The stock market is arguably one of the most rewarding investments anyone can make. With any investment however, there is some level of risk involved, but not all risks are created equal. The purpose of this article is to provide a breakdown of the different components of the stock market, including, but not limited to: an investor’s mindset, different strategies used in the market, different platforms used to invest, and some common myths.
Introduction
Investopedia defines a stock as “a type of security that signifies ownership in a corporation and represents a claim on part of the corporation's assets and earnings” (“Stock Definition | Investopedia”). All this means is that you put (invest) money into a company and you now become an owner of that company. This is true even if you own just one share of that company. Once you become an owner, you gain your share of the profits and losses of that company (we’ll talk more about this later on in the article, but that’s the general idea).
Why You Should Invest
Many people want to live a lifestyle they either cannot afford or they simply want to retire early. It’s very difficult, if not, impossible to do both of these things without investing. The stock market is my go-to investment strategy because it’s pretty easy to get started and understanding some of the concepts is not really that difficult. It also doesn’t take that much to start investing. Did you know that you can start investing in the stock market with just $1? Some people think you need thousands, or even millions of dollars to start investing, but this is a complete myth. I started investing about three years ago when I was in college (back in 2013) when I woke up one day and said, “I’m a college student and I don’t have much to lose.” So I bought my first set of shares in General Electric (NYSE: GE). I put in roughly $2,700 (although I could’ve started with much less). Over time this money grew by a pretty significant amount and I still own shares of that company to this day. So basically, if you want to grow your money, then the stock market is an excellent place to do so. More benefits will be discussed later.
How to Develop an Investor’s Mindset
The purpose of any investment is to generate profit. As an investor, you should always look for ways to grow your money. Even better said, you should look for investments where the potential value is greater than the price you paid for that investment. This is the same investment philosophy that the likes of Warren Buffet uses. Why is it important to know this and what does it have to do with the stock market? Because before selecting a company, you have to understand the potential value it will generate for you vs. how much you paid for it. This is true whether you’re a short-term or long-term investor. The only way to grow your money is by making investments where the value is greater than the price.
Different Types of Investors
There’s primarily two types of investors: a short-term investor and a long-term investor.
A short-term investor is a person that buys a stock at a relatively low price, waits a day or sometimes even a month or a year, when the price goes up by a fairly significant amount, sells the stock at that point, and makes a profit. Another fancy term for a short-term investor is a day trader. For example, Best Buy (NYSE: BBY) went up about 16% on August 16, 2016 compared to the previous day because the company had better than forecasted earnings results. Predicting a company’s earnings is one of the most difficult things to do in life, but there’s a bunch of tools out there to help you make the best prediction. We’ll talk more about this strategy later in this article, but what a day trader would do is buy Best Buy on (or before) August 15, 2016 (assuming he/she somehow knew the company would beat earnings) and sell it on August 16, 2016 to make a 16% profit. To add more numbers to it, let’s say you invested $1,000 in Best Buy on August 15, 2016 and sold it on August 16, 2016. You would’ve made $160 in one day. $1,000,000 invested and you would’ve made $160,000 in one day. Remember, day traders do this almost every day so you can only imagine if we multiplied this scenario by 30 days. Of course you won’t always get it right, but I believe the odds work out fairly decent in their favor.
A long-term investor on the flip side takes a very similar approach, but over a longer period of time. He/she buys the stock at a relatively low price, accumulates dividends (monthly or quarterly checks overtime), and at some point in the future (i.e. 5 years, 10 years, until he/she dies), sells the stock at a fairly high price.
Studies show that over the long-term, a long-term investor will make more money than a short-term investor. And this makes sense because a long-term investor for one: reduces his/her risk by collecting dividend payments/checks overtime and also capitalizes on the price increase. Remember price vs. value? You pay a fairly low price for the stock, let it accumulate value over time (dividends and price appreciation), and eventually, sell it to make a profit. Double the bonus. Not all long-term investments will have dividend payments, but ideally, you want to aim for companies that pay dividends when using this strategy.
Knowing this, I’m personally a long-term investor. I invest in companies that are very stable and pay nice dividends. However, I have an 80-20 rule (not to be confused with the 80-20 savings rule). At any point in time in which I’m invested in the stock market, 80% of my money is in long-term dividend stocks and 20% is “day-trading” money. Meaning the majority of my money will be in the “safe” stocks that I collect dividends from, but 20% is money that I can use to speculate and capitalize on opportunities such as Best Buy. So in reality, I’m primarily a long-term investor, but have some short-term investments as well.
