Investing with Stocks: A Beginner's Guide
Table of Contents
The First Stock
I like to share a little history on topics because it makes for a fun introduction and also gives you some cocktail party knowledge that most investors won't know. Humor me, I'm an investment geek and I love this stuff but I promise to keep it short. Only two paragraphs of boring historical reference and then I'll talk shop. Besides, the origin of stock trading is pretty bizarre, you might even be entertained.
The first stock traded company was the Dutch East India Company which was the Netherland's version of a weapon of mass destruction. The company was incorporated in 1602 and was granted a monopoly that extended from the Cape of Good Hope to the Strait of Magellan with sovereign rights over whatever territory it could conquer. For over 100 years, the Dutch East India Company monopolized trade, erected fortifications, appointed governors, maintained a standing army, and formed treaties in the name of the Dutch government. At the peak of its power in 1669, the Dutch East India Company commanded 40 warships, 150 merchant ships, and 10,000 soldiers.
The Dutch East India Company was an outstanding investment, between 1602 and 1696 the annual dividend paid to investors was never less than 12% and sometimes as high as 63%. However, history was eventually witness to a pattern doomed to repeat itself hundreds of times: Every publicly traded company that becomes arrogant, treats people badly and has a lot of internal strife will eventually implode (thank you Enron and WorldCom for being such outstanding modern examples). Because they abused the natives in occupied territories and had a lot of internal conflict, by 1795 the Dutch East India Company was powerless to resist the growing British and French naval powers at home and in their territories abroad.
What is a Stock?
Now I can talk about stock investing basics of the 21st century, and I'll begin by clearing up one of the most confusing concepts for new investors. How do stock transactions affect companies? Selling stock allows a company to raise money for expansion without having to take on debt. In other words, Investing Education Inc. wants to open a new store but doesn't want to borrow so they sell stock to raise money instead. This initial stock transaction is considered to happen in the Primary Market because shares are sold by Investing Education Inc. directly to the public. This is called an Initial Public Offering of stock or an IPO.
After a company completes its IPO stock sale, all the shares that they sold are now in the Secondary Market. So what's the difference between the primary market and the secondary market? Investing Education Inc. receives cash from the IPO stock sale (primary market) but is not involved in and receives no cash benefit from any transactions afterwards in the secondary market. Stock traded in the secondary market is called Common Stock and is appropriately named since it will make up most, if not all, of your trades. How does this all tie together? Simply put, when you hear people talk about the stock market, they are referring to common stock in the secondary market.
Who can own Stock?
Anyone can own stock, there are no restrictions on who can purchase or own common stock and you could put in an order right now if you felt like it. But I want you to fully understand your options before you decide between a local stock broker, financial planner, or online brokerage. Your choice will likely have a major impact on your investing strategy and results. There is more about these options in detail later in the Online vs. Traditional Brokerage guide.
So you've bought a stock what does that mean?
When you buy a stock you are actually buying a very small piece of the company. For example, if a company sells 100 shares of stock to the public and you buy one share you literally own 1% of the company. As a shareholder, you technically own a percentage of the assets and earnings of a company, but don't go charging down there and demanding a check just yet. Profit will be passed back to you either from capital appreciation which is a fancy way to say the stock price went up, or in the form of dividends which means a company shared part of its earnings with stock holders.
We all love to see our stock prices soaring, but don't be confused into thinking that the current stock price tells you anything about the value of a company, far from it. Stock price doesn't take into account how many shares are outstanding and that is a critical piece of the puzzle. To find the market capitalization, which is a fancy word for company value, analysts multiply the number of shares outstanding by the stock price. You don't need to practice this calculation though, we only want you to understand that a stock that sells for $30 per share isn't necessarily worth less than the stock that sells for $100 per share.
What causes the Stock price to change?
Obviously the goal is for the stock price to go up more accurately, most beginners want their stock price to go WAY up. So our next subject will be what causes the stock price to change. In literal terms, the stock price fluctuation is a simple matter of supply and demand, and no, we don't think economics is a four letter word. When there are more people that want to buy than people that want to sell, the stock goes up because there is a greater supply of buyers than sellers and this puts upward pressure on the stock price. The reverse is true when there are more sellers than buyers, the stock price goes down.
