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Stock Market for Beginners

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           1
           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 great-
           est 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 foun-
           dation 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 en-
               able you to build your knowledge base systematically. The old adage
               “Look before you leap” applies nicely here. Know what you want to ac-
               complish, 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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        4                                                  QUESTIONS AND EXERCISES

            • Fourth, define your limits in terms of the amount of money you can af-
              ford 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 in-
        flation, 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 observ-
        ing and by reading. Watch the daily investing programs on CNBC and CNNfn, or
        evening broadcasts, and read the major financial newspapers. Look for informa-
        tion 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 mu-
        tual 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 invest-
           ment 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                                                                  5


                                                PERSONAL BALANCE SHEET
                    Assets                     Amount                Liabilities            Amount
            Finances                                           Short-Term Debts
            • Cash                            __________       • Credit card debt          __________
            • Checking account                __________       • Medical/dental debt       __________
            • Savings account                 __________       • Vehicles debt             __________
            • Trading account                 __________       • Short-term loans          __________
            • Mutual funds                    __________       • Miscellaneous debt        __________
            • 401(k)                          __________
            • IRAs                            __________
            SUBTOTALS                         __________                                   __________
            Long-Term Assets                                   Long-Term Debts
            • House (mortgage)                __________       • Mortgage                  __________
            • Vehicles                        __________       • Tuition loans             __________
            • Fixtures                        __________       • Long-term loans           __________
            • Recreation                      __________
            • Equipment                       __________
            • Miscellaneous                   __________
            SUBTOTALS                         __________                                   __________
            NET TOTALS                        __________                                   __________
            Assets – Liabilities =                                                         __________



           Figure 1.1     Personal Balance Sheet

                                              MONTHLY INCOME STATEMENT
               Monthly Income                  Amount            Monthly Expenses           Amount
            Cash Received                                     Basic Living Expenses
            • Wages after taxes               __________      • Rent/mortgage              __________
            • Alimony income                  __________      • Food                       __________
            • Child support                   __________      • Utilities                  __________
            • Rental income                   __________      • Phone/ISP bill             __________
            • Business income                 __________      • Heating                    __________
            • Additional income               __________      • 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        __________
               Totals                         __________                                   __________
            Income Total – Expenses Total =                                                __________



           Figure 1.2      Monthly Income Statement
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        6                                                     QUESTIONS AND EXERCISES


                                   RISK TOLERANCE AND INVESTMENT GOALS
                           Risk Tolerance                            Investment Goals
         Monthly income                     __________   Investment goal ÷              __________
         – Monthly expenses                 __________   Years until retirement         __________
           Net profit/loss                   __________   Annual return goal             __________
         Total assets                       __________   Financial Potential
         – Total liabilities                __________   • Tax bracket                  __________
           Net worth                        __________   • Utilities                    __________
                                                         • Phone/ISP bill               __________
         3 × monthly expenses                            • Heating                      __________
         (aggressive)                       __________   • Transportation               __________
                                                         • Clothes                      __________
         6 × monthly expenses               __________   • Entertainment                __________
         (moderately aggressive)                         • Miscellaneous
                                                         Insurance Payments
         9 × monthly expenses               __________   • House/renter's
         (conservative)                                     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          __________
         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                                                7

           10. Match up the three basic investment products with their defining state-
               ments:
               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 re-
               ferred 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 Nas-
               daq, or the American Stock Exchange.

           16. Based on margin rules, a trader needs to put up only _________ of the to-
               tal 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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        8                                                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                                                   9

           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 se-
               curity. 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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        10                                              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 in-
        vestment 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 invest-
        ment habits. Start by looking for trends and industry movements in the sto-
        ries 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? Re-
        member, learning is a cumulative experience. If you are new to the invest-
        ment 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                                     11

           Vocabulary Study
           Be able to use these terms:
             • Annual report                 • Institutional investor
             • Ask                           • Interest rates
             • Auction-style market          • Investor
             • Bid                           • Liquidity
             • Bond                          • Load fund
             • Brokerage account             • Margin
             • Cash equivalents              • Market maker
             • CD (certificate of deposit)    • Mutual fund
             • Closed-end fund               • National Association of
                                               Securities Dealers (NASD)
             • Commodities
                                             • Net asset value (NAV)
             • Currencies
                                             • No-load fund
             • Day trading
                                             • Open-ended fund
             • Dividends
                                             • Quotation
             • Earnings
                                             • Risk
             • Executed
                                             • Risk tolerance
             • The Fed
                                             • Rule 144
             • Float
                                             • Shorting a stock
             • Floor trader
                                             • Specialization
             • Futures
                                             • Stock
             • Gap-down
                                             • Stock market
             • Hedging
                                             • T-bill
             • Index
                                             • Ticker symbols
             • Index fund
                                             • Trader
             • Index share
                                             • Trading pits
             • Inflation
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        12                                              QUESTIONS AND EXERCISES

        Useful Web Sites
        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.

				
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