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
3. The opportunity to sell the shares at a price higher than the
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
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
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
- 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.
- 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.
- 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.
- 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.