Many of the richest people in the world, including Warren Buffet and Bill Gates, made a fortune through stock market investing. In fact, over the years, participating in the market helped Americans grow their savings, raise money for mortgages, and enjoy more than comfortable retirements.
Choosing the right stock and building your strategy depends on how much money you have to invest, what your goals are, and other factors.
This article will allow you understand how the financial markets work, different investment tools that you can utilize, and other useful information that will help you become successful in stock market investing.
To understand how stocks work and what buying them entails, here is an example that explains the process. Let’s assume that John, a local coffee stand owner, wants to raise money for his business. John determines that the value of the coffee stand, if he sold it to an investor, would be $10,000. Instead, however, John decides to split the business into 10 parts and each of them is worth $1,000. John’s sister, Laura, invests $2,000 in the coffee stand and owns 2 out of its 10 parts (or 20% of the business). Additionally, 8 more people also invest in the company and each of them purchased 10% of it for $1,000.
In this instance, Laura and the 8 other investors would be the coffee stand’s shareholders. The business’ 10 parts, worth $1,000 each, are its stocks. After 5 years have passed, the coffee stand’s revenues grew, the company opens 5 new locations, and its overall value increases from $10,000 to $30,000. Laura, who originally bought 20% of the business (or 2 stocks) for $2,000 can now sell them for $6,000 ($3,000 per share) and make a total profit of $4,000.
This is how the stock market investing works. However, publicly traded companies, like Amazon and Microsoft, don’t just issue 10 stocks. They have millions, if not billions, of shares. Investors can buy these stocks and own a portion of the company.
Many people can become wealthy by researching businesses that have a lot of potential to grow, investing in their shares, and selling the stocks when their value increases. For example, 5 years ago, in 2014, Amazon’s stock price was at $300 per share. Today, it is almost $1,800 per share. If someone bought 10 Amazon stocks for $3,000 in 2014, their investment would be worth almost $18,000 today.
Once you purchase a company’s share, your money will work for you and grow on its own. Investors who bought Amazon’s stock in 2014 did not manage its day-to-day operations nor did they get involved in any decision making.
It is very important to thoroughly research companies and determine if their business will likely grow in the future. Otherwise, investors would risk losing money. Ford’s stock, for instance, was worth almost $17 per share in 2014. Today, the stock’s price is just over $8. An investor that purchased 1,000 Ford shares for $17,000 in 2014 would only have $8,000 left today.
In this article, we will go over all that you need to know about identifying the right stocks, knowing how to determine profitable investments, and managing risk to minimize your potential losses in stock market investing.
There are several factors that will impact your stock holdings’ prices, including the volume of trade, the different players involved in the market, and volatility.
Enter Going back to our coffee stand example, Laura — who originally bought 2 shares for $1,000 each — wanted to sell her stocks for $3,000 when the company’s value went up. To do so, Laura must identify potential buyers and convince investors why buying her stocks would benefit them, a process that might take several months. In this instance, volume (the amount of buying and selling) is considered low and Laura’s stocks are relatively illiquid (they can’t be immediately converted to cash).your text here...
In the US stock market, where major national and international companies are traded, volume is much higher than in our example (which only serves as a microscopic illustration of how stocks work). During 2017, an average of $505 billion worth of shares was traded per day. Larger companies tend to have more volume and their shares are more liquid (i.e. easier to buy or sell immediately) than their smaller counterparts.
When you are stock market investing, it is important to look at a company’s volume and liquidity. An illiquid share is harder to sell at your desired price level. During market downturns or unexpected events, you want to be able to close a position quickly in order to minimize your risk. Otherwise, when there aren’t enough buyers who would purchase your stock at a desired price, you risk having to sell for lower and, consequently, incur larger losses.
One of the key factors that impact volume is related to the different players involved. Investments in the New York Stock Exchange come from several sources. Each of them varies when it comes to the capital amount and strategy. Apart from individual investors, such as yourself, here are the major players that are involved:
Stock prices are impacted by several factors, including both company-specific news stories and larger economic events. Under federal laws and regulations, publicly traded firms (those whose stocks are bought and sold on the New York Stock Exchange), must publicly release their earnings each quarter. When a company outperforms expectations, their stock price significantly increases (and vice-versa).
Larger economic events including data releases, government policy changes, and geopolitical relations impact the larger market, as a whole, as well as entire industries. If you invest in a company that relies on trade with China, its stock price will sharply react to developments. Each month, the federal government releases data on retail sales, consumer confidence, business activity, and other economic activity. Grim numbers that fall below expectations can impact both the larger market and specific sectors. A bad retail sales report means that stocks like Amazon and Target will likely go down.
