Surviving a Roller Coaster Stock Market
Tips and Tricks for Avoiding Retirement Derailment
There have been a number of research papers proving that investors, as a whole, experience far lower returns than the stock market itself as a result of frequent trading. It's not difficult to see why: Men and women, with no training in finance, attempting to manage their own 401k, Roth IRA, or Traditional IRA, or retirement accounts, panic when faced with volatility. After building up an investment portfolio over decades of work, a drop in stock prices of only ten or twenty percent can lead to tens, or even hundreds, of thousands of dollars in paper losses.For an experienced investor with little or no debt, such a drop would be a non-event. They would know why they own the companies they hold, have estimated the future profitability, and calculated that into a discounted cash flow formula that gives them a rough idea of what their rate of return should be provided the variables they plugged in are accurate or conservatively projected. In fact, these investors (what have been called "true" investors) would welcome price drops, even if it meant half of their net worth disappeared from their monthly statements. I can tell you with absolute certainty that, all else being equal, if Berkshire Hathaway were to fall from $120,000 per share to $50,000 per share compared to its $72,000 per share book value, I would not for a moment lament the paper loss in my net worth, but rather back up the truck and attempt to buy as many shares as possible, even selling off other assets to fund the acquisition. There's a good chance the folks at my office would have to stop me from doing cartwheels. That's because I know the company, how it generates its cash, and have a rough approximation, adjusted on a rolling basis, of its intrinsic value.
In this article, I'm going to attempt to lay an intellectual foundation to help you think differently about stock market volatility, as well as provide you with some tips and tricks that might help traversing the stormy seas of Wall Street a whole lot easier.
Lay the Foundation
First, and please correct me if I'm wrong here, but you probably want to retire comfortably. You work hard, and want to be rewarded for that work; because of that, I want you to bookmark your page right here and take a moment to lay the foundation of what we're going to discuss by reading How to Think About Stock Prices, Price is Paramount, and Defensive Investing: Building a Portfolio for Volatile Markets. These three pieces of content will arm you with some background that allows me to go further in this discussion, making it easier to serve you better.
It's All About the History Books
Bill Gross, arguably the greatest pure bond investor alive today, has said that if he were only able to study one book, it would be a comprehensive history of the financial markets. That's because it can provide a framework for understanding financial psychology. Most people make the mistake of thinking that investing success is related to intelligence. I want you to repeat after me: Being a successful investor isn't about intelligence. Isaac Newton, one of the most brilliant minds the human race has ever produced, was wiped out in the Dutch Tulip Bubble.A good place to start is the Ibbotson & Associates Stocks, Bonds, Bills, and Inflation Classic Yearbook. Although it costs around $100 per hard bound copy, it provides data about market levels and returns for more than a century. A quick glance, and you'll be comforted to see that over periods of ten years or longer, the stock market almost always performs well, especially when coupled with a dollar cost averaging plan that allows you to take advantage of low prices and fat dividend yields.
Some Checkpoints to Lower Your Risk
If you are worried about risk management and not necessarily generating maximum returns (which most likely describes 99% of the readers), here are some things to consider:- The price-to-earnings ratio of your portfolio is no more than 10% higher than the market as a whole.
- The price-to-earnings ratio of your portfolio is no higher than twenty.
- You have a diversified base of stocks and bonds appropriate for your distance from retirement (you should own more and more fixed income or cash equivalents as you approach the end of your working career).
- Focus on mutual funds with low expense ratios, good historical performance ratings and established management who invest in the funds they manage.
- If you are interested in long-term (five years or more) returns that are competitive, stop moving assets around in your retirement account. You don't know more than the market, and you aren't experienced enough to make rational judgment calls. Stick to your plan, continue your contributions, and wait until retirement. Unless there is a fundamental deterioration in the underlying asset, the stupidest time to sell anything is after it has fallen in price.
Get Competent Professional Advice
If you don't know what to do or feel completely lost, seek out a competent, well respected, and conservative financial adviser or planner. You want someone who has a good record and can explain, in one short paragraph, the rational for each investment held in your portfolio. You want someone who values your needs and listens to you; what good is it to have someone managing the money for which you work so hard if they don't understand what it is you are trying to accomplish?How Do I Actually Make Money From Buying Stock?
If you’ve spent a lot of time on the site, you see that we provide resources on some pretty advanced topics – financial statement analysis, financial ratios, capital gains tax strategies, and more. Our focus, however, is on the new investor. Sometimes I’ll get emails from readers that ask some pretty basic and straightforward questions. One of the perennial favorites is, “How do I actually make money from a stock?” If you’ve ever wondered how the mechanics actually work, print this article, grab a hot cup of coffee, get comfortable in your favorite reading chair, and prepare to learn the basics of common stock.
