Investing in Stocks

Unless you have been living in a hole or on Mars for the past 10 years, chances are you've heard about stocks and the stock market. It usually comes in the form of something like: "Bob's cousin made a killing in the stock market with XYZ company" or "watch out for ABC stock, my brother-in-law lost his shirt in that company!"

The fact is, most people don't truly understand what the stock market is and many consider investing in stocks to be equivalent with gambling. Contrary to this belief, investing in the stock market is not gambling. Stocks should be considered a financial tool, not a roll of a dice, and can be quite profitable if you learn the basics and understand the rules to the game, just as anything else in life. The next few pages will introduce you to the world of stocks and give you a basic foundation for future lessons.

What are Stocks?

Stock is sometimes referred to as a share, security or equity. Plain and simple, a share of stock is part ownership in a company. For every share of stock you own in a company you "own" a part of the assets of the company and part of the revenues those assets generate. As the company acquires more assets and the stream of cash it generates gets larger, the value of the business increases. This increase in the value of the business is what drives up the value of the stock in that business. The more shares you own, the larger the portion of the company (and profits) you own.

You might be asking yourself why a company would want to sell stock? Why share the profits with thousands of people when they could keep profits for themselves. The reason companies issue stock is to raise money (called equity financing). By selling some ownership in the company in the form of stock they get money that they do not have to pay back. The companies do not have to pay back the money because it is not a loan, instead they have sold part of the company for the money. This capital can be used for expansion, upgrading equipment, marketing, or whatever the company needs. The other method of raising money is through debt financing (borrowing money from the bank or through issuing bonds), equity is more popular for raising money because there is not a loan to pay back and there are no interest payments to make like there is from taking on debt.

Because shareholders own a part of the business, they get one vote per share of stock to elect the board of directors. The board is a group of individuals who oversee major decisions made by the company. The board of directors normally has the most power in corporate structure. Boards decide how to spend the money the company makes. The board will also make decisions on whether a company will reinvest in its self, buy other companies, pay a dividend, or repurchase stock. The top company management that is hired and also fired by the board give some advice, but in the end it is the board makes the final decision.

As with most things in life, the potential reward from owning stock in a growing business has some possible pitfalls. Shareholders also participate in the risk inherent in operating the business. If things go bad, their shares of stock may decrease in value - or even end up being worthless if the company goes bankrupt.

In addition to owning part of a corporation, owning stocks for the long term allows investors to capitalize on the power of compounding, that is, to earn a return on top of returns. Compounding is part of the reason that over the past several decades stocks have outperformed practically every other investment tool. A great example: 1 share of General Electric in 1928 would be worth over $500,000 today!

Different types of Stock

There are two main types of stocks: Common Stock and Preferred Stock.

Common stock is just that, "common". It is the standard form of stock an investor will encounter. The majority of stocks trading today are in this form. Common stock represents ownership in a company and a portion of profits (dividends). Investors also have voting rights (one vote per share) to elect the board members who oversee the major decisions made by management. In the long term, common stock, by means of capital growth, yield higher rewards than other forms of investment securities. This higher return comes at a cost of higher risk than some of the more safer investments. Should a company go bankrupt and liquidate, the common shareholders will not receive money until the creditors, bondholders, and preferred shareholders are paid. What this means is simple, don't expect anything if the company goes belly up.

Preferred Stock is a different type of stock that most investors will not own. Preferred Stock represents some degree of ownership in a company but the stock usually doesn't have voting rights (this may vary depending on the company). On preferred shares investors are guaranteed a fixed dividend forever, rather than the variable dividend that common stocks receive. However, one advantage is in the event of liquidation they are paid off before the common shareholder (but still after debt holders). Preferred stock may also be callable, meaning that the company has the option to purchase the shares from shareholders at anytime, usually for a premium price.

Occasionally, companies find it necessary for various reasons to concentrate the voting power of a company into a specific class of stock where the majority is owned by a certain set of people. For instance, if a family business needs to raise money by selling equity, sometimes they will create a second class of stock that they own and control that has ten votes per share of stock. Then they will sell a class of stock that only has one vote per share to others. Does this sound like a bad deal? Many investors believe it is and routinely avoid companies where there are multiple classes of voting stock. This kind of structure is most common in media companies and has been around only since 1987.

