Investing in the Stock Market: Part Two

Making Money

There are two main ways to make money with stocks:

  1. Dividends. When a publicly owned company is profitable, management can choose to distribute a percentage of profit to shareholders by paying a dividend. Shareholders can either take the dividends in cash or reinvest them in more shares in the company. Retired investors typically focus on stocks that generate consistent dividend payments to replace their job income. Stocks that pay a higher than average dividend are sometimes referred to as “income stocks.”
  2. Capital gains. Stocks are constantly bought and sold throughout trading sessions, which causes their prices to change. When a stock price goes above what you paid, you can sell your shares for a profit. These profits are known as capital gains. On the other hand, if you sell your stock for a price lower than what you paid to buy it, you have incurred a capital loss.

Both dividends and capital gains depend on the company’s performance – dividends as a result of the company’s earnings and management’s decision, and capital gains as a result of investor demand for the stock. Stock demand goes to the outlook for the company’s future performance. If a company’s shares are experiencing strong demand by many investors, in an increase in the stock’s price will most likely occur. In contrast, if a company is not profitable, or if investors are selling rather than buying the stock, the shares may be worth less than what was paid for them.

Individual stock performance is also affected by overall stock market performance in general, which is in turn affected by the economy as a whole. For example, if interest rates go up, and you believe you can make more money with bonds or fixed income investments than you can with stock, you might liquidate your stock holdings and allocate that money to bonds. If many investors have the same sentiment, the stock market is likely to drop in value, which may affect the value of your investment holdings. In addition, factors such as geopolitical uncertainty, unstable energy prices, and acts of nature can also influence stock market performance.

One important element of investing to remember is that over-priced or expensive stocks will most likely trade low enough to attract investors again. If investors begin to buy again, prices tend to rise, which offers the potential for making a profit. In turn, that market reaction may breathe new life into the stock market as more and more people begin to invest. Such a cyclical pattern of strength and weakness in the stock market recurs, but the timing is not predictable. In some cases, the market moves from strength to weakness and back to strength in only a few months. Other times, the described pattern, which is known as a full market cycle, takes many years.

While the stock market is experiencing its ups and downs, the bond market is fluctuating as well. That is why “asset allocation,” or holding different types of investments in your portfolio, is such an important strategy because, in many cases, the bond market is usually up when the stock market is down, and vice versa. This anomaly is know as negative correlation.

What Causes Stock Prices To Change?

Stock prices fluctuate every day as a result of market forces or changes in supply and demand. If more investors want to purchase a stock (demand) than sell it (lowering supply), then the stock price moves up. Conversely, if more investors want to sell a stock (increasing supply) than buy it (decreasing demand), supply will exceed demand and the stock price would fall.

Grasping the concept of supply and demand is not difficult. What is difficult to understand is what drives investors to like a particular stock and dislike another stock. One factor is determining out what news is positive for a company and what news is negative. There is no single answer to this problem, and each investor has her own sentiments and strategies.

That being said, the principal theory is that the general trading direction of a stock indicates what investors feel a company is worth. However, you should not equate a company’s value with its stock price. Generally, the value of a company is its market capitalization or stock price multiplied by the number of shares outstanding. For example, a company that trades at $10 per share and has 1 million shares outstanding has a lesser value than a company that trades at $5 per share and has 5 million shares outstanding ($10 x 1 million = $10 million while $5 x 5 million = $25 million). Furthermore, the price of a stock does not only reflect a company’s current value but also what investors expect the company to be worth in the future.

When evaluating a company, the most important factor to consider is its earnings. Earnings are the profit a company makes, which every company needs to survive in the long-run. If a company cannot generate earnings, it is not going to stay in business. Public companies are required to report their earnings each quarter of the year. Wall Street and investors in general keep a close eye during the reporting period, which is referred to as earnings season. The reason behind this is that analysts base future valuations on the companies they follow on their earnings projection for those companies. If a company’s results are worse than expected, the price will fall. If a company’s results are better than expected, the price will rise. However, stock prices can fall or sell off after favorable news reports as some investors may want to lock in profits.

An earnings report is not the only factor that can change sentiment towards a stock. For example, during the dot.com bubble, dozens of internet companies accumulated billions of dollars in market capitalization without ever making even the smallest profit. Investors were simply placing their bets on expectations of future profits. Unfortunately, these valuations did not hold, and nearly all internet companies saw their values shrink to a fraction of their highs. Investors have developed hundreds of ratios and complex indicators such as the price/earnings ratio, oscillators, and moving average to determined optimum price or market entry points.

The reason for stock price changes is not entirely certain. Some theorist believe it is not possible to predict how stock prices will change, while others believe that by compiling data, creating charts, and looking at past price movements, an investor can determine when to buy and sell a stock. One thing that is for certain is stocks can be volatile and can change in price instantaneously.