It's Simple, Really
When you buy a share of stock, you are buying a piece of a company. Imagine that Harrison Fudge Company, a fictional business, has sales of $10,000,000 and net income of $1,000,000. To raise money for expansion, the company’s founders approached a Wall Street underwriting firm (an investment banker) and had them sell stock to the public. They might have said, “Okay, we don’t think your growth rate is great so we are going to price this so that future investors will earn 9% on their investment plus whatever growth you generate … that works out to around $11,000,000+ value for the whole company ($11 million divided by $1 million net income = 9% return on initial investment.)” Now, we’re going to assume that the founders sold out completely instead of issuing stock to the public (for an explanation of the difference, see Investing Lesson 1: Introduction to Wall Street.)The underwriters may say, “You know, we want the stock to sell for $25 per share because that seems affordable so we are going to cut the company into 440,000 pieces, or shares of stock (440,000 shares x $25 = $11,000,000.) That means that each “piece” or share of stock is entitled to $2.72 of the profit ($1,000,000 profit ÷ 440,000 shares outstanding = $2.72 per share.) This figure is known as Basic EPS (short for earnings per share.) In other words, when you buy a share of Harrison Fudge Company, you are buying the right to your pro-rata profits. Were you to acquire 100 shares for $2,500, you would be buying $272 in annual profit plus whatever future growth (or losses) the company generated. If you thought that a new management could cause fudge sales to explode so that your pro-rata profits would be 5x higher in a few years, then this would be an extremely attractive investment.
What Makes It a Bit More Complicated
What muddies up the situation is that you don’t actually see that $2.72 in profit that belongs to you. Instead, management and the Board of Directors have a few options available to them, which will to a large degree determine the success of your holdings:
- It can send you a cash dividend for some portion or the entirety of your profit. This is one way to “return capital to shareholders.” You could either use this cash to buy more shares or go spend it any way you see fit.
- It can repurchase shares on the open market and destroy them. For a great explanation of how this can make you very, very rich in the long-run, read Stock Buy Backs: The Golden Egg of Shareholder Value.
- It can reinvest the funds into future growth by building more factories, stores, hiring more employees, increasing advertising, or any number of additional capital expenditures that are expected to increase profits. Sometimes, this may include seeking out acquisitions and mergers.
- It can strengthen the balance sheet by reducing debt or building up liquid assets.
Which way is best for you? That depends entirely upon the rate of return management can earn by reinvesting your money. If you have a phenomenal business – think Microsoft or Wal-Mart in the early days when they were both a tiny fraction of their current size, paying out any cash dividend is likely to be a mistake because those funds could be reinvested at a high rate. There were actually times during the first decade after Wal-Mart went public that it earned more than 60% on shareholder equity. That’s unbelievable. (Check out the DuPont desegregation of ROE for a simple way to understand what this means.) Those kinds of returns typically only exist in fairy tales yet, under the direction of Sam Walton, the Bentonville-based retailer was able to pull it off and make a lot of associates and stockholders rich in the process.
Berkshire Hathaway pays out no cash dividends while U.S. Bancorp has resolved to return more 80% of capital to shareholders in the form of dividends and stock buy backs each year. Despite these differences, they both have the potential to be very attractive holdings at the right price (and particularly if you pay attention to asset placement) provided they trade at the right price. Personally, I own both of these companies as of the time this article was published and I’d be upset if USB started following the same capital allocation practices as Berkshire because it doesn’t have the same opportunities available to it as a result of the prohibition in place for bank holding companies.
The Two Ways You Make Money
Now that you see this, it’s easy to understand that your wealth is built in two distinct ways:
- An increase in share price. Over the long-term, this is the result of the market valuing the increased profits as a result of expansion in the business or share repurchases, which make each share represent greater ownership in the business as a percentage of total equity. In other words, if a business with a $10 stock price grew 20% for 10 years through a combination of expansion and share repurchases, it should be nearly $620 per share within a decade as a result of these forces assuming Wall Street maintains the same price-to-earnings ratio.
- Dividends. When earnings are paid out to you, these funds are now your property in that you can either use them to buy more stock or go to Vegas and blow it all at the craps table.
Are You Gambling or Investing?
Know How to Treat Wall Street Like a Business, Not a Roulette Wheel
Mention the stock market or investments and some families or organizations will react with loathing and disgust, likely drawing parallels between a trip to Vegas and a call to a broker. A good deal of this is due to the cultural aftermath of the Great Depression and the simultaneous drop in the financial markets as a result from the excess of the 1920’s. Yet, the primary reason for this attitude is a complete lack of understanding regarding accounting, finance, economics, and basic compounding. Yet, this attitude isn’t entirely irrational. Gasoline, for example, can be extraordinarily helpful if you are trying to power a tractor that will provide food to thousands of people. But in the hands of rash, uninformed people, you could end up with horrific physical damage and even the loss of life. Without an understanding of what exactly a stock is, outside of an indexing strategy, the market can be a very dangerous place. (For information on what stocks are and how they are created, read Investing Lesson 1 – An Introduction to Wall Street.)How do you know if you are gambling or investing? Here are a few simple tests to give you a clue.
