of each security you consider buying or selling as a small part of your fundamental analysis. This is best achieved by using price charts of varying lengths of time.
The easiest part of stock investing is buying; you just need money. The hardest part is deciding if and/or when to sell; that requires wisdom. Failing to sell or buying an overvalued stock will almost always lead to losses and vice versa. It is wise to decide on your selling price and loss limit before you buy a stock (and sticking to them).
Never let tax consequences dictate you purchases and sales but keep in mind there are tax incentives (different tax rates on gains and losses) for holding shares with gains for a year and a day. This also serves to diminish the tax benefit if you have losses. It is always better to pay a high tax on a high gain than a low tax on a high gain that evaporates into a low gain.
No one likes to lose money but it is part of all but the most conservative investment strategies; no one honestly bats 1000. Try very hard not to allow emotions, hope or pride to affect your decisions. It is far better to acknowledge a mistake and take a small loss (that is not likely to be short lived) than to let to let it become a large loss. Never chide yourself for buying or selling too early. It is far better than waiting until it is too late and realizing a larger loss. There are very few stocks that you can buy and hold for a lifetime.
If you are unwilling to learn about a company/industry/sector on a fundamental basis you should not attempt to pick individual stocks. It is more appropriate to buy an index, mutual, or exchange traded fund based on your views of the future. This entails less risk (as well as lower returns) than stock picking, reducing possible losses. If you have the inclination and time to learn how and do fundamental analysis you will generally realize better results over time.
You must also recognize that share prices can sometimes become completely disconnected and unrelated to fundamental, intrinsic value not merely over or under priced. That is the greatest opportunity for gains (or losses) as noted above over the long term.
There is only one true thing about the stock market and stock prices; they will fluctuate. This observation is attributed to JP Morgan.
Risk, Risk Premiums and Diversification
Stocks are risky. There is no guarantee that the return on a particular stock will beat the market average or even be positive. The riskier a stock is the greater it's average return (but with a greater risk of no return or worse). This is called the "risk premium". Essentially, the seller is giving a discount to the buyer in return for taking on risk.
Risk can be reduced through diversification while retaining the same average return (called the "expected return"). Imagine a stock (stock A) costing $10 with a 50% chance of paying $2 and a 50% chance of paying $0. This stock would have an expected return of $1 (the average of 2 and 0) but would be risky. Now imagine that instead of buying 10 shares of stock A we bought 5 shares plus 5 shares of stock B. The cost and payback of B is identical to A with the caveat that B is a stock in an industry totally unrelated to A, and thus is not linked in its results. The stock A + B combination now has exactly the same expected return as A alone, but with lower risk! In other words:
DIVERSIFICATION LOWERS RISK WHILE MAINTAINING RETURNS.
The more diverse a portfolio is, the less risky it is. This is one of the rationals behind the new breed of index funds which recreate broad indexes such as the S&P 500 or the Wiltshire index. For long-term investing, index funds of this type are an excellent choice.
When to Sell
Knowing when to sell is often the most difficult part of buying and selling stocks. When a stock goes down, it is often difficult to admit that you made a mistake. When a stock goes up, will it keep going up? It is easy in hindsight to think that you should have held onto stock when you see it go up after you sold.
You generally don't know when a stock has really reached its peak, or whether it will go back up again, but there are some things to look for. Remember the reason you bought the stock. Considering all currently available data, is that reason still valid? Try to avoid coming up with new justifications for holding a falling stock. If you bought the stock, because you thought the company's new product would do really well, and it hasn't it may be time to sell.
There is nothing wrong with admitting you were wrong. However, you also need to be careful you aren't just selling to buy into the latest fad, either. The way the stock market works has been fairly consistent for many years. Different sectors have become hot, and later become not so hot. If you are going to revise your strategy, make you sure you still consider long term trends.
However, if something doesn't continue to fit your strategy, sell it. It doesn't matter if it has gone up a lot, or is almost worthless. Unless, you still think it fits with your strategy sell it. Remember, just because it may have a chance of going up a lot, doesn't mean there isn't another stock out there that is better. Selling based simply on past performance is generally a bad idea.
- This article is based on text from Wikibooks, available under the GFDL.