Here are a couple of terms that you will regularly come across when researching stocks and companies:
When a company’s stock price moves up or down in a very quick manner, it is referred to as “volatile”. Similarly, during periods of uncertainty or rapidly changing news developments, markets tend to be more volatile and price movements are more severe.
Many seasoned investors and traders can still make money during bear markets though short selling (or “shorting”) stocks. In these instances, you would gain profit when prices go down and lose money when they go up. Here’s an example of how shorting works:
ABC stock is trading at $10 per share. However, you expect the price to go down to $7. First, by initiating a short position, you borrow ABC’s stocks from the broker and sell them at their current price of $10 (assume that you short sell 1,000 shares and receive $10,000 in cash). A few days later, when the stock reaches $7, you use the $10,000 to buy back the 1,000 shares you borrowed from the broker for only $7,000 ($7 per share). Afterwards, you return the 1,000 stocks that you borrowed from broker (who only want their shares back, regardless of their value) and keep the extra $3,000 as your profit.
This is an advanced stock market investing vehicle.
While the basic principles that influence stock prices are the same, different types of shares have their own unique characteristics. You should pick the ones that suits your strategy and goals for stock market investing.
This is a widely popular investment tool that offers a guaranteed income. A dividend is an amount, usually paid out every 3 months, that shareholders receive for simply owning a company’s stocks. Apple and Microsoft are 2 of the most prominent dividend stocks. If you invest in Apple, you will get a $0.77 dividend on every share that you own. Buying 100 shares for $200 you will get you $77 in dividends ($0.77 for each stock).
With a dividend stock, you gain twice: From the dividend payment and the increased share prices.
A dividend yield pertains to the percentage of the payout in relation to the stock price. For example, if a company’s stock price is $100 per share and they pay a dividend of $0.25 each quarter (or $1 annually), the yield would be 1% ($1 divided by $100).
In order to receive the dividend, you must purchase shares before the ex-dividend day. Those who buy a stock on or after the ex-dividend day do not get the payment. Generally speaking, companies set the ex-dividend day a few weeks ahead of the payment day (when the dividend amount is deposited into shareholders’ accounts).
Some firms offer dividend reinvestment programs (DRIP). Instead of immediately paying shareholders dividends, the company would reinvest the amount in order to accumulate more revenues. In a way, DRIPs are long-term investments that pay you dividends on your dividends.
In general finance, a bond is a type of loan. When someone buys a bond, they are lending the issuer the money in order to receive interest revenues on a regular basis. A bond is similar to how your credit card and mortgage/auto loan issuers make money by charging you interest with each payment.
When it comes to stocks, many companies issue bonds that members of the public can buy and sell on the market. So does the US Treasury Department, as well as state and local governments. One of the main benefits of investing in bonds is that, just as with dividends, they guarantee a regular and recurring source of income (interest payments). Many consider bonds to be less risky than dividend-paying stocks because investors are not exposed to price fluctuations.
Having said that, this is also a negative aspect. Bond purchasers, as opposed to dividend investors, do not enjoy the returns from price increases that stocks have to offer. It is also important to note that bonds are not as liquid as shares. While stocks can be immediately sold for cash, bond holders must wait until the maturity date (when the amount is paid back to them in full) in order to realize the entire interest revenue. Selling your bond early will likely cause you to lose money, especially if you do so for less than what you originally paid for it.
Some of the most profitable types of bonds are the ones that pay you a compounding interest rate. Here is how it works: Regular bonds generate interest revenue as a percentage of the principal amount (what you loaned to the bond issuer). For example, if you buy a bond for $10,000 with a 5% biannual (twice per year) interest rate, you will make $1,000 in revenues each year ($500, which is 5% of the $10,000 principal, every 6 months) — alongside the loan repayments you receive. With a compounding rate, you get paid interest on your interest. But how much do you receive? That depends on how often the interest compounds.
In most cases, corporate and government bond interest rates compound bi-annually (every 6 months). Here is how it works if we assume that you purchase a $10,000 bond in January of 2020 with a 5% compounding biannual interest:
Between January of 2020 and up to December 2021, your total interest revenues from the compounding bond are $2,155.07. This will continue to add up and compound until the bond matures and you receive the full principal back (plus interest). With a nominal, non-compounding interest rate — that also pays 5% biannually — your total revenues between January 2020 and December 2021 would only be $2,000.