The type of investor that you should be depends on many different factors. Some of these factors include stage of life, personal circumstances, patience level, financial needs/desires, etc. For example, an older person would probably be a long-term investor since they have more to lose (i.e. they're either getting close to retire or are already retired). Some people want to become rich very quickly so they choose to become short-term investors. So the choice of short-term vs long-term is up to you.
Benefits of Investing
One of the major benefits of stock market investing other than (potentially) growing your money at a fairly significant rate, is that even if you lose, the IRS has your back (literally). Anything you lose, you can eventually claim it as a tax deduction on your tax return, period. So can you actually lose then? Theoretically, no. With that being said, the stock market is a win-win scenario. Of course your goal should be to make profit, but understand that if you have a bad year, the IRS has your back. They want you to invest your money. Why? Corporations will most likely use this money to make a profit and the IRS will get a share of that profit by taxing them on it. Another benefit of the stock market is that you can withdraw your money at any time you want, just like a savings account. If an emergency comes up while you’re invested in a company, you simply withdraw the money from your investment account and call it a day.
Even more benefits? You bet. The dividends you collect aren’t taxed or are sometimes taxed at a lower rate if you’re in a certain tax bracket. A concept known as long-term capital gains. I’ve never paid a dime in taxes on dividends, although that will most likely change in the near future. For anything tax related in this article, please refer to my article “IRS vs. You vs. Charity: Tax Saving Strategies.” And that’s not even all of the benefits, but we’ll move on to the next section.
How to Trade Stocks/Different Platforms to Use
Up to now, I’ve provided you with a lot of different components of the stock market. Now to everyone’s favorite part: “How do I actually invest.” There are many different trading platforms you can use to start investing. You have TD Ameritrade, Scottrade, Fidelity, Robinhood, Computershare, and the list goes on and on. I use TD Ameritrade and Computershare. Let’s take a step back however and talk about transaction costs. Most of these trading platforms (also known as brokerage accounts, brokers, etc.) charge you a fee per each transaction you make (i.e. when you buy shares and when you sell shares). With that being said, choosing the right trading platform is extremely critical. Your goal should be to lower your costs as much as possible while ensuring that the platform you use has everything you need. So now back to where we left of. I use Computershare for all, but one of my dividend stocks (long-term investments). Why? Computershare is the direct broker of a lot of different companies. This means that most of the costs are shifted directly to the corporation, rather than you as the investor. So they charge lower transaction costs. When I invested in GE, I paid about $7.50 for my initial one-time start-up fee plus a mere $1 per buy transaction. So now every time I buy a set of GE shares (whether I want to buy 1 share or 1,000 shares), I only pay $1. Since I tend to buy in bulk each time I buy, I’m saving a ridiculous amount of money by paying just $1 fee for the money I invest. Whether I want to invest $1,000 or $250,000, I only pay $1 fee. When I sell however (which I don’t do often with my long-term investments), I pay $10 per transaction. Each company will have their own fee structure. Let’s compare that with TD Ameritrade, which is a day trader’s dream. I use TD Ameritrade for my occasional 20% day trading that I do. They charge a flat $9.99 per transaction (whether buying or selling). Very high amount compared to my mere $1 per buy transaction on Computershare. So why in the world would I use TD Ameritrade?
TD Ameritrade is arguably the best trading platform because it is very quick to trade and provides a substantial amount of information about the stock market and the company I’m interested in investing in. I have the mobile app downloaded to my phone and I can literally trade by clicking two buttons and my trade will be complete. So easy that I can fully initiate and execute a trade in less than 10 seconds. Computershare? Not so fast. It would take me about a week to complete a trade (from initiation to execution), but remember, it’s used for my long-term investments so I can care less how long a trade takes. As a day trader though, you need a platform that can be as fast as lightening. So when I see nice buying and selling opportunities like Best Buy, I can buy the stock on August 15, 2016 and then sell it the next day without any sort of delays. Timing is the most important aspect of the stock market, especially for a day trader. Missing a trade by even a day can hurt you. Also, if I want to find out what GE is up to these days, I go to my mobile app, click GE, and go to the news section and there, I know exactly what’s going on with my company. Also, TD Ameritrade has virtually every company listed on the site. Something Computershare does not have since not every company pays dividends. Also the mobile app? No such thing for Computershare. So in summary, a short-term investor should ideally use TD Ameritrade and a long-term investor should ideally use Computershare (assuming the company you want is listed on Computershare which was not the case for one of my dividend companies). As an added bonus, I use dividend.com to keep track of all of my current and future dividend stocks. It's an excellent site to find out about trends, payment history, and some other key dividend statistics.
