Finance > Stocks and Stock Mutual Funds

What are stocks?

Fundamentally, stock represents ownership of a company. The benefits of owning the stock of a company are:
1. Dividend paid by the company, usually on a quarterly basis.
2. The right to attend shareholder meetings and vote when the company makes decisions.
3. The opportunity to sell the shares at a price higher than the purchase price.

Today, benefit No. 1 is minimum to zero. Most of the newer stocks (such as Microsoft, Cisco) do not pay any dividend. Benefit No. 2 is almost a non-existence in most cases. Therefore, capital appreciation has become the main reason for owning a stock.

Concepts in Buying/Selling Stocks

Return vs. risk. In the world of investing, higher return (stock price appreciation) usually comes with higher risk. FDIC insured bank CD's are very safe. Its return is relatively low as compared to stocks over the long term. So is government bond. Among stocks, well established companies are usually safer bets. But the potential for such large-cap stocks to go up is usually smaller than for smaller, fast-growing companies, which in turn are riskier to be in.

Long-term investment vs. short-term speculation. Investing means participating in the business of the company by purchasing its stock. Investors truly believe in the long-term profitability of the company's business. Long-term usually means 5 years or longer. Speculation means that you think the company's stock price will go up significantly very soon (e.g. a rumor is out that the company is going to be acquired by another company at a value much higher than what the company is worth in the stock market).

Value vs. momentum investing. Value investors look for stocks that are undervalued, especially those that are misunderstood. They tend to "buy low, sell high." Momentum investors look for stocks have just reached a new-high in price. Their theory is that the only way for a stock to have a spectacular performance is for it to make one new-high after another. They tend to "buy high, sell higher."

It's a stock market, not a market of stocks. This means that when you consider investing in the stock market, it's more important to understand where the market as a whole is going, than to choose which stock to buy. If the whole market is going down south, it doesn't matter too much whether you chose Cisco or Oracle.

Smart money (accumulation vs. distribution). This refers to the activity of professional money managers, who have millions or even billions of dollars to play the market, and who are the first to know what's happening with the company. Smart money often starts accumulating shares of a stock before the public start to buy it. When the stock price reaches a certain point, smart money starts to sell or distribute shares to the public.

Buy on rumor, sell on news. Stock price usually goes up when there is a rumor saying something great is happening with the company. However, once the rumor has become reality or news, the stock price tends to go down. Why? Because the value of the "great thing" is already included in the stock price by the time the news comes out. Once the news is out, smart money has accomplished its mission and is ready to distribute shares to the public and move on to the next mission. Be aware that not every rumor will become reality. Be alert to people who spread rumor just to pump up the stock price.

Greed vs. fear. Investors as human beings all want to make as much money as possible, and at the same time are afraid of losing it. Greed drives people buy stocks even when their prices are already very high. Fear drives people sell stocks when the market tanks. Very irrational, isn't it? What else would you buy when the price goes up, and sell when the price goes down?

Fundamental vs. technical analyses. Fundamental analysis is to look at the company's current and future sales, earnings, assets, and liabilities, and determine whether the stock is over- or undervalued at the current price. Technical analysis is to look at the recent stock transactions and determine whether the stock is on a up trend or down trend. Fundamental analysis will tell you how much the stock is worth and that you should not buy above a certain level. Technical analysis will tell you to buy a stock when its price has gone up to a certain point, and sell it when the price has gone down to a certain point. You can use fundamental analysis to determine whether or not to buy the stock, and use technical analysis to determine if it's a good idea to buy it now.

Short-term vs. long-term capital gains. If you are lucky enough to make some money in the stock market, don't forget that Uncle Sam wants his share. This is called capital gain tax. If you had held the stock for less than a year, a short-term capital gain tax applies. For over a year, the long-term capital gain tax applies.

Wash sell. Uncle Sam allows you to pay less tax as a result of losing money in the stock market. However, he doesn't want you to lose money in stocks in order to reduce tax. Here is the rule against that: if you lost money on a stock, you cannot buy back the same stock within 30 days of selling it (which is called a wash sell).

Free riding. This rule prohibits riding the upward movement of a stock price without actually having the cash (or margin) to complete the initial purchase. Technically, you don't need to have enough cash or margin to initiate the stock purchase. However, you must have enough cash/margin on the settlement date, which is 3 business days after the purchase date. By allowing the purchase, your broker assumes that you will make sure that your account has enough cash/margin on the settlement date. When that is not the case, you have done "free riding," even if you sold the same stock on the same day at a higher price, because the settlement for the `buy' happens before the settlement for the `sell.' The punishment for "free riding" can be a freeze on your account for a period of time (say 60 days).

