| The Stock Market For Beginners |
|
Every successful investor has a basic understanding of the stock market and how it works. In the next few paragraphs we provide an overview of the stock market for beginners and show you how to trade stocks. The stock market for beginners can be a tough place and we are going to give you the tools necessary to survive.
The Stock Market For Beginners: Introduction
A stock market, by definition, is a private or public market for the trading of company stock and derivatives of company stock at an agreed upon price. The main function of the stock market is to enable trade in the shares of public companies, which in turn reflect the performance of the companies whose shares are traded in the stock market. The stock market in the United States consists of the trading of all securities listed on the New York Stock Exchange (NYSE), the NASDAQ, the American Stock Exchange (AMEX), as well as on the many regional exchanges such as the OTC Bulletin Board and Pink Sheets.
Each developed country has its own stock exchange. In Europe, there is the Euronext for the Eurozone, and the London Stock Exchange for the United Kingdom, and in Japan there is the Tokyo Stock Exchange. Major stock market indices exist to track the values of specific baskets of stocks traded on the exchanges. In the US, you have the Dow Jones Industrial Average (DJIA), S&P 500 and NASDAQ Composite Index. In Europe there is the Dow Jones Euro Stoxx 50; In the UK there is the FTSE 100; In Japan there is the Nikkei 225, just to name a few.
The stock market is one of the most important sources for companies to raise money and is vital to economic growth. Through the use of the stock market, companies are able to raise additional capital for expansion by selling shares of ownership to investors. The market also provides the liquidity for investors to quickly purchase and sell shares. This makes investing in stocks more attractive when compared with more illiquid investments. Stock markets can either function as a primary or secondary market.
Primary Market
- When a company decides to sell its shares to the public through an Initial Public Offering (IPO) then the stock market is functioning as a primary market for this company.
Secondary Market
- After a company has completed its IPO and is listed in the stock market, its shares are allowed to trade and the stork market is acting as a secondary market for this company.
How to Classify Stocks
Because of the sheer number of stocks trading on exchanges around the world, it is important to be able group them into categories. There exists a Global Industry Classification Standard (GICS®) that assigns each stock to a sub-industry, industry, industry group, and sector. In addition to GICS, stocks can also be classified by capitalization or investing style.
Global Industry Classification Standard (GICS®)
Standard & Poor's and MSCI Barra jointly developed the Global Industry Classification Standard (GICS®) to establish a common, global standard of industry classifications for companies worldwide. GICS consists of four levels of detail. At the most specific level, an individual company is assigned to a single GICS Sub-Industry according to the definition of its principal business activity as determined by Standard & Poor’s and MSCI Barra. The hierarchical nature of the structure automatically assigns the company’s Industry, Industry Group, and Sector. As of August 28, 2008, there were 10 Industry Sectors, 24 Industry Groups, 68 Industries, and 154 Sub-Industries. The 10 GICS Sectors are the following:
- Energy, Materials, Industrials, Consumer Discretionary, Consumer Staples, Health Care, Financials, Information Technology, Telecommunication Services, and Utilities.
For more information on GICS, please visit the Standard and Poors website.
Market Capitalization
Market capitalization is a number that represents the aggregate value of a company or stock. It is obtained by multiplying the number of shares that a company has issued and are in the hands of the public (shares outstanding) by the current price per share. For example, a company having 1 billion shares outstanding and a share price of $15, would have a market cap of $15 billion. Traditionally companies are divided into the categories of Large Cap, Mid Cap, Small Cap, Micro Cap, and Nano Cap that traditionally have followed these rules of thumb.
- Large Cap - Market Cap over $5 billion
- Mid Cap - Market Cap between $1 billion and $5 billion
- Small Cap - Market Cap between $300 million and $1 billion
- Micro Cap - Market Cap between $50 million than $300 million
- Nano Cap - Market Cap less than $50 million
"Penny Stocks" which are stocks that trade for less than $5 a share and are traded over quotation services such as the OTC Bulletin Board or the Pink Sheets are usually classified as Nano & Micro Cap companies. Please keep in mind that these classifications are only approximations and may change over time.
Investing Style
When deciding to invest in stocks, the typical trade off is between growth and value.
Growth Stocks
- Are stocks that appreciate in value and are expected to yield a high return on equity. The company's earnings are expected to grow at an above average rate relative to other stocks in the market. To be classified as a growth stock, analysts expect to see at least 15 percent return on equity. These stocks usually do not pay a dividend because earnings usually get reinvested in the company to help feed its growth.
Value Stocks
- Are stocks that tend to trade at a lower price relative to its fundamentals, and are thus "undervalued". Undervalued stocks may have a low price to earnings ratio, low price to book ratio, or low dividend yield. If you are investing in value stocks, you believe that the market isn't always efficient and it is possible to find companies trading for less than what they are worth. Value stock investing was pioneered by Benjamin Graham and has been made famous by Warren Buffett, his student.
How to Trade Stocks
Investors trade stocks based on two characteristics: fundamentals and technicals. The fundamental investor is concerned with market sectors, industry groups, market capitalization, growth versus values, and most importantly earnings whereas the technical investor is focused on chart patterns that the particular stock price may be making at any instant. When deciding what type of analysis best suits your investment goals, it is important to define your investment horizon. Depending if you are looking to make a profit intraday, over the course of a week, a month, a couple of months, a year, or several years, a particular investing style may be best suited to your goals. Fundamental analysis is only appropriate when your time horizon is at least a year, preferably several years, whereas technical analysis can be applied to any time horizon.
Technical Analysis
- Tries to forecast the future direction of stock prices based on the study of past market data (i.e. prices and volume). In doing so it ignores the actual nature of the company and its past, present, and future earnings. Technical analysis is primarily used by active day traders and financial professionals that are betting that "history will repeat itself".
Fundamental Analysis
- By looking at a company's financial statements and its revenues, expenses, assets and liabilities, one tries to predict a company's stock valuation and its probable price evolution. In addition, one must take into account the intangible aspects of a company's value such as its management team, brand name, and its competitors.
After conducting the proper analysis, an investor can decide to go long or short the company's stock. Most people are familiar with "going long" or purchasing stock, where you are betting on an increase in price, but investors can also bet on a decrease in stock price by "going short". Shorting company stock involves borrowing shares and selling them immediately on the open market. Since you are betting on a decrease in price, you expect to be able to buy them back at a later date for a lower price and return them to the lender. Being able to go long or short enables investors to make money in bull or bear markets.
Final Note
As an individual investor, it is always important to remember that the law of averages is not on your side. Research has proven that the majority of professional money managers that manage billions of dollars for mutual funds do not outperform their benchmarks. For example, the majority of mutual funds that have the S&P 500 as their tracking index do not outperform the index. This begs people to ask the question, why pay for active management?, and has led to the popularity of exchange traded funds. However poorly mutual fund managers may perform, the average individual investor performs even worse if he/she tries to select stocks on their own. It's important to start small, get educated, and remember that this can be a tricky, yet fun game.
|
|
Recommended Reading