Real Life Scenarios
So now you know how to actually trade/invest, let me demonstrate some other real life scenarios that might get you hyped up. Amazon (NASDAQ: AMZN) was trading at about $180 per share in January of 2012 (less than five years ago). As of August 26, 2016, the stock closed at $769 per share. Let that sink in for a minute. That’s a profit of $589 per share. 1 share. So had you invested $5,000 in Amazon during that time span, you would now have $21,361, a profit of $16,361 or 327% return. Now let’s say you invested $100,000. You would’ve made a pure profit of $327,222. And guess what? This profit would potentially be tax-free since you held the stock for longer than a year (long-term capital gains rates apply to stocks held longer than one year). You can repeat this scenario for Google and other companies or better yet, let’s even do GE. In January of 2012, GE was trading at around $14 a share. As of August 26, 2016, GE closed at $31.23 a share. Had you invested $5,000 in GE, you would now have $11,154 or a $6,154 profit or 123% return. But wait, there’s more. GE (unlike Amazon) currently pays dividends each quarter of 23 cents per share or 92 cents a year per share. So that $6,154 profit is not the only thing you made, you also made money on the dividends you collected. So let’s be simple and say you got 92 cents per share over those approximately 5 years (assuming GE paid the same amount of dividends each year which they actually didn’t, but this is only for demonstration purposes), you would’ve made $1,643 in dividends alone. And of course there’s more. Incorporate time value of money into those dividends and you would see a (potentially) higher amount. That’s just a few scenarios. These opportunities happen every year and in some cases, every day. You just have to go find them. If you look at stock charts, you’ll notice that a ridiculous amount of companies’ stock prices have more than doubled over the past five years. So had you invested in one of these companies five years ago, you should’ve at least doubled your money. I just hope you don’t miss out on the next opportunity.
Virtual Trading Platforms
If you plan to start off as a short-term investor, it's highly recommended to use a virtual trading platform to begin. Since the short-term approach is viewed as riskier than the long-term approach, you probably shouldn't start trading/investing your own (real) money until you've developed a solid game plan that will work well for you. The best way to test that plan is by trading virtual money. A virtual trading platform allows you to buy and sell stocks using virtual (fake) money. It acts just like a regular trading platform; only now you're using virtual money. TD Ameritrade, Scottrade, and Kapitall all have a virtual trading platform that you can use. Once you feel comfortable enough to begin trading with your own (real) money, then at that point you should move to a regular (real) trading platform. Most of the regular trading platforms offer virtual trading platforms so you can use the same platform for both virtual and real trading. Be sure to test out different strategies and find the ones that work best for you. It may take a few days, a month, or even a year to become comfortable with that strategy. If a strategy doesn't work, then try a different one or revise that strategy. I actually started investing using a virtual trading platform, which was a requirement for my financial markets class back in college. A virtual trading platform is not really necessary when starting off as a long-term investor, but it doesn't really hurt to try it out and get the hang of things.
Realized vs. Unrealized Returns/Gains/Profit
A pretty simple, yet important concept, although the calculations can get a bit tricky. A realized gain simply means that you actually made money on the stock by selling it. Also, dividends should be a part of that realized gain calculation since dividends are in fact money that you get back on your investment (i.e. returns). To calculate realized gains as a percentage, simply take your selling price plus any dividends per share and divide that by your purchase price. Your brokerage account will calculate a realized gain amount for you (both as a percentage and as a dollar amount). You just have to factor in the dividends you've collected over time. An unrealized gain just means you haven't sold the stock yet. However, an unrealized gain can easily turn into a realized gain since you can sell stocks whenever you want. Another thing to note about unrealized gains is that they are not taxable until realized.
Percentages are far more important that dollar amounts when calculating gains from a performance standpoint. For example, you telling someone that you made 200% rate of return on an investment sounds very impressive. Even if you only invested $1 and made that type of return. That tells someone that you could've easily invested $1,000 or even $1,000,000 instead and made that same percentage return. Another example: telling someone you made $5,000 on an investment doesn't really mean much. How much did you invest to make that $5,000? Did you invest $10,000 or $1,000,000? So focus on percentages when determining how well you're performing. Another fancy term for this theory is known as return on investment (ROI).