Volatility

Stock prices fluctuate throughout the day, week, month, and year as demand by investors in the markets fluctuate. Short-term fluctuations occur as a stock’s price moves within a certain price or trading range. Longer-term trends develop over months and years. The size and frequency of short-term fluctuations are known as the stock’s volatility.

Highly volatile stocks have a relatively large price range over a short period of time and may expose investors to increased risk of loss if liquidation is necessary when the price is trading lower. As mentioned above, growth stocks tend to be more volatile than value stocks. On the contrary, if over a short period of time the price range is relatively narrow, a stock is considered less volatile and may be less risky. However, less risk also means less potential for substantial short-term returns as the stock price is unlikely to appreciate very much.

It is possible for stocks to become more or less volatile over time. For example, a recently issued stock that used to see giant price swings might becomes less volatile after six months of trading on an exchange. Another example is a stock with a stable price history that becomes extremely volatile following heavy amounts of buying or selling due to unfavorable or favorable news reports.

Buying and Selling Stock

Investors interested in buying and selling stock need to open a brokerage account at a brokerage firm and place orders with a stockbroker, who will execute trades on the investors behalf, or online, where the firm’s technology system routes orders to the appropriate market for execution. The type of broker will determine how orders are conveyed, access to investor services, and transaction fees. In general, the more services offered by the firm, the more a customer should expect to pay per transaction. Brokerage firms may also charge account maintenance fees.

Full-service brokerage firms offer investment research, portfolio management services, investment advice, financial planning, and banking services. Discount brokerage firms offer fewer services but, as their name implies, charge less to execute orders. Investors are encourages to determine what brokerage firm is right for them. Investors should balance whether fees will cut into returns with the benefit of investment guidance. Investors should also consider whether the total amount of their investable assets will affect the level of service by the firm as well as the costs of enhanced services, if any.

Buy and sell orders can be placed over the phone or online. Many full-service firms even offer full account access and trading through their websites at discount prices. However, online traders should be wary of excessive trading simply because of the ease of placing trades. Investors and traders should consider account the fees, tax implications, as well as the impact on the balance of assets in their portfolio before placing an order.

There are ways to purchase company stock directly, i.e., without using a broker. For example, if an investor used a broker to purchase a share of stock in a company that offers a dividend reinvestment plan (DRIP), the investor can elect to buy additional shares through the DRIP plan. Therefore, DRIPs allow for automatic reinvestment of dividends and periodic purchases of more stock. Some companies also offer direct purchase plans (DPPs) that allow share purchases directly from the issuer at any time.

DRIPs and DPPs are usually administered by a third party known as a shareholder services company or stock transfer agent. In addition, a shareholder services company or stock transfer agent can assist in sales of shares. Transaction fees for DRIP and DPP orders tend to be substantially less than brokerage firm transaction fees.

Trading vs. Buy-and-Hold

Buying low and selling high is a common goal among investors, and there are two well known approaches for implementing a “buy low, sell high” strategy.

One approach is termed “trading.” Trading involves closely following short-term price fluctuations of a stock, buying it for a low prince, and selling it for a higher price. Traders typically project the percentage increase prior to entering into a buy or sell transaction.

Though trading has tremendous potential for immediate profits, it also involves a good share of risk because a stock may not recover during the anticipate time frame, and it may even drop further in price. In addition, frequent trading can be expensive because every time you buy and sell, you may pay fees for each transaction. Further, if a stock is sold that was not held for a year or more, any profits made are taxed at regular income rates not at the lower tax rate for long-term capital gains.

Trading should not be confused with “day trading,” which is the rapid buying and selling of stock to profit on small price changes. Day trading can be an extremely risky strategy, especially if leverage or borrowed money in involved. Individual investors often lose money by trying to profit from day trading.

Another approach is termed “buy-and-hold.” Buy-and-hold investing involves holding an investment over an extended period of time and anticipating that the price will rise during that time frame. Though buy-and-hold investing reduces transaction costs and short-term capital gains taxes, it requires patience and detailed decision-making. Buy-and-hold investors generally pick stocks based on a company’s long-term business prospects. Stock price appreciation over many years tends to be based on the company’s fundamentals, such as earnings, management expertise, industry prospects, and market share, rather than on the volatile nature of the market’s shifts in demand.

Buy-and-hold investors should still monitor price movements and seek an optimum entry point to add to potential profits. While the stock is held, it is also important to monitor the direction your investment is taking to prevent future losses. For example, if a company regularly misses its earnings targets, the stock will most take a turn for the worse.

After reviewing a company’s fundamentals and making a decision to invest, buy-and-hold investors are usually committed to holding a stock over the medium- to long-term. If after several years the stock’s price has not recovered or performed well, the investor will have to decide whether better returns can be earned elsewhere. Either way, it is imperative that investors closely follow their stocks and pay attention to any and all factors that could affect their value.

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