When there is more than one kind of stock, the shares are often designated as Class A or Class B shares, this is signified on the New York Stock Exchange and American Stock Exchange by a period and then a letter following the ticker symbol The ticker symbol is a shorthand name for the company's shares that brokerages use to facilitate transactions. For instance, Berkshire Hathaway Class A shares trade as BRK.A, whereas Berkshire Class B shares trade as BRK.B. On the NASDAQ stock market, the class of stock becomes a fifth letter in the ticker symbol. For example, Tele-Communications, Inc. has TCOMA, the Class A shares, and TCOMB, the Class B shares.

Different categories of Stock

Professionals divide stocks into various categories attempting to narrow the list of stocks that will meet their investment needs. Stocks may be divided into categories such as: size or market capitalization (large cap, mid cap, small cap, etc); some may be separated by industry such as technology or energy, while others are divided by relative sensitivity to the economic cycle such as growth and cyclical.

Stocks may be divided into the following common categories:

  • Cyclical Stocks
  • Defensive Stocks
  • Income Stocks
  • Growth Stocks
  • Emerging-Growth Stocks
  • Blue Chip Stocks
  • Speculative Stocks
  • Value Stocks

As you can see by the different categories, each stock has its own set of characteristics. Separating stocks is not always clear and precise, because a stock may fall into several categories, such as a utility stock, which can be classified as both a defensive and an income stock. Below is a brief description of some of the different types of stocks.

CYCLICAL STOCKS - Industries usually classified as cyclical stocks include: chemical, machinery, airline, railroad, steel, paper, and automotive. Cyclical stocks are companies whose profits and earnings are tied to the economy and whose stock prices fluctuate with the business cycle. The company's profitability is increased and its stock rises when economic conditions are good. Conversely, when the economy worsens, the company's business falls off, with the company's profits and stock price.

DEFENSIVE STOCKS - Defensive stocks include: electric and gas utilities, food, beverage, and drug companies, and are characterized by their degree of stability during periods of economic uncertainty and decline. Anything that is considered to be in the category of human needs and/or vices is thought of as a defensive stock. These companies may lack the appeal of high-growth companies, but are considered to be recession-resistant companies.

INCOME STOCKS - Some stocks are classified as income stocks, because they pay higher than average dividends, and investors, especially the elderly and retired, buy these stocks for the purpose of current income. Careful attention must be given to these stocks, because a high dividend yield does not always insure safety. For example, the price of a stock may have fallen over concerns about the safety of the dividend, thus a high yield is the result. In addition, the stock could be in an industry that is not favored and is believed to have no future. In order to avoid mistakes, investors should buy quality stocks that have had a steady trend in rising dividends.

GROWTH STOCKS - These are generally companies whose sales, market share, and earnings are growing faster than the general economy and their industry average. These companies are usually involved in research and are more aggressive than others. Furthermore, they reinvest their earnings back into the business to facilitate this growth. Because investors generally place a higher value for this above-normal growth, the price-earnings ratios of these stocks will be higher than their counterparts and average stocks, and the dividend if any will usually be lower.

EMERGING-GROWTH STOCKS - Technology companies are a good example of a stock in this group. These are usually smaller companies that are emerging and have survived their formative years. They have entered a period of strong earnings and expanding unit sales and profit margins. These stocks are normally traded on the American Stock Exchange (AMEX) or over-the-counter (NASDAQ), and their stock prices may be more volatile, therefore having a higher risk.

BLUE CHIP STOCKS - These companies hold leading positions in their industry and have a long, unbroken record of earnings growth and dividend payments. These stocks are high-grade, investment-quality issues of major companies that have the fundamental strength and size to hold their own during a recession and enough resources to capitalize on an economic recovery. All in all, investors who are conservative and who seek safety and stability, will usually invest in this group.

SPECULATIVE STOCKS - When investing in a speculative stock, an investor needs to remember the phrase: Caveat Emptor! Buyer Beware! These companies usually have a great story, but lack the earnings, revenue history, and the visibility of the more established companies. The stock price can be highly volatile because there is uncertainty that the company can meet expectations of future earnings and revenue. This is not to say that money cannot be made on these stocks, we just think that an investor should gather enough information to determine whether or not this is a stock with a high potential or a stock with no value other than speculative appeal. Just understand the risk involved up front before investing in a speculative stock.

