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Welcome to the Stock Market
Chapter Summary In this chapter, the reader is introduced to various types of investments—cash equivalents, mutual funds, futures and commodities, options, bonds, and, last but not least, stocks. It is important to note that stocks have provided the greatest return of any of the trading instruments, and I thoroughly endorse their use as an investment. But how you choose to invest in them is a personal decision based on your time availability, risk tolerance, and capital restraints. Trading and investing are the ultimate balancing act. No one can tell you the best way to trade, and I certainly will not try to. But I do hope to give you a strong foundation of knowledge, a clear picture of the choices at hand, and enough tools to help you get where you want to go. In this initial approach to the stock market, we’ve addressed what the stock market actually is and the keys to making money in the market. • The first key to winning as an investor is to develop a healthy respect for and clear understanding of risk. Know what the risks are beforehand, and become comfortable with them. Defining your risk tolerance is critical. • The second task is to develop a low-stress investment plan that will enable you to build your knowledge base systematically. The old adage “Look before you leap” applies nicely here. Know what you want to accomplish, then look for a way to achieve that goal. • Third, beginners need to start by specializing in one or two markets at a time. Focusing on one aspect is crucial. Don’t fall into the generalist trap, looking at everything. By becoming informed about a particular sector, you can then transfer the lessons learned there to another sector, and so on up the learning curve. 3
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QUESTIONS AND EXERCISES • Fourth, define your limits in terms of the amount of money you can afford to lose.
Before you know where you’re going, you need to know where you are. By doing this you’ll reduce your personal anxiety, and, further, you’ll know how much you can afford to put at risk. Doing nothing is also a risk because of inflation, so the time to act is now. No step is too small to take. The aura of the market is scariest for those unfamiliar with it. Learn by observing and by reading. Watch the daily investing programs on CNBC and CNNfn, or evening broadcasts, and read the major financial newspapers. Look for information regarding market breadth as well as the sector you’re most interested in. It’s important to become better informed about the economy; but don’t try to be an expert. When you are ready to place that first trade, whether it’s for a mutual fund or a stock, go slowly. Learn the procedures brokers and mutual fund representatives take; these people are usually very patient and friendly. They won’t bite! Questions and Exercises 1. To assess your financial condition, completely fill out the financial investment worksheets in Figures 1.1, 1.2, and 1.3. Keep these sheets handy and update them regularly as changes occur in your life. 2. What are the four key approaches to becoming a successful investor? 1. ___________________________________________________________ 2. ___________________________________________________________ 3. ___________________________________________________________ 4. ___________________________________________________________ 3. What is the difference between gambling and investing as a speculative process that encompasses the element of chance? _______________________________________________________________ _______________________________________________________________ 4. What can make an investment a gamble? _______________________________________________________________ 5. True or False: Like real estate, a brokerage account can be purchased with no money down. 6. What is the difference between investors and traders? _______________________________________________________________ _______________________________________________________________ 7. True or False: Stocks are definitely the least lucrative and the least risk free of the three investment products.
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WELCOME TO THE STOCK MARKET
PERSONAL BALANCE SHEET Amount Liabilities Short-Term Debts __________ • Credit card debt __________ • Medical/dental debt __________ • Vehicles debt __________ • Short-term loans __________ • Miscellaneous debt __________ __________ __________ Long-Term Debts __________ • Mortgage __________ • Tuition loans __________ • Long-term loans __________ __________ __________ __________ __________
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Assets Finances • Cash • Checking account • Savings account • Trading account • Mutual funds • 401(k) • IRAs SUBTOTALS Long-Term Assets • House (mortgage) • Vehicles • Fixtures • Recreation • Equipment • Miscellaneous SUBTOTALS NET TOTALS Assets – Liabilities =
Amount __________ __________ __________ __________ __________
__________ __________ __________ __________
__________ __________ __________
Figure 1.1
Personal Balance Sheet
MONTHLY INCOME STATEMENT Amount Monthly Expenses Basic Living Expenses __________ • Rent/mortgage __________ • Food __________ • Utilities __________ • Phone/ISP bill __________ • Heating __________ • Transportation • Clothes • Entertainment • Miscellaneous Insurance Payments • House/renter's insurance • Health insurance • Dental insurance • Car insurance • Life insurance • Long-term care insurance Debt Payments • Credit card (minimum payment) • Alimony • Child support • Tuition loan • Miscellaneous loans __________
Monthly Income Cash Received • Wages after taxes • Alimony income • Child support • Rental income • Business income • Additional income
Amount __________ __________ __________ __________ __________ __________ __________ __________ __________