1. Do you have a clear reason for investing in a particular stock or security, or are you just going on your “gut”?
In every case, you should be able to write out a short, simple explanation that makes sense to the average high school student as to why you are purchasing a specific investment. It should lay bare your expectations and they should be reasonable.Here’s an example. Say you were interested in acquiring shares of U.S. Bank for your IRA. You might write something like this, “As of the market close on Sunday, July 1, 2007, the stock traded at $32.95 per share, or a price-to-earnings ratio of 12.66 as a result of $2.60 earnings per share. Taking 1 divided by the p/e ratio of 12.66, we get .0789, or 7.89%. This figure is known as the earnings yield. When compared to the long-term yield on the risk-free U.S. Treasury bonds of 5.22%, this amounts to a 2.67% higher rate for the stock. This is supposed to compensate me for inflation and the risk of investing in a stock. In and of itself, this is insufficient. However, management has vowed to return 80% of earnings to shareholders each year and expects to maintain growth in earnings per share of 10%. In other words, I am buying an ‘equity bond’, to borrow a phrase from Warren Buffett, that currently yield 7.89%, which will grow earnings per share of no more than 10% for the next few years (and probably top out at 3% thereafter.) In the meantime, the 4.8% dividend yield can be used to acquire more shares and, because they are held in an IRA, will not have taxes assessed against them. Compared to the S&P 500, this appears to offer an attractive value. I’m not particularly concerned about competition as the bank has an enormous base of branches throughout communities in the Midwest and beyond. With metrics that are typically the highest in the big banking field – return on assets, return on equity, and a stellar efficiency ratio – it appears management is clearly doing right by owners. It’s unlikely I’ll have a lollapalooza bonanza on an investment like this, but it does offer a conservative way to compound my capital in a manner that appears to be above average compared to the broader index if left alone in an account with instructions that all dividends be reinvested.
2. Are you hoping to profit from a move in share price over the short-term, or from the long-term performance of the business?
If you ultimately expect to earn your profits in the market because a stock is going to go up as investors find it more fashionable, rather than an improvement in the long-term performance of the underlying business, you are gambling. One of the stupidest reasons to buy a stock is because you believe one of the company’s products or services is going to be a huge hit. That alone could be a reason if you believed it would result in underlying profits increasing on a per-share basis.When you bank on someone else paying a higher price (the so-called “greater fool” theory), rather than selecting a demonstrably superior business, you are putting your financial well being in jeopardy.
3. Do you utilize leverage to amplify your return?
Margin debt is dangerous because it’s so easy to access. If you approach a traditional bank, you’re going to have to complete a myriad of paperwork, prove you have the cash flow to repay the loan, post collateral in the event you are unable to meet your obligation, go through a background check, and a whole lot more. With a brokerage firm, you may have $100,000 in assets in an account and instantly be able to borrow another $100,000, effectively leveraging your funds on a 2-1 basis. The problem, of course, comes if stocks fall – which they are often prone to do. In this example, a 20% drop would result in $40,000 of losses for you on your $100,000 equity, bringing your net account equity balance to $60,000.With results like that, you may be right in the long-run, but, as the Wall Street expression goes, you’ll be explaining it to someone in the poor house. You must play your hand in a way that no matter what happens in the financial markets, you and your family will still have enough chips to participate in the recovery when it comes. We’re big fans of another Buffett assertion, “Don’t risk what you have and need for what you don’t have and don’t need.” It just doesn’t make sense to put yourself in a position where being wrong can cost you your standard of living.
If you are determined to put as much capital to work for you as possible, focus your energy on generating more cash in your professional life either by working more hours, starting a side business, cutting expenses, etc. It may take you a bit longer to get to your ultimate goal. But it will still be a much shorter journey than if you are completely or partially wiped out as a result of borrowing against your securities. For more information, you may be interesting in: Margin – Road to Riches or Playing with Fire?Does a High P/E Ratio Mean a Stock is Overvalued?
The Answer May Surprise You!
Readers of this site know that I’m an unabashed, dyed-in-the-wool value investor. Yet, a mistake many people tend to make is to associate this with only buying low price-to-earnings ratio stocks. While this approach has certainly generated above-average returns over long-periods of time (see Tweedy, Browne & Company’s publication What Has Worked in Investing), it is not the ideal situation.
Understanding Intrinsic Value and Why Different Businesses Deserve Different Valuations
At its core, the basic definition for the intrinsic value of every asset in the world is simple: It is all of the cash flows that will be generated by that asset discounted back to the present moment at an appropriate rate that factors in opportunity cost (typically measured against the risk-free U.S. Treasury) and inflation. Figuring out how to apply that to individual stocks can be extremely difficult depending upon the nature and economics of the particular business. As Benjamin Graham, the father of the security analysis industry, entreated his disciples, however, one need not know the exact weight of a man to know that he is fat or the exact age of a woman to know she is old. By focusing only on those opportunities that are clearly and squarely in your circle of competence and you know to be better than average, you have a much higher likelihood of experiences good, if not great, results over long periods of time.All businesses are not created equal. An advertising firm that requires nothing more than pencils and desks is inherently a better business than a steel mill that, just to begin operating, requires tens of millions of dollar or more in startup capital investment. All else being equal, an advertising firm rightfully deserves a higher price to earnings multiple because in an inflationary environment, the owners (shareholders) aren’t going to have to keep shelling out cash for capital expenditures to maintain the property, plant, and equipment. This is also why intelligent investors must distinguish between the reported net income figure and true, “economic” profit, or “owner” earnings as Warren Buffett has called it. These figures represent the amount of cash that the owner could take out of the business and reinvest elsewhere or spend on diamonds, houses, planes, charitable donations, or gold-plated fine china.