Some dividend-paying companies have 2 categories of shares: Preferred and common. Shareholders who own preferred stocks receive dividend payments before common stockowners do. This is especially important when it comes to smaller companies that may not have enough cash on hand to pay all of its stockholders the dividends when they are due.
In addition, preferred stocks share certain characteristics with bonds. While the latter pays a fixed interest rate on a recurring basis, preferred shareholders also receive dividends with a consistent yield (as opposed to common stocks that have a regularly changing dividend). However, if a company goes through financial troubles, they can delay or change the dividends that preferred stockholders receive. With a bond, the firm has to make its payments on time. Otherwise, its credit rating and trustworthiness will be severely damaged.
Let us go back to our coffee stand example for a moment. John, the founder and owner of the company, valued his firm at $10,000 and split it into 10 stocks (worth $1,000 per share) that investors can buy. Laura, John’s sister, invests $2,000 in the coffee stand and buys 2 stocks. Another investor, Sam, buys 1 stock. In this instance, the company has 3 outstanding shares. The remaining 7 are still owned by John, the initial business owner, until someone buys them from him.
Outstanding shares are defined as stocks that investors purchased. Market capitalization refers to the total value of the outstanding shares. The coffee shop has a $3,000 market cap (Laura’s 2 stocks and Sam’s single share). Market cap is important because it allows investors to evaluate a company’s worth if its stock price accurately reflects it.
Since John only sold 3 out of 10 stocks, his market cap suggests that he may have overestimated the coffee stand’s worth since investors did not purchase the shares at the $1,000 price level. Conversely, if John sold 8 or 9 stocks, this would indicate that he accurately estimated the value of his company. He may have even underestimated it.
In the New York Stock Exchange, there are small cap and large cap stocks. Over 90% of publicly traded companies are large cap, with a market capitalization of $2 billion or more. Small cap stocks have a market capitalization that is between $300 million and $2 billion. There are certain advantages to investing in each type.
Since small cap companies tend to be relatively compact, investors can easily buy shares at a low price and enjoy significant returns when the firm grows. Those who purchased Amazon or Apple stocks when they were small cap companies have seen their investments multiply in value by the 100s. Needless to say, it is not easy to identify the next Amazon or Apple amongst smaller firms. Investing in a small cap stock comes with its own risks. The companies are more likely to suffer financial problems and their stock prices are more volatile.
A large cap company — since they have been long established as an industry leader — offers a more stable stock (in terms of pricing) with minimal risks. However, given that a large cap company’s rapid growth from a small business to a multinational corporation is behind them, the returns on these shares are not as lucrative as their small cap counterparts.
Previously, we talked about the main market players and how financial management firms invest large amounts of their clients’ capital. Mutual funds fall under this category and publicly traded firms invest their shareholders’ money in other stocks. One of the main benefits of buying a mutual funds’ stocks is that its managers regularly invest in dividends, which are paid out to shareholders (i.e you).
Your investment will also be professionally managed. For example, when mutual funds buy other stocks in the market and their price goes up, the gains are passed to stockholders (known as Net Asset Value or NAV). This, of course, is on top of making money when the mutual fund’s stocks — that you originally bought — increase in value.
Having said that, when you initially invest in a mutual fund by purchasing its stocks, they will charge you a transaction fee that other companies/types of shares don’t. There is another transaction fee for selling the stock. These fees shouldn’t be confused with commissions, which are charged by brokers and not the companies you invest in. We will discuss this topic more in the article.
Mutual funds also charge stockholders other fees, which go towards the costs of managing your investments and related operational costs (staff, research, mail, …etc.).
If you want to invest in a commodity, such as gold or silver, your main option would be to purchase a futures contract. However, futures are very different from stocks. They are riskier and require a larger account size. There is another way to purchase commodities, which is through an ETF.
An ETF is a mutual fund where its holdings are tied to a specific commodity or index. The SPDR Gold Shares ETF (GLD), as an example, has its holdings in gold. Through purchasing GLD, you benefit when the price of Gold goes up, exactly as you do through a futures contract. Other ETFs also track major market indices, such as the Dow Jones Industrial Average and the S&P 500.
Just as with any other mutual fund, certain ETFs pay investors dividends. However, it is also important to keep an eye out for fees and study the components of an ETF before making an investment decision. Each of them has its own method of tracking commodities and/or indices that you should be aware of.
As the name suggests, REITs hold their funds in real estate investments, ranging from residential property to hospitals and malls. REITs are perfect for you if you want to invest in real estate but lack the capital resources to purchase large chunks of property.