How Do You Know Which Company to Buy/Invest In
There are many different factors that investors pay attention to when choosing a company to buy. I’ll share mine personally for my long-term investments. There are five things I pay attention to when buying a company’s stock. 1. What does the company actually do? You want to know this because it will tell you about the potential of that company. For example, GE is a global digital industrial company and is virtually a monopoly. The company makes things that people can’t really live without. Not to mention, it incorporates Internet of Things (IoT) technology into virtually everything it does. Very healthy company if you ask me. 2. How much room does the company have to grow? (Price-to-earnings) P/E ratio. Some might argue that P/E ratio is an indicator of whether a company is over-priced or not (which is true to some extent), but can also be a great measure of growth. I like companies that have room to grow (companies with a relatively higher P/E ratio than their peers although it’s not good to aim too high). Let’s take a step back. None of these numbers really mean anything unless you compare it to something such as another company of similar size or the industry that the company operates in. Now back to the five factors. 3. How much does the company make? Earnings per share (EPS). The higher this number, the more the company makes relative to how many shares it has outstanding. I don’t invest in long-term companies that have a negative EPS. 4. Dividend yield. Extremely important for dividend investors. I like companies that have a fairly high yield, but nothing more than 7%. There are things out there known as dividend traps where a company can pay very high dividends over the short-term, but either plans to reduce or potentially eliminate their dividend payments altogether. I’ll admit that I fell into this trap once and one of my companies was on the verge of bankruptcy. I no longer own shares in that company so please watch out. 5. Dividend growth rate/history. Very simple concept, but the more history a company has of increasing their dividends, the more attractive they appear. GE has a dividend growth history of 6 years which means that they’ve increased their dividend payments for the past 6 years (with the exception of this year due to the sale of GE Capital and other restructuring strategies).
As time passes, you’ll become more comfortable in choosing the right company. Other things you can look at is what analysts think of the company (i.e. buy/sell recommendations), history of earnings beats/misses (for my day traders), and look at a chart to see if it’s been trending up or down in the past five years. You should know your company up and down and always keep up with what’s going on with it. As a note: I can pick a stock in as little as 5 minutes using TD Ameritrade (either mobile or online) by looking at some of these factors.
Rules of Trading/Investing
Like anything, there are ground rules that you should set for yourself. 1. Don’t get greedy. The stock market can make you a fortune, but remember to set certain limits. Don’t stare at your computer all day every day looking for trades. There are other better things to do in life. 2. Set price targets. When you buy a stock and want to sell it in the short-term, set a target selling price. Sell if and only if it reaches that target price and don’t get greedy by trying to let it get above that target price. You can risk losing out on money if you let it get above your target price and then it subsequently falls below your target price. That’s why they call it a target price in the first place. 3. Don’t trade with emotions. The stock market fluctuates every trading day. Don’t let one bad day in the market get to you (i.e. Brexit). Instead, use those moments as learning opportunities and capitalize the next time it happens. You can make money even when the market is down by using hedge strategies such as options (a topic far too complicated to describe in this article). So take the long-term investment approach and understand that the market will always recover whenever it’s down. So relax, be patient, and you’re bound to make some nice money. 4. Never get away from your true self. If you’re good at day trading and that’s your strategy, then stick to it. If you’re like me and take the long-term investment approach, then buy companies that will do you good in the long run. The only reason I use the 20% short-term strategy is because I made some successful short-term trades and I have a pretty good understanding of how the market works in order to capitalize on it both long-term and short-term. So set rules and stick to those rules. You will get burned in the market if you don’t follow your own rules.
Events that Have Impacted the Market So Far this Year
This year, three main events/factors have impacted the stock market: oil prices, interest rates, and international factors. The price of oil has had a massive impact on the stock market this year. Normally, when the price of oil goes up this year, stocks also go up. The price of oil was so low at one point this year that some oil companies went bankrupt. To capitalize on this opportunity, some investors bought the big time oil companies such as BP (NYSE: BP), knowing that the company is “too large” to go bankrupt. Remember, the market is always going to recover. Oil eventually recovered and investors made a ton of money on these big time oil companies. This was very easy to predict. The next thing that has impacted the market this year is interest rates. The Federal Reserve (Fed) makes a decision roughly every three months on whether or not it wants to increase interest rates. They in fact increased in December of last year, where stocks spiked up and then took a massive downfall. Investors don’t like interest rate increases because it becomes more costly to borrow money and some of these companies rely heavily on debt. The market is currently down because the Fed hinted that it might (fairly decent probability) increase interest rates in September of this year. So brace yourselves for a sea of red (lower stock prices) if it happens. But remember, the market will always recover so there goes your hint. The beginning of this year saw one of worst starts to a year in stock market history. As a matter of fact, the Dow Jones Industrial Average (DOW aka one of the stock indices in the U.S. next to NASDAQ and the S&P 500) had the worst start to a year since the index was actually created. As a smart investor of course, you know that the market will recover at some point. It’s just a matter of when. So many investors bought stocks at the beginning of this year and made a fortune. Remember, opportunities like this happen every year and even every day. Lastly, international factors have impacted the markets. Brexit. Everyone’s favorite topic this year. No one knew what was coming and then boom! U.K. votes to exit the European Union. Emotional investors chose to sell their stocks (when the prices were relatively low, a very silly move). Smart investors bought the day of Brexit or around then and eventually sold their stocks (or held on to them) and made a fortune. These things happen all the time. I just hope you don’t miss the next opportunity. The market will recover at some point when it’s down. It can take a day, a month, a year or two, but it will recover.