In other words, it doesn’t matter what the reported net income is, but rather, how many hamburgers the owner can buy relative to his investment in the business. That’s why capital-intensive enterprises are typically anathema to long-term investors as they realize very little of their reported income will translate into tangible, liquid wealth because of a very, very important basic truth: Over the long-term, the rise in an investor’s net worth is limited to the return on equity generated by the underlying company. Anything else, such as relying on a bull market or that the next person in line will pay more for the company than you (the appropriately dubbed “greater fool” theory) is inherently speculative. I don’t know about you, but I don’t want to be in doubt about my ability to retire comfortably.
The result of this fundamental viewpoint is that two businesses might have identical earnings of $10 million, yet Company ABC may generate only $5 million and the other, Company XYZ, $20 million in “owner earnings”. Therefore, Company XYZ could have a price-to-earnings ratio four times higher than its competitor ABC yet still be trading at the same value.
The Importance of a Margin of Safety
The danger with this approach is that, if taken too far as human psychology is apt to do, is that any basis for rational valuation is quickly thrown out the window. Typically, if you are paying more than 15x earnings for a company, you need to seriously examine the underlying assumptions you have for its future profitable and intrinsic value. With that said, a wholesale rejection of shares over that price is not wise. A year ago, I remember reading a story detailing that in the 1990’s, the cheapest stock in retrospect was Dell Computers at 50x earnings. That’s right – had you bought it at that price, you would have absolutely crushed nearly every other investment because the underlying profits really did live up to Wall Street’s expectations, and then some! However, would you have been comfortable having your entire net worth invested in such a risky business if you didn’t understand the economics of the computer industry, the future drivers of demand, the commodity nature of the PC and the low-cost structure that gives Dell a superior advantage over competitors, and the distinct possibility that one fatal mistake could wipeout a huge portion of your net worth? Probably not.
The Ideal Compromise
The perfect situation is when you get an excellent business that generates copious amounts of cash with little or no capital investment on the part of the owners relative to the profits at a steep discount to intrinsic value, such as American Express during the Salad Oil scandal or Wells Fargo when it traded at 5x earnings during the real estate crash of the late 1980’s and early 1990’s. A nice test you can use is to close your eyes and try to imagine what a business will look like in ten years; do you think it will be bigger and more profitable? What about the profits – how will they be generated? What are the threats to the competitive landscape? An example that might help: Do you think Blockbuster will still be the dominant video rental franchise? Personally, it is my belief that the model of delivering plastic disks is entirely antiquated and as broadband becomes faster and faster, the content will eventually be streamed, rented, or purchased directly from the studios without any need for a middle man at all, allowing the creators of content to keep the entire capital. That would certainly cause me to require a much larger margin of safety before buying into an enterprise that faces such a very real technological obsolesce problem.Know Your Opportunity Cost
One Key to Successful Investing
For the average investor without any understanding of basic accounting, economics, or finance, the best option over time is most often to dollar cost average into a diversified group of common stocks or a low-cost index fund. By spreading purchases out over time, as well as reinvesting cash dividends, your money buys more shares during market crashes and fewer shares during market bubbles. The result is often a lower weighted average price (known as “WAP” on Wall Street.) By following this system, preferably through direct electronic withdrawals from your paycheck, checking, or savings account, you can take all emotion out of building a complete portfolio, ignoring the day-to-day, and even month-to-month fluctuations of asset prices thinking of your collective stocks just as you would a house; steadily growing in value until you need to sell it years and years in the future.However, as we pointed out in 7 Keys to Successful Investing, those investors with more experience would be wise to take the advice of Berkshire Hathaway Vice Chairman and famed investor Charlie Munger who said that every investment you make should be compared to your personal risk-adjusted opportunity cost. In this context, opportunity cost is defined as the expected compound annual growth rate of return, or CAGR, on the next best available option to you as an individual. For each of us, this is different. If you had been in the immediately family of Sam Walton prior to the IPO of Wal-Mart when the company was raising capital by allowing individual store managers to acquire ownership in the stores they managed, you would have been more likely to know how profitable the business was, the potential for market growth, and the talent of those running the show. This opportunity was not available at the time to someone working as a chef in Manhattan. When selecting an investment such as whether or not to acquire more shares of an index fund or to buy a bigger house in anticipation of a substantial rise in the local real estate market, the chef would have arrived at a different answer whereas the manager of Wal-Mart as they might be comparing the attractiveness of, say, shares of Exxon-Mobile against the returns they estimate they could earn by opening their own restaurant.
Here are some quick ways to gauge your opportunity costs. Ask yourself the following questions:
What are my liquidity needs?