__________ __________ __________ __________ __________ __________
Totals Income Total – Expenses Total =
__________ __________ __________ __________ __________ __________ __________
Figure 1.2
Monthly Income Statement
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QUESTIONS AND EXERCISES
RISK TOLERANCE AND INVESTMENT GOALS
Risk Tolerance Investment Goals __________ __________ __________ __________ __________ __________ Investment goal ÷ Years until retirement Annual return goal Financial Potential • Tax bracket • Utilities • Phone/ISP bill • Heating • Transportation • Clothes • Entertainment • Miscellaneous Insurance Payments • House/renter's insurance • Health insurance • Dental insurance • Car insurance • Life insurance • Long-term care insurance Debt Payments • Credit card (minimum payment) • Alimony • Child support • Tuition loan • Miscellaneous loans __________ __________ __________ __________ __________ __________ __________ __________ __________ __________
Monthly income – Monthly expenses Net profit/loss Total assets – Total liabilities Net worth 3 × monthly expenses (aggressive) 6 × monthly expenses (moderately aggressive) 9 × monthly expenses (conservative)
__________ __________
__________
__________ __________ __________ __________ __________ __________
Totals Income Total -– Expenses Total =
_________
__________ __________ __________ __________ __________ __________ __________
Figure 1.3
Risk Tolerance and Investment Goals
8. Name and define the three types of risk. 1. ____________________________________________________________ 2. ____________________________________________________________ 3. ____________________________________________________________ 9. When investors talk about the bond market, they are referring to the: A. ____ 30-year bond market B. ____ 20-year bond market C. ____ 25-year bond market D. ____ 50-year bond market
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WELCOME TO THE STOCK MARKET
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10. Match up the three basic investment products with their defining statements: A. ____ Stocks 1. Easy conversion B. ____ Bonds 2. Company ownership C. ____ Cash equivalents 3. Cash debt obligations 11. What are your three basic rights as a shareholder? 1. ___________________________________________________________ 2. ___________________________________________________________ 3. ___________________________________________________________ 12. Decipher these acronyms: A. OTC: ______________________________________________________ B. Nasdaq: ____________________________________________________ C. NYSE:______________________________________________________ D. AMEX: _____________________________________________________ E. ECN:_______________________________________________________ 13. How is the Nasdaq different from the other exchanges? _______________________________________________________________ _______________________________________________________________ 14. If your stocks are listed on the Nasdaq, why would they sometimes be referred to as four-letter stocks? _______________________________________________________________ _______________________________________________________________ 15. True or False: Where a trade takes place does not depend on whether that particular company is listed on the New York Stock Exchange, the Nasdaq, or the American Stock Exchange. 16. Based on margin rules, a trader needs to put up only _________ of the total amount to purchase shares, while the brokerage lends the trader the rest at a small interest rate. A. One-third B. One-fourth C. Two-thirds D. One-half E. One-tenth
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QUESTIONS AND EXERCISES
17. When a stock surges up on heavy volume, it is a very good indication of: A. ____ Declines in the offing B. ____ Trend reversals C. ____ Further price increases D. ____ Technological developments E. ____ Financial losses 18. When a stock sells off on heavy volume, it’s a fairly reliable indication of: A. ____ Declines in the offing B. ____ Trend reversals C. ____ Further price increases D. ____ Technological developments E. ____ Financial losses 19. Correctly match these three descriptions of the chief players in the stock market today along with the terms that follow: A. ____ A person hired to make buying and selling decisions who is paid for his or her work B. ____ A person who buys and sells often, even intraday C. ____ A buy-and-hold kind of guy 1. The short-term trader 2. The individual investor 3. The professional 20. If your floor broker cannot fill your order, it is left with a _____________ who keeps a list of all the unfilled orders, matching them up as prices fluctuate. A. Trader B. Specialist C. Investor D. Floor broker E. Market maker 21. The market maker makes a profit by bringing together buyers and sellers and taking a small amount from each of them to process the transaction. This is called the ______, ______, or ______. Check those that apply. A. Bid B. Spread C. Hedging instrument D. Slippage E. Bid/ask spread
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WELCOME TO THE STOCK MARKET