When compared to other types of stocks, REITs have a very generous yield. On average, dividend-paying components of the S&P 500 index have a 1.85% annual yield. For REITs, that number is 4.59%. On top of that, when a publicly traded REITs stock price goes up, shareholders can sell their shares for higher than what they bought it for.
Another major advantage to investing in REITs is Net Asset Value (NAV). When the trust purchases new properties or sees an increase in the value of existing ones, the gains are passed on to stock owners. When an REIT sells some of its properties, you also benefit from that revenue. The costs of acquisitions and divestment, however, are passed on to shareholders, alongside performance and management fees.
Another disadvantage when it comes to REITs has to do with risk. Because these funds only focus on real estate, a drop in property values or an under-performing housing market could cost you a lot of money.
You can also directly invest in real estate.
CEFs are similar to mutual funds, which are open-ended. Both of them offer professional management that reinvests shareholders’ capital and the 2 entity types charge stock buyers fees to cover operational expenses. One key difference, however, is how close-ended funds’ shares and bought and sold.
CEFs initially make their stocks available to the public, before being traded on the market. After the shares are sold and the CEF raises enough money from investors, they don’t issue any new stocks nor do they buy them back from existing investors. Instead, shareholders must sell their stocks to other buyers via brokerage firms and ECNs. Open-ended mutual funds’ shares, on the other hand, can be easily sold (including to the company, itself).
BDCs are a type of close-ended fund where management invests in small and medium sized companies — as opposed to buying the shares of publicly traded firms. BDCs offer investors lucrative dividend yields and opportunities to significantly grow their returns. This is because BDCs work with small and medium size entities that have potential to grow over the years.
An options contract gives you the opportunity to buy/sell stocks at their current price level or a predetermined one within a certain period of time. Let’s say you bought Marriott International (MAR) stocks (not options) for $120 per share. You expect prices to go up to $135 and you plan on selling your shares when they reach that level. During the following week, the hotel’s stocks go up to $123.
There is always the possibility that things will go wrong and the stock plummets, erasing your gains and turning them into losses. To offset this risk, you buy a Marriott options contract that gives you the right to sell your stocks at the current price level ($123) within the next 14 days. If an unexpected scenario causes MAR to drop to $115 per share and forces you to sell at a loss, the options contract gives you a layer of protection.
It is important to note that an options contract is a separate instrument from a regular stock purchase. It does not give you more shares nor does it impact your original investment. Options provide you with another tool to manage your risk as a separate financial instrument.
There are different ways to find shares that have a strong potential. A lot of it depends on your background and skills, but your sources of information and approach to research are just as important when stock market investing.
Here, we will cover all that you need to know about how to pick the best equities.
A good place to start looking is in areas that you understand well. For example, if you work in the insurance industry, you probably know who the major companies are, what their pricing policies are, which of their products are most popular, and how their business model works.
This makes it easy for you to evaluate new products or promotions and whether or not they will impact the company’s stock price. You can also analyze their earnings statements and identify notable information. Keep in mind that you might have to familiarize yourself with financial and technical terms, to begin with. Focusing on sectors that you know well gives you one less mountain to climb.
There are 2 general approaches to equity analysis: Fundamental and technical. Each has its own way of determining a stock’s value, price targets, and potential risks.
Technical analysis studies other factors, such as moving averages, momentum charts, and other statistical trends. They with help managing risk and the overall investment.
As an individual investor learning about stock market investing, ongoing education is going to be crucial. The more you read and learn, the faster you improve. Charles Schwab, Warren Buffett, Matthew Kratter, Charles Payne, and others are amongst the top authors of stock market books. When you read analysts reports and news articles, try to see if a writer that you like has a published book (which is common).
There are many reliable and highly insightful news sources that cover the stock market. You should identify outlets that cover stories that are aligned with your goals and strategy.
For example, some analysts might recommend buying or selling a certain stock. But, who is this advice intended for? If the buy/sell suggestion is intended for day-traders, it most likely pertains to a very short term (few minutes to few hours long) investment. Those who want to grow their retirement or mortgage account will find this advice useless and are incredibly likely to lose money if they followed it.
Similarly, are you going to follow a fundamental or technical approach? Some news sources specifically cater to technical traders while others focus on fundamentals.
Some of the top news sources include Bloomberg TV, Fox Business, the Wall Street Journal, Seeking Alpha, investing.com, and Yahoo Finance (especially for charts).