It makes no sense to invest in common stocks, private businesses, or real estate if you are going to require liquid assets in the short-term (one year or less) for items such as a balloon payment on a bank loan, taxes, or any number of countless other potential reasons. Always maintain a conservative balance sheet by keeping sufficient cash and cash equivalents on hand to meet your daily funding needs. In many cases, access to a home equity line of credit can serve the same purpose.
What is my circle of competence?
One of the cornerstones of investing is reducing risk. No matter how attractive an investment may appear, if you lack the understanding to value the cash flows and project profits into the future, buying the stock is just as risky as throwing your money into a spin of the roulette wheel - at least you are likely to understand how that game of chance works as compared to derivatives! So, repeat after us: Never, never, never invest outside of your circle of competence. If you pass on a hot IPO that subsequently goes up four-fold, don’t kick yourself; it cannot count as an opportunity cost if you did not understand the opportunity!
What are the opportunities that are available to me and how do they fit within my priorities?
Take out a notepad and make a list of the investments that are available to you – stocks, bonds, mutual funds, real estate, a new home, storage units, a restaurant franchise, etc. Now, make another list that details your priorities – paying off your debt, staying home with your children, going back to school, starting your own business, becoming a millionaire, etc. Next, identify which assets and investment types will help you reach your priorities. For example, opening a franchised Tim Horton’s or Dunkin Donuts would allow you to become your own boss and build wealth for retirement if done correctly whereas shares of an index fund will grow your wealth passively without the need for you to do any work on a daily basis.
Get more helpful tips and information about building a portfolio
Some great resources on building your portfolio that can help you quickly and easily make sense of the financial markets. Check out my earlier blogs posted.The Three Primary Types of Financial Capital
There are three categories of financial capital that are important for you to know when analyzing your business or a potential investment. They each have their own benefits and characteristics.
Equity Capital
Otherwise known as “net worth” or “book value”, this figure represents assets minus liabilities. There are some businesses that are funded entirely with equity capital (cash written by the shareholders or owners into the company that have no offsetting liabilities.) Although it is the favored form for most people because you cannot go bankrupt, it can be extraordinarily expensive and require massive amounts of work to grow your enterprise. Microsoft is an example of such an operation because it generates high enough returns to justify a pure equity capital structure.
Debt Capital
This type of capital is infused into a business with the understanding that it must be paid back at a predetermined future date. In the meantime, the owner of the capital (typically a bank, bondholders, or a wealthy individual), agree to accept interest in exchange for you using their money. Think of interest expense as the cost of “renting” the capital to expand your business; it is often known as the cost of capital. For many young businesses, debt can be the easiest way to expand because it is relatively easy to access and is understood by the average American worker thanks to widespread home ownership and the community-based nature of banks. The profits for the owners is the difference between the return on capital and the cost of capital; for example, if you borrow $100,000 and pay 10% interest yet earn 15% after taxes, the profit of 5%, or $5,000, would not have existed without the debt capital infused into the business.
Specialty Capital
This is the gold standard. There are a few sources of capital that have almost no economic cost and can take the limits off of growth. They include things such as a negative cash conversion cycle (vendor financing), insurance float, etc.
- Negative Cash Conversion (Vendor Financing)
Imagine you own a retail store. To expand your business, you need $1 million in capital to open a new location. Most of this is the result of needing to go out, buy your inventory, and stock your shelves with merchandise. You wait and hope that one day customers come in and pay you. In the meantime, you have capital (either debt or equity capital) tied up in the business in the form of inventory.Now, imagine if you could get your customers to pay you before you had to pay for your merchandise. This would allow you to carry far more merchandise than your capitalization structure would otherwise allow. AutoZone is a great example; it has convinced its vendors to put their products on its shelves and retain ownership until the moment that a customer walks up to the front of one of AutoZone’s stores and pays for the goods. At that precise second, the vendor sells it to AutoZone which in turn sells it to the customer. This allows them to expand far more rapidly and return more money to the owners of the business in the form of share repurchases (cash dividends would also be an option) because they don’t have to tie up hundreds of millions of dollars in inventory. In the meantime, the increased cash in the business as a result of more favorable vendor terms and / or getting your customers to pay you sooner allows you to generate more income than your equity or debt alone would permit. Typically, vendor financing can be measured in part by looking at the percentage of inventories to accounts payable (the higher the percentage, the better), and analyzing the cash conversion cycle; the more days “negative”, the better. Dell Computer was famous for its nearly two or three week negative cash conversion cycle which allowed it to grow from a college dorm room to the largest computer company in the world with little or no debt in less than a single generation.
- Float
Insurance companies that collect money and can generate income by investing the funds before paying it them out in the future in the form of policyholder payouts when a car is damaged, or replacing a home when destroyed in a tornado, are in a very good place. As Buffett describes it, float is money that a company holds but does not own. It has all of the benefits of debt but none of the drawbacks; the most important consideration is the cost of capital – that is, how much money it costs the owners of a business to generate float. In exceptional cases, the cost can actually be negative; that is, you are paid to invest other people’s money plus you get to keep the income from the investments. Other businesses can develop forms of float but it can be very difficult.