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22. Fill in these blanks with the following terms: The ______ is the highest price a prospective buyer is prepared to pay for a share of a specified security. The ______ is the lowest price acceptable to a prospective seller of the same security. These two prices constitute a ______. The difference between them is called the ______. A. Ask B. Spread C. Bid D. Quote 23. Check the items associated with the Small Order Entry System or SOES: A. _____ The ability to trade directly from offices using telephones and continuously updated computerized prices B. _____ Significant reduction of the current position held in the market C. _____ Permitting the little guy to compete with institutional traders D. _____ Market makers who create liquidity by narrowing the spread E. _____ Financial web sites that cater to individual investors F. _____ The birth of day trading G. _____ Detailed research reports on the stock market and companies H. _____ Permitting lightning-fast executions for orders up to 1,000 shares I. _____ A trading account hosted by a firm that acts as an agent for a customer J. _____ The market crash of 1987 24. True or False: With a mutual fund, a professional investor who is hired by the investment company makes the investment decisions on which stocks to buy or sell. 25. True or False: The net asset value (NAV) of a mutual fund is calculated by dividing the market value of the fund’s portfolio by the number of shares. 26. What is the difference between a load and a no-load mutual fund? _______________________________________________________________ _______________________________________________________________ 27. What are the advantages and disadvantages of the three different classes of load funds? Class A: Advantage:_____________________________________________ Disadvantage: __________________________________________ Class B: Advantage:_____________________________________________ Disadvantage: __________________________________________ Class C: Advantage:_____________________________________________ Disadvantage: __________________________________________
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QUESTIONS AND EXERCISES
28. What are two reasons why an investor would want to mirror an index rather than have a professional make individual buy and sell decisions that reflect the sensitivity of market movement? 1. ___________________________________________________________ 2. ___________________________________________________________ 29. How are index shares, which are similar to index funds, also like a stock? _______________________________________________________________ _______________________________________________________________ 30. True or False: When the economy is hot, inflation begins to accelerate and adds to the purchasing power of money over time. 31. What are three basic methods of stock investing? 1. ___________________________________________________________ 2. ___________________________________________________________ 3. ___________________________________________________________
Media Assignment If you’re not already doing it, make it a habit to read the business section of the newspaper daily. You may want to subscribe to the Wall Street Journal or Investor’s Business Daily. Both of these papers are mainstays of the investment world and have a big effect on the markets. You should also keep yourself informed on a state and local level by reading the local papers. The Internet is a media world unto itself. There are multitudes of sites that report about the markets, and some that have a hand in swaying public opinion. You need to incorporate all of these news sources into your daily investment habits. Start by looking for trends and industry movements in the stories provided. Keep in mind that most stories originate as press releases from corporate public relations (PR) desks, so recognize that there is an agenda and underlying strategy behind every company announcement. Find stories about one or two companies that pique your interest. Start a trading journal and make notes on why these stories draw your attention. Follow their progress to get a feel for your instinctive abilities. How do they affect the market in general? What other stocks are affected? How are their respective industries affected? As a story fades, does the stock rebound? Remember, learning is a cumulative experience. If you are new to the investment world, you have to make a start by just getting to know the markets one story at a time.
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WELCOME TO THE STOCK MARKET Vocabulary Study Be able to use these terms: • Annual report • Ask • Auction-style market • Bid • Bond • Brokerage account • Cash equivalents • CD (certificate of deposit) • Closed-end fund • Commodities • Currencies • Day trading • Dividends • Earnings • Executed • The Fed • Float • Floor trader • Futures • Gap-down • Hedging • Index • Index fund • Index share • Inflation • Institutional investor • Interest rates • Investor • Liquidity • Load fund • Margin • Market maker • Mutual fund • National Association of Securities Dealers (NASD) • Net asset value (NAV) • No-load fund • Open-ended fund • Quotation • Risk • Risk tolerance • Rule 144 • Shorting a stock • Specialization • Stock • Stock market • T-bill • Ticker symbols • Trader • Trading pits
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12 Useful Web Sites
QUESTIONS AND EXERCISES
CBS MarketWatch cbs.marketwatch.com An absolute must for any trader who wants to stay aware of scheduled and breaking news. Excellent journalists and plenty of timely market data are mainstays of this premier news-oriented web site. E*Trade www.etrade.com The mother of all online brokerages hosts this excellent site to help you get your bearings with quotes, company profiles, and trading tools. Microsoft Investor moneycentral.msn.com/investor/home.asp This site has it all—quotes, charts, graphs, market reports, finders, screeners, research, online workshops, custom portfolios, feature news and investment articles from MSNBC, as well as impressive commentary from prime financial journalists. Red Herring Online www.herring.com This site offers a plethora of insider news, analysis, and commentary by highly respected journalists, as well as an excellent e-mailed newsletter. Look for Wolf picks, option picks, and the “Catch of the Day” column for investment ideas. Check out the search tools and the featured links to hot web sites. TheStreet.com www.thestreet.com Controversial and extremely popular, this site has cornered the market on public appeal through its clever journalism, insightful articles, and everyday analyses of market performance.