Different Money Making Strategies in the Stock Market
There’s even more. Let’s talk briefly about some strategies people use to make money in the market (short-term strategies). One strategy is known as the earnings beat strategy where a day trader predicts whether or not a company will beat (or miss) earnings forecasts. Historically, if a company beats earnings, that company’s price will increase by a fairly decent amount. Some people look at historical earnings beat/miss trends, different economic impacts such as how that company’s industry is performing, and the other million ways day traders use to predict earnings. Some companies’ earnings are easier to predict than others. You can also use the recommendations of analysts to back up your predictions. A very difficult strategy to use, but you can make a fortune from it nonetheless. I use this as part of my 20% short-term strategy.
The next strategy is known as the dividend capture strategy. It takes some background knowledge to understand this strategy, but basically a dividend company has four different dates related to dividends: declaration date, ex-dividend date, record date, and payment date. A dividend capture strategist pays attention to the ex-dividend date which states that if you buy the stock before the ex-dividend date, you get to be paid the dividends. If you sell it on or after the ex-dividend date, you still get to keep the dividends. So simply put, some investors buy the stock before the ex-dividend date, then sell on or after the ex-dividend date to claim the dividends. You can make a fortune using this strategy, but there’s two flaws: 1. Transaction costs reduce your earnings potential. 2. A company’s stock price tends to decrease by the same amount of the dividend amount, so you really end up gaining nothing. However, as a smart investor, you’re in it for profit. So why would you sell if you won’t make a profit? Instead some investors wait a few more days when the price increases or is at the same price they bought it at, then sell it. Factors such as oil prices, interest rates, etc. skew stock prices every day so this strategy actually works more than people think. It does take more money than normal to be successful with this strategy, however. The purpose of this strategy is to claim the dividend payment. Some investors do this every day. I also use this strategy as part of my 20% short-term investment strategy. Of course there are more strategies out there such as using stock charts (resistance vs. support), but we’ll leave that there for now.
Market News
As a stock market investor, you should always know what’s happening in the market as well as with your companies. Some great news sources include Bloomberg, TD Ameritrade News Section, Money and Markets, and the Wall Street Journal. Always stay alert for news and how they impact your current and future investments. Know how to use news to your advantage by using the information to capture profits. I pay attention to the market every day. I also subscribe to the news updates of the companies I’m invested in, which can be found in the investor relations section of each company’s website. Furthermore, although not required to be successful in the market, I look at financial statements from time to time to gain some more insight.
Diversification
Very important concept. One of the reasons why some people get burned in the market is because they aren’t diversified enough. Diversification simply states: Don’t put all your eggs in one basket. I mentioned GE a lot in this article, but that’s not the only company I’m invested in. I’m also an owner of Apple (NASDAQ: AAPL) and AT&T (NYSE: T) as it relates specifically to stocks. The stock market is not the only thing I’m invested in. The point is, you want to make sure that you spread out your investments a little bit. This way, when one company is down, another company might be up. If you need to sell, you sell the company that’s up and hold on to the company that’s down.
Conclusion
That was quite a lot of information, but the stock market is arguably one of the best things you can invest in. There’s even more to it than what was described in this article, but understanding the main concepts will help you become a successful investor.
If you would like to discuss further or have any questions, please don’t hesitate to reach out to me.
Disclaimer
Something I have to include. The companies mentioned in this article are strictly for demonstration purposes, unless otherwise noted. None of these companies represent my personal recommendations. Stock market investing involves risk and you should conduct your own research before investing in any company.
Sources:
"Stock Definition | Investopedia." Investopedia. 26 Nov. 2003. Web. 27 Aug. 2016. <http://www.investopedia.com/terms/s/stock.asp>.