Sweat Equity
There is also a form of capital known as sweat equity which is when an owner bootstraps operations by putting in long hours at a low rate of pay per hour making up for the lack of capital necessary to hire sufficient employees to do the job well and let them work an ordinarily forty hour workweek. Although it is largely intangible and does not count as financial capital, it can be estimated as the cost of payroll saved as a result of excess hours worked by the owners. The hope is that the business will grow fast enough to compensate the owner for the low-pay, long-hour sweat equity infused into the enterprise.What is Stock
Question: What is Stock
Answer: Imagine that you own a business. If you were to divide that business up into small pieces and sell those pieces, you would essentially have issued stock. Quite simply, stock is ownership in a company.
The money you raise from selling those "pieces" of your business can be used to build new plants and facilities, pay down debt, or acquire another company. A smart owner will keep at least 51% of the stock, which will allow them to retain control of the day to day activities. Any person or institution that owns over a majority of the stock is called the "controlling shareholder". Essentially, this person can do anything they want - right down to firing the CEO.
You can find a more in-depth information inhttp://beginnersinvestment.blogspot.com/2008/10/investing-lesson-1-introduction-to.html
What is a Ticker Symbol
Question: What is a Ticker Symbol
Answer: A ticker symbols is a sort of identification tag for a stock. It is comparable to a person's social security number. For instance, if you wanted to find information on Coca-Cola, you could go to a page such as Yahoo Finance and enter "KO" into the symbol box. After pressing the submit button, the site will bring up all the information you need on the Coca-Cola company.
The ticker symbol is used mostly for placing orders with brokers and looking up information on particular company / stock.
You can tell which exchange a stock trades on based on the number of letters in its ticker symbol. Stocks with four or more letters, for example, trade on the NASDAQ.
Why Do Stock Prices Fluctuate?
Question: Why Do Stock Prices Fluctuate?
Answer: The stock market is essentially a giant auction - only instead of antiques and heirlooms, it's ownership in businesses that's up for grabs. Stocks are traded at places called exchanges. At these exchanges, traders buy and sell shares of companies. Generally, the price of a stock is determined by supply and demand. For example, if there are more people wanting to buy a stock than to sell it, the price will be driven up because those shares are rarer and people will pay a higher price for them. On the other hand, if there are a lot of shares for sale and no one is interested in buying them, the price will quickly fall.
Because of this, the market can appear to fluctuate widely. Even if there is nothing wrong with a company, a large shareholder who is trying to sell millions of shares at a time can drive the price of the stock down, simply because there are not enough people interested in buying the stock he is trying to sell. Because there is no real demand for the company he is selling, he is forced to accept a lower price.
http://beginnersinvestment.blogspot.com/2008/10/investing-lesson-2-why-stocks-become.html provides greater insight into the movement of stock prices.
What is the Dow Jones Industrial Average
Question: What is the Dow Jones Industrial Average
Answer: The Dow Jones Industrial Average (DJIA) is an index of thirty, blue chip stocks that are traded in the United States. It is believed that by looking at the companies on the list, a person can get a general picture of how the market as a whole is performing. The Dow is perhaps the most quoted and followed index in the world, and dates back to May 26, 1896. It was then comprised of 12 stocks and opened at 40.94.
For more information, go to http://www.dowjones.com
What is the NASDAQ
Question: What is the NASDAQ
Answer: The NASDAQ is an electronic exchange where stocks are traded through an automated network. It stands for National Association of Securities Dealers Automated Quotations System. As a general rule of thumb, it is where most technology stocks are traded. A quick way to tell if a company is listed on the NASDAQ is to check out the ticker symbol... those made up of four letters are listed here (e.g. Microsoft = MSFT, Dell Computers = DELL, Cisco = CSCO).
What is the S&P 500
Question: What is the S&P 500
Answer: The Standard and Poors 500 (S&P 500) is an index made up of five hundred different stocks. Each is selected for liquidity, size, and industry. The index is weighted for market capitalization. The S&P 500 is the benchmark of the overall market, and frequently used as the standard of comparison in terms of investment performance.
What is a Brokerage Account
Question: What is a Brokerage Account
Answer: The first step to building your portfolio is to open a brokerage account. These accounts allow you to purchase stocks, bonds, mutual funds, and other investments by paying professionals to buy or sell the items you tell them to. The fee you pay them is called a "commission", and can range from as low as $5 to $10 dollars, to upwards of several hundred dollars. The price difference arises when you choose between either a discount or traditional broker. Traditional brokerages provide a wider range of services, and have the price tag to match. They serve along the lines of professional money managers and can offer advice as to what investments might be right for you. Discount brokers are companies that tailor to the more self-directed investor; they don't offer advice as to what to put your money into, leaving you to make your own financial decisions and charging you much less than their traditional counterparts. Some firms, such as Charles Schwab and Merrill Lynch, offer both services to their customers, allowing them to choose between the traditional and discount formats.