VALUE STOCKS - Value stocks are basically stocks that appear inexpensive relative to earnings, sales, or other fundamental factors. In the past, the demand for growth stocks and value stocks tend to fluctuate. When value stocks are in favor, growth stocks are usually out of favor. Conversely, when growth stocks are in demand, value stocks lag behind.

Company Sizes - Large, Mid, Small and Micro Caps

Company size is typically based on market capitalization. Market capitalization is the total value of the company's outstanding shares and is defined as current price per share times the number of total outstanding shares. For example, if a company has 1 million shares outstanding and is trading at a price of $20 per share, it has a market capitalization or market cap of $20 million. Stocks are usually classified as follows:

  • Large Cap: $5 billion dollars or more
  • Mid Cap: $1 billion - $5 billion dollars
  • Small Cap: $100 million - $1 billion dollars
  • Micro Cap: $100 million or less

Large cap stocks are usually more stable, mature companies. These generally have lower beta and are not as volatile as small caps, as small cap companies tend to fluctuate more in price but have historically offered higher returns for the higher volatile.

How the Stock Market Works

Probably one of the most confusing aspects of investing is understanding how stocks actually trade. Words such as "bid," "ask," "size," "volume," and "spread" can be quite confusing if you do not understand what they mean. Depending on which exchange a stock trades; there are two different systems.

Listed Exchange - The New York Stock Exchange and the American Stock Exchange are both listed exchanges, meaning that brokerage firms contribute individuals known as "specialists" who are responsible for all of the trading in a specific stock. With the help of technology, the specialist quickly matches buyers with sellers. Sometimes referred to as "an auction market," from the resemblance of all the people throwing their arm up, waving and yelling at the local auction house. The specialist can see who has stock to buy or sell and at what price. He acts as the auctioneer and links them up for a small fee. The number of shares that are traded on a given day is called the volume, and it is the responsibility of the specialist to keep an accurate count and relay that information to the exchange. There are many Stock Exchanges located in hundreds of countries around the world. The major ones are located in New York, London, and Tokyo. When people refer to "The Market" they are usually referring to the New York Stock Exchange (NYSE).

Over-the-Counter Market - These markets have no floor brokers whatsoever; instead, it is basically a computer network of dealers. An example of a computerized exchange (ECN) you've probably heard of is the NASDAQ. In over-the-counter market, brokerages (also known as broker-dealers) act as market makers for various stocks. The brokerages interact over a centralized computer system managed by the NASDAQ, providing liquidity for the market to function. One firm represents the seller and offers an ask price (also called the offer), or the price the seller is asking to sell the stock. Another firm represents the buyer and gives a bid, or a price at which the buyer will buy the stock.

For example: A particular stock might be trading at a bid of $10 and an ask price of $10.50. If an investor wanted to sell shares, he would get the bid price of $10 per share; if he wanted to buy shares, he would pay the ask price of $10.50 per share. The difference is called the spread. This difference called the spread is the 50 cents difference between the two firms prices involved in the transaction. Volume on over-the-counter markets is often double-counted, as both the buying firm and the selling firm report their activity.

Stock markets facilitate the exchange of stocks between buyers and sellers thus reducing the risks of investing. Just imagine how difficult it would be to sell shares if you had to call around the neighborhood trying to find a buyer. Think of the stock market as a sophisticated farmers market linking buyers and sellers. Or say you wanted to buy or sell a stock in a foreign company, what would you have to do? Go to that country, find a buyer or seller, negotiate a price, then exchange your currency for theirs to get the transaction completed? Well the answer could be yes unless you were to purchase an ADR of the company.

Why do Stock Prices Change?

Stock prices are changing every moment of the trading day. Buyers and sellers cause prices to change as they decide how valuable each stock is at that moment in time. Basically, share prices change because of supply and demand. If more people want to buy a stock than sell it - the price moves up. Conversely, if more people want to sell a stock, there would be more supply (sellers) than demand (buyers) - the price would start to fall.