Just as importantly, you should keep a close eye on what analysts have to say about companies whose stocks you invested in. Generally speaking, several research firms and/or financial institutions rate a company, ranging from a “strong sell” (worst) to a “strong buy” (best). Analysts also set their own price target for stocks, based on how they expect the firm to perform in short and intermediate future. When a stock is downgraded (from “buy” to “neutral”, as an example), prices tend to plummet and vice-versa when upgraded. The same logic applies when target prices are increased or lowered.
The law requires publicly listed companies to release their earnings report to the pubic every quarter (3 months). When researching a stock or company, you can easily access their financial statements on their website (typically under the ‘Investor Relations’ section).
There, you will find answers to most of the basic questions that fundamental analysts ask.
You can also jump in on the company’s conference call, where management discusses the latest earnings release and answer investor questions. If you miss it, that part is also available on the firm’s website (in most cases). You should also keep an eye out on their guidance (how much management expects to make during the year and in the next quarter) and if there are any changes to predictions.
Here are some key metrics that you can use to evaluate whether a stock is overbought, oversold, or being traded at fair value.
You must also be prepared for black swan events, which are unexpected circumstances that rarely occur but, when they do happen, they cause severe economic damage. Black swans can have a very negative impact on your holdings and your portfolio could lose as much as one-third of its value or more. Recessions, sector bubbles (such as housing or technology), and currency crises are all black swan events.
A good way to protect your portfolio is to dedicate a portion of your investments to blue chip stocks, which are large firms and corporations that have a track record of maintaining growth during turbulent times.
There is no “right” or “wrong” way to invest and your circumstances define your strategy. It is important that you write a business plan or trading approach document, specifying all your goals, timelines, and how decisions are made (will you rely on fundamentals, technical analysis, or both?).
If your goal is to save for a mortgage, then you will look at a shorter investment time-frame. Someone who plans to retire in 10 to 15 years might prefer secure dividend stocks or bonds from reliable and larger companies. Volatile stocks and sizable losses might require them to delay retirement for another year or more.
A college student, on the other hand, would look for small cap growth stocks that have a strong long-term potential. Their risk tolerance is relatively flexible, especially with a smaller account and more room to recover.
There are many online brokers — or electronic communications systems (ECNs) — that allow you to buy and sell stocks with 1 click. Each of them has its own features. Some offer detailed data and unique reports, while others who lag in that department make up for it by offering minimal commissions.
Some of the best online brokers include E*Trade, Merrill Lynch (operated by Bank of America), Fidelity Investments, TD Ameritrade, and Interactive Brokers.
Many people will tell you that brokers who offer low commissions are the best, but that’s not always the case. This is especially true for longer term investments, such as retirement accounts, where stocks can be held for years if not decades.
Here, research and analysis might be more useful, especially if you have limited investment experience. Many ECNs that charge high commissions do so for a reason. They offer account holders access to unique and thoroughly researched investment recommendations. The value of this is much higher than what the commissions will cost, especially if you are not actively buying and selling stocks.
Another important aspect to consider is how much margin the ECN is willing to give you. In most cases, ECNs let account holders borrow funds from them that they can invest. This is known as margin and every ECN has its own requirements. Some will allow you to purchase stocks with as much as what you put in. For example, if you deposit $10,000 in your account, you can use up to $20,000 to buy shares. ECNs typically give you more margin the larger that your account is.
Some brokers also offer banking services, such as a check book and debit card. This is especially useful if you plan on investing to grow a savings or emergency account. In case you needed the money, you can immediately sell stocks and use the debit card or other banking features to access the funds.
The Securities Exchange Commission (SEC) is the federal government agency that regulates and monitors financial markets. Their goal is to make sure that companies don’t manipulate prices, mutual funds are ran by licensed/authorized managers, and ECN/brokerage firms’ offer fair/less risky tools to investors.
The Federal Industry Regulatory Authority (FINRA) is a private entity — rather than a governmental one — that oversees firms or individuals who solicit investment services.
As an individual investor, your broker will have you fill out forms and regularly update your information, as required by federal law.
After you start investing, you will need to monitor and manage your portfolio to ensure that everything is going as planned.
One of the safest ways — as far as risk goes — to manage your portfolio is through diversifying your holdings. This means that you should invest in companies across different industries and sectors.
For example, if someone’s portfolio mostly consists of airlines stocks, they would have lost a large sum of money after Boeing’s engine crashed earlier this year. Here, the portfolio is considered to be “overweight” because it is highly leveraged towards 1 industry.
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