In opening a new account, the minimum investment can vary, usually ranging from $500-$1,000 (and even lower for IRA's and other retirement and education accounts). Most offer the option of either having an application form sent to you, or allowing you to fill them out online, print them, and mail them in with a check. The process is easy and can be done fairly quickly at almost all financial institutions.
Among the best discount brokers are E-Trade Financial, Ameritrade and TD Waterhouse. Each offers commissions of $8-$30 and have easy-to-navigate web sites. Almost all allow you to invest in mutual funds just as easily as in common stocks, which is a big plus for those who are just getting involved in managing their own finances. (Mutual funds are a collection of different stocks and bonds that are managed by professional money managers. For instance, if you wanted to invest in oil and / or gas and energy, but weren't sure which stocks in that industry to purchase, you could look for a mutual fund that dealt exclusively with those types of companies. You buy shares in the mutual fund, and the fund manager spends his time researching the different opportunities available.)
Once you have opened an account, you have the ability to start investing your money. All brokerages give you the option of setting up automatic monthly withdrawals, which will transfer an amount you specify each month from your savings or checking account to your brokerage account. This can be an easy way to start building up your equity; if you don't see it, you won't spend it. Since you won't notice the money that is missing each month, saving will be relatively painless.
What are Money Market Accounts
Question: What are Money Market Accounts
Answer: A money market is more or less a mutual fund that attempts to keep its share price at $1. Professional money managers will take your cash and invest it in government t-bills (aka "treasuries"), savings bonds, certificates of deposit, and other safe and conservative short term commercial paper. They then turn around and pay you, the owner of the money market, your portion of the interest earned on those investments.
Most banks offer money market accounts to their customers, although the amount of interest paid will vary by account size. Generally, the highest interest rates are paid to those who invest $100,000 or more.
Money market accounts are frequently used to park cash between investments.
What is a Dividend
Question: What is a Dividend
Answer: Some stocks, especially blue chips, pay dividends. This means that for every share you own, you are paid a portion of the company's earnings. For example, for every share of AT&T you own, you will get sent $0.15 every year. Most companies pay dividends quarterly (four times a year), meaning at the end of every business quarter, the company will send a check for 1/4 of $0.15 for each share you own.
This may not seem like a lot, but when you have built your portfolio up to thousands of shares, and use those dividends to buy more stock in the company, you can make a lot of money over the years.
What is a Blue Chip
Question: What is a Blue Chip
Answer: A "blue chip" is the nickname for a stock that is thought to be safe, in excellent financial shape and firmly entrenched as a leader in its field. Blue chips generally pay dividends and are favorably regarded by investors. A few examples of blue chips are Wal-Mart, Coca-Cola, Gillette, Berkshire Hathaway and Exxon-Mobile.
Blue chip stocks are sometimes referred to as bellwether issues.
What is a Stock Split
Question: What is a Stock Split
Answer: A stock split is essentially when a company increases the number of shares. For example, if you owned 25 shares of XYZ at $15 per share, and there was a 2-1 stock split, you would then own 50 shares worth $7.50 each. Why do companies issue splits if you still have the same amount of money?
Liquidity. Some companies believe that their stock should be inexpensive so more people can buy it. This creates a condition where more of the company's stock is bought and sold [this is called "increased liquidity"]. The problem, in theory, is that the increased activity will also leads to bigger gains and drops in the stock, making it more volatile.
Many investors believe splits are a good thing. (Their thinking goes "Well, if the stock was at $15, and now it's at $7.50, it has to go back up to where it was!) This is wrong. The stock is where it was... remember that each share now represents half of the equity in the company that it did before the split. That means that each share is entitled to half the dividend, half the earnings, and half of the assets that it once was.
A few corporations have been famous for their no-split policies. The Washington Post has traded well into the $600 per share range, and Berkshire Hathaway [which was at $8 a share in the 1960's] has traded around $71,000. This has created the welcome condition of a stable shareholder base.
What is a Reverse Stock Split?
Question: What is a Reverse Stock Split?
Answer: Many companies attempt to list their securities on one of the major stock exchanges, like the NYSE, in order to provide greater liquidity to shareholders. In order to earn and maintain exchange listing, however, the corporation must meet several criteria, including a minimum number of round lot holders (shareholders owning more than 100 shares), total shareholders, net income, public shares outstanding, and price per share.
In times of market or economic turmoil, individual businesses or entire sectors may suffer a catastrophic decline in the per share stock price. The aftermath of the Internet bubble is the perfect example; many stocks fell by 90 percent or more. If the market price falls far enough, the company risks being delisted from the exchange; a terrible tragedy for existing stockholders. At the New York Stock Exchange, for example, this is triggered after an issue trades at below $1 per share for 30 consecutive days.
In order to avoid this fate, the Board of Directors may declare a reverse stock split. The move has no real economic consequences. Here’s an illustration: Assume you own 1,000 shares of Bubble Gum Industries, Inc., each trading at $15 per share. The business hits an unprecedented rough patch; it loses key customers, suffers a labor dispute with workers, and experiences an increase in raw commodity costs, eroding profits. The result is a dramatic shrinkage in the stock price – all the way down to $0.80 per share.