Of course you're thinking “it can't be that simple” and you're right. There are a lot of other factors that move stock prices but putting too much information in the introduction to stocks would cause serious information overload (a fancy way to say boredom). And don't worry, there will be plenty more information later in guides like our Introduction to Investing Strategies but we recommend that you finish this one first. What we can give you in an intro are some examples that will be very easy for you to spot in the market. Watch for these triggers in the news and then check the stock, we guarantee you'll see the price jumping around like it's on fire.
You may not know what some of these mean, but when you spot them in the financial headlines, go watch the stock prices flail around
- A company significantly beats or misses earnings estimates
- The Federal Reserve announces a bigger or smaller rate cut than analysts expected
- A significant increase or decrease in oil prices
- A major scandal breaks like Arthur Anderson's creative accounting or the WorldCom world record bankruptcy
- Surprisingly uncertainty. When you start seeing synonyms for the word uncertainty in major market headlines, you'll see some movement, usually down
- Surprises in major economic announcements such as inflation, GDP, or unemployment reports
- A company announces a large acquisition
How to look up a stock
I guess if I'm telling you to go look at stock prices I better explain how. In almost every investing article you'll ever read that refers to a stock or an index, you will notice that when they mention a company name they will follow it with some gibberish in quotes like this (GOOG). This gibberish is called a “ticker” and it is the symbol you use when you want to buy, sell or look up information about a stock on any investing website.
Why do companies need tickers? Because there would be a lot of confusion otherwise. For example, if you wanted to look up information about or buy Citigroup (C) would you ask for Citi, Citigroup, Commercial Credit (for you history buffs) or some other variation? A ticker acts as an ID tag so that everyone knows which company you're referring to regardless of which variation of the name you use. One of the easiest ways to look up a stock ticker is to go to google.com and type in “Stock:” followed by the ticker of the company you want to search for. Try “Stock: GOOG”. There are also ticker rules that tell you which exchange a stock trades on but the only info worth sharing this early in your investing education is that the NASDAQ requires four or more letters in their tickers (i.e. Google =”GOOG”) and the NYSE requires three or less (i.e. Citigroup Inc = “C”).
Different categories of stock
I couldn't write an intro without mentioning the three major categories of stock. What, more categories!? I know, I know, your head is already spinning with primary vs secondary market and common stock vs. other types of stock but this will be relatively painless since you've probably heard most of these terms but never really knew what they meant. I'm going to quickly cover the three major stock classifications and they are Capitalization (how BIG or small a company is), Industry (what they do) and Situation (how they are viewed by investors). Almost every stock fits in one of the capitalization categories, one of the industry categories, and one of the classification categories, they are not mutually exclusive.
Category 1: Market Capitalization
The first category, Market Capitalization, tells you how big a company is. I mentioned above that market capitalization is calculated by multiplying the number of shares outstanding by the price of the stock. You'll never have to do this calculation, every major investment site provides this and tons of other metrics but it's important to understand for this conversation. If you DID do this calculation, a result greater than $5 Billion dollars is a Large Cap company, a result between $1 and $5 Billion dollars is a Mid Cap company, and a result less than $1 Billion dollars is a Small Cap company. No one size is better than another, in fact, a wise investing strategy would require that you have some of each size in your portfolio for diversity.
Category 2: Industry
The second category, Industry, is pretty self explanatory. We've all heard of the high-flying techs, pharmaceuticals, and energy stocks, these are popular industries that always seem to find a way to stay in the headlines. There are, however, dozens of other industries that contain great stocks but that you won't hear about near as often such as retail, food manufacturing, and telecommunication. There are certainly exceptions. Financial stocks, for example, are usually a page 15a small print and surrounded by ads type of industry but they sure found their way to the front page during the 2007-2008 subprime mortgage crisis. Remember that no matter how hot an industry is, never invest in just one, that's a sure way to see your money vanish quicker than 2008 home values. A word I've already used and that you'll hear a lot from any respectable investor is diversity, don't put all your eggs in one basket.
Category 3: Situation
The third category, Situation, is pretty vague but it gives you an idea of how investors view a stock and often about the management style of the executives that run the company. The four broad situations are Blue Chip Stocks, Value Stocks, Income Stocks, and Growth Stocks. Unlike the other two categories, there is some overlap within these groups, a stock can belong to more than one situation and I'll give you an example after we explain each.