Stock as we have said represents ownership in a company. Therefore, the price of a stock shows what investors feel the company is worth at that point in time. Stock prices can change at any rate; some have dramatic price swings everyday while others stay the same for days at the time. There are hundreds of variables that drive stock prices, the most important of which is earnings. Think of earnings as the profit of a company, the money left after all expenses have been paid, this is what shareholders desire.

"Bulls and Bears"?!

As you invest more and more you will hear about the bulls and bears. No, these names do not refer to farm animals, they are terms that describe the performance of the stock market.

A bull market is when stocks are rising, people are finding jobs, GDP is growing, everything looks just plain rosy. Picking stocks during a bull market is sometimes easier because everything is going up. Bull markets cannot last forever though, and sometimes lead to a dangerous situations if stocks become overvalued. If a person is an optimist, believing that stocks will go up, they are called a "bull".

The opposite, a bear market, is when there are falling stock prices, recession, high unemployment, and relatively high inflation. Bear markets make it tough for investors to pick profitable stocks, one solution to this is to make money when stocks are falling using a technique called short selling (discussed in our short selling tutorial). Another strategy is to wait on the sidelines until you feel that the bear market is nearing its end and start buying in anticipation of a bull market. If a person is a pessimist, believing that stocks are going to drop, they are called a "bear".

Types of Accounts and Orders

You've learned what a stock is and a little bit about the principles behind the stock market, so how do you actually buy the stock? There are two ways:

Using a Brokerage Firm The most common method to buy and sell stocks is to use a broker. Brokerage firms come in many different shapes and sizes. There are big well-known "full-service" brokerage firms such as Merrill Lynch and Goldman Sacks, as well as a incredible number of well-known "discount" brokerage firms such as E-Trade and Charles Schwab. There are also a multitude of no name brokerage firm of both full and discount services. We will discuss the pros and cons of each in our Broker Basics tutorial later under Getting Started.

When you use a brokerage firm, you have the choice of setting up a cash account or a margin account. Having a margin account meaning you can borrow money from the brokerage firm to buy stocks. We will also discuss margin in more detail in the Getting Started section.

DRIPs & DIPs Using Dividend Reinvestment Programs and Direct Investment Plans Dividend Reinvestment Plans (DRIPs) and Direct Investment Plans (DIPs) are the official names for what many people refer to as Drips. These are plans in which individual companies allow shareholders to purchase stock directly from the company with only minimal cost or commissions. Drips are great for those who have small amounts of money but who are willing to invest it at regular intervals.

Placing the Trade

In order to make your trade you'll have to be specific how the stock should be traded. The following terms are common terminology you'll encounter:

Day Order: An order that expires at the end of the business day if it has not been filled.

GTC (Good Till Canceled): An order either to buy or to sell a stock that remains in effect until the customer cancels it or until it is executed by the broker. Some brokerage firms cancel these orders after 90 days check with you firm on their company policy.

Limit Order: An order to buy or sell at a specified price or better. This type of order allows you to set the price you will buy or sell a stock at. Remember the danger of a limit order is you might not get filled.

Market Order: An order that requires immediate execution. When you place this kind of order you are saying I want to buy this stock immediately at its current price, or sell this stock now at the current selling price. If you have access to real time quotes, you will have a good idea what price you will receive with your market order. If you don't, trading stocks with market orders is not the smartest thing to do in most cases.

Stop Loss Order: An order that is lays dormant until the stock trades at a specified price, once the stock trades at the specified price the order is triggered and becomes an active market order. Remember the danger of a market order is the buy or sell price is unknown, but the execution is guaranteed.

Stop Limit Order: An order that is lays dormant until the stock trades at a specified price, once the stock trades at the specified price the order is triggered and becomes an active limit order. Remember the danger of a limit order is that it my not get filled.

All or None (AON): A stipulation on a limit order either to buy or sell a stock only if the broker can fill the entire order and not part of it. If the order is not completely filled by the end of the business day it is canceled.

Fill-or-Kill: A stipulation on a limit order either to buy or sell a stock only if the broker can get an immediate execution. If it cannot be filled immediately the order is automatically canceled.