Short-term prospects don’t look good. Management knows it has to do something to avoid delisting, so it asks the Board of Directors to declare a 10 for 1 reverse stock split. The Board agrees and the total number of shares outstanding is reduced by 90 percent. You wake up one day, log into your brokerage account, and now see that instead of owning 1,000 shares at $0.80 each, you now own 100 shares at $8.00 each. Economically, you are in the same position as you were prior to the reverse stock split, but the company has now bought itself time.
What are Penny Stocks
Question: What are Penny Stocks
Answer: Penny Stocks are any stock that trades below $5 per share. Most financial advisors and long-term investors tend to avoid them completely because of the extremely high risk that comes with owning them. They generally tend to fluctuate wildly in price, and although some report spectacular gains in a matter of a few days [or even hours], those who invest in them are generally surprised when they disappear altogether.
Generally, if a stock is trading that low, it is danger of losing its listing with an exchange. When this happens, a company is normally either in very bad financial shape, or on the brink of bankruptcy. Smart investors opt to avoid these.
What is a Certificate of Deposit
Question: What is a Certificate of Deposit
Answer: A certificate of deposit ("CD") is a short to medium-term, FDIC insured investment available at banks and savings and loan institutions. Customers agree to lend money to the institutions for a certain amount of time. In exchange for doing so, the customers is paid a predetermined rate of interest. Often, banks will charge a penalty fee if the money is withdrawn from the CD before it matures.
What are Commodities
Question: What are Commodities
Answer: Commodities are objects that come out of the earth such as orange juice, wheat, cattle, gold and oil. People buy and sell commodities based on speculation. For instance, if you thought hurricanes over Latin America were going to destroy much of the coffee crop, you would call your commodity broker and have them purchase as much coffee as possible. If you were correct, the price of coffee would be driven up drastically because the crop had been destroyed by weather, making the surviving harvest worth more.
Almost all commodity speculators trade on margin which results in substantial risk to the invested principal. The odds are heavily against anyone hoping to build permanent wealth in the commodity markets.
You can find more information in the Commodities Subject.
Beginner's Corner
What are stocks? How do they work? What is the Dow Jones? How do bonds make money? If you need simple questions like these answered, the Beginner's Corner is the place for you! Drop in to learn all the basics.
Do Not Despise the Day of Small Beginnings
Small Amounts Can Yield Huge Wealth
One of the questions I most often hear is, "I don't have enough money to invest. The frictional expenses make it pointless."While it's true you must control your transaction costs and keep your expenses low to benefit from the growth in your investments, it is a mistake to discount the value of small investments. It may be often quoted, but the parable of the mustard seed certainly applies to your portfolio - the smallest start can yield huge results if given enough time and thought.
Here's a perfect example that I talk about in my latest book, The Complete Idiot's Guide to Investing, 3rd Edition. In 1919, Coca-Cola went public at around $40 per share. Due to some problems in the business and other factors, the stock price fell to $19 per share by the end of 1920. Investors that had subscribed to the initial public offering were now sitting on a more than fifty percent (50%) paper loss.
They could have gotten spooked and sold out of their position. Those who had faith in the business, however, have been extraordinarily well served. Despite wars, recessions, depressions, a Presidential assassination, price controls, and other huge geopolitical and macroeconomic events, that single share, with dividends reinvested (that is crucial!) has now grown into more than $5,000,000!
In fact, a $10,000 in any number of companies - Berkshire Hathaway, Wal-Mart, Home Depot, McDonalds, Capital Cities, Wells Fargo, American Express, The Washington Post, Chico's, and Microsoft, just to name a few - was enough to make you rich enough to never work again. Hang in there, focus on building a complete portfolio, and time will take care of the rest if you are diligent about protecting your capital and limiting risk.
What are the Summer Doldrums?
A Wall Street Tradition
If you've spent a lot of time hanging around your broker's office or reading financial publications, you may have heard of a phenomenon known as the summer doldrums.What exactly are the summer doldrums? Simply put, traders, brokers, money managers, and investment analysts are human. On warm, summy days, many would rather be heading to the Hamptons to catch up with friends, or laying by the pool sipping a lemonade. If they aren't in the office, that means they aren't as likely to buy and sell stocks (would you be thinking about Home Depot, Berkshire Hathaway, or Coca-Cola while grilling steaks and playing with the kids?).
The reduced volume results in greater volatility because the transactions that are completed are going to have a bigger impression on the price of the stock. If you wanted to sell 1,000 shares of a thinly traded bank stock in North Carolina, the order may not have a huge effect on the equity's price if the company trades an average of 100,000 shares each day. If, however, trading volume falls 30% in the summer to 70,000, your order is going to have a more powerful influence on the price of the stock by pressuring it to fall as you sell your holdings.
In Wall Street lore, the summer doldrums officially end after labor day in September, when hedge fund managers, mutual fund gurus, and stock pickers head back to work and are forced inside as their kids return to school.