The first situation is Blue Chip. This refers to is a prestigious group of companies viewed as the leaders in their respective fields. Thirty of these Blue Chips combine to make up the most widely tracked index in the world, the Dow Jones Industrial Average. (Remember that an index just means that you are combining a group of stocks together and tracking their combined performance) Blue Chips are generally very large companies that pay dividends, are in excellent financial shape, have a long history of success and are seen as low-risk compared to most other types of stock. Given this definition you would hope to have heard of some of them, right? Examples of Blue Chip stock are Wal-Mart, Microsoft, Disney, and Coca-Cola. Any of these companies ring a bell?
The second situation is Value Stock and this is a stock that investors feel is underpriced. In other words, they believe that the fundamental performance measures of the company such as earnings or dividends justify a higher price than the stock is currently trading at. Two of the most common characteristics that value investors look for is a low price-to-book ratio (value the market places on the book value, or assets minus liabilities, of the company) and a high dividend yield (the company gives you back a lot of their earnings). Pretty broad, eh? Yeah, we think so too but people like Warren Buffet have proven that this can be a home run category for long-term investors as long as they have a method that allows them to accurately select undervalued stocks. We won't give examples because the status can change so quickly, a stock that is undervalued today could shoot up tomorrow if a popular analyst takes notice and then it would no longer be a value stock. We'll talk more about how investors identify value stocks in the Introduction to Investing Strategies.
The third situation is Income Stock which is the easiest to define. It's simply a company seen as a great income opportunity because they pay out generous dividends on a regular basis. Remember that a dividend is when a company pays you a share of their earnings in cash. This is a very popular type of stock for retirees because dividends offer not only another way to make money but also current income. Many Blue Chips are often seen as good income stock opportunities, especially during stock price dips.
The last situation, Growth Stock, refers to companies that investors believe have strong growth potential as a result of their unique product, competitive dominance or strong market segment. A great example would be a biotech company with a patent on a drug that will reverse hair loss. This company would have a unique drug with a competitive advantage from patent protection and could likely experience explosive growth and price appreciation since it is in the popular biotech segment.
It's probably obvious to you by now that the last category, Situation, is not mutually exclusive like the first two. Stocks can be in several situations and can migrate back and forth as well. For example, Coca-Cola (KO) is a Blue Chip stock but it is also often classified by investing sites such as Morningstar.com as a large growth stock because of the strong stock price growth from 1995 to present. To add to the confusion, Coca-Cola has recently been making significant increases to their dividend payment which is usually a sign of an income stock.
It's not important that you always know exactly which situation or category a stock belongs to. The goal for beginners is to begin recognizing the characteristics of each type of stock so you'll always know the type of investment you're making and, after reading our more advanced guides, the risk associated with each.
Conclusion and Next Steps
After this section most people are starting to get an idea, based on their personality and goals, of what kind of stock they want to buy. Don't cave into the temptation to buy the first stock you fall in love with, continue reading the guides. You've dipped your toe in the water but you're not ready to go jumping in head first. The best piece of advice we can give to you this early in your investing education is that even after you read our most advanced guides, you will still have trouble narrowing your choice down to a single stock to buy.
It's easy to use the tools at a site like Morningstar.com to create a query that will pull a list of stocks that meet all of the investing criteria for whatever strategy you choose. Unfortunately, regardless of your criteria and strategy, that list of stocks is likely to be long which means you need another list of criteria to narrow this group down. Do you see where we're going with this? Eventually you have to get that list down to one stock, and that requires a lot of expertise, sound judgment, and intuition.
The easiest and, in our opinion, the smartest way for beginners to choose stocks, funds, or any other investment vehicle is to buy some good and affordable investment advice from people with a lot of experience and a proven track record. Then use what you learn on this site to validate their advice or narrow down their short list to a single stock. Many advisory services tracked by an independent organization called the Hulbert Financial Digest have historical track records of beating their competitors and the S&P 500 for over 25 years. That's pretty remarkable considering nearly 75% of professional advisors and fund managers fail to beat the S&P 500 returns each year.
Do your homework before you pick one! Don't be fooled into thinking that the quality of advice determines the price, several of the top 10 performing newsletters in the world cost less than $200 per year while many of the worst performers that haven't beaten the S&P or even turned a profit cost thousands of dollars per year.