Margin and short-sell. Credit card companies give you credit to buy things. Brokerage firms also can give you credit to be used to buy stocks. This is called margin. You will be charged interest on the margin you are using. Some people think this is a good way to make money, as they think it's easy to make money on stocks to pay off the interest charged by the broker. Well, keep in mind that stocks can lose their value very fast. If you buy stocks on margin, your worst nightmare is to see the stock price drop significantly, your margin position being sold by your broker when the stock price was at its bottom, and then see the stock price come back. Short-sell is to have negative number of shares of a stock by selling it short. The hope is that the price of the stock will drop and you can buy shares at a lower price to cover your short position. This is also risky. Even if you are right in the long run, the stock may go up significantly in a short-term. As a result, your broker may close your short position by buying share at a much higher price, before the share price actually drops to your predicted level. As you can see, with both margin and short-sell, you have limited resource (your broker would prevent your account balance from going below a certain level by making transactions without your permission). This put you at very high risk even if your prediction is correct in the long run.

Options. Margins are credit for purchasing stocks. Options are insurance for your long or short stock positions. Each options is the right to buy or sell 100 shares of a certain stock at a certain price. It has an expiration date, and will become worthless after that date. The right to buy a stock at a certain prices is a "call option." The right to sell is "put option." Option trading is very speculative and risky. It's not for long-term investors. But it can be used as an insurance for you to lower your risk. For example, if you buy a stock at $200 per share, hoping it would go to $300, but fear it may fall to $20, then you can buy a put option for $150 per share (if there is one). Before the option expires, if the stocks fell below $150 per share, you can use your option to sell at $150 and lose less money. (If you are a long-term investor, you can simply hold and wait for the stock to come back). If the stock never fall under that level, well, the option didn't buy you anything except maybe a better sleep. Instead of thinking about using options to protect your investment, spend more time researching the company, and invest for the long-term. Definitely keep away from option trading, where 80% of the people who tried have lost money.

Stock Mutual Funds

Because it's rather risky to invest in stocks if you can only buy a few of them, mutual funds are created so that people can put money together to buy a large number of stocks to lower the risk.

Managed funds vs. index funds. Managed funds pay professionals to select stocks and decide when to buy and when to sell. Index funds simply buy-and-hold all stocks in an index (e.g. S&P 500). You would think that fund managers can outperform the market. However, research showed that it's very hard for a fund manager to consistently beat the market over a long period of time. To put it in a simple way, the performance of all fund managers put together is roughly the performance of the whole market. Therefore, for every fund manager who outperforms the market, there will be one who under-performs. The problem is that they often change positions and you never know for a certain period of time who is going to win. The biggest advantage of an index fund is low cost, which means more of the investment returns will go back to the shareholders of the fund, instead of to the fund managers. Index funds with low turnover rates are tax-efficient. The problem with an index fund is inflexibility. When a stock is added to the index, the funds that track this index will have to buy the stock no matter how expensive it becomes.

Growth funds vs. value funds. Growth funds tend to buy the "hot" stocks, based on the philosophy of "buy high, sell higher." Value funds tend to buy the "cold" stocks that they think are undervalued, or misunderstood, based on the philosophy of "buy low, sell high." Historically there is no strong evidence in favor of any of the two, although in the last few years growth funds have significantly outperformed value funds. Maybe it's time to buy those beaten-down values funds, because they are "undervalued" now.

Large-cap, mid-cap, and small-cap funds. Large-cap funds buy stocks with a market capitalization of at least $5 billion (the number may change over time). Mid-cap funds buy smaller stocks (maybe $1-5 billion). Small-cap funds buy small stocks (e.g. less than $1 billion). Historically small-cap stocks have higher risks but not significantly higher returns. Mid-cap stocks tend to be more promising than the other two, in terms of risk/return tradeoff.

Suggested Investment Strategy

  1. Be a long-term investor, instead of a short-term speculator. Even though the US stock market has posted big gains over the last 5 years, about 70% of short-term nonprofessional traders have lost money during the same period. In fact only about 10% of these people have made money. The other 20% managed to break even. You would be much better off investing in a diversified mutual fund and do something else than trying to pick the winners.
  2. Diversify across market sectors. Have up to 20% in small-cap, up to 20% in mid-cap, and at least 60% in large-cap. Besides the hot technology sector, have some exposure in other sectors: health care, financial services, retail, energy, etc.
  3. Use "dollar-cost averaging." Invest a small amount each time, but invest regularly. The best approach is to set up payroll deduction into a mutual fund. This way you will average out the ups and downs of the market and lower your risk.
  4. Be proactive, not reactive. Have a sound investment plan and stay with it. Don't react to the market fluctuation. Don't chase what has been hot. Don't get out of the market when you think a crash is due. Nobody knows in the short-term where the market is going. By getting out of the market, the risk for you to lose a good opportunity is bigger than the risk for losing money that your are trying to avoid. If it's a taxable account, you will also owe capital-gain taxes.
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More than 48% of American households owned stocks in 1999, up from 41% in 1995 and just 12% in 1975.


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