Chapter One
Exploring the Basics
In This Chapter
* Knowing the essentials
* Doing your own research
* Recognizing winners
* Exploring investment strategies
Stock investing became all the rage during the late 1990s. Even tennis stars and punk rockers got into the act. Investors watched their stock portfolios and stock mutual funds skyrocket as the stock market was reaching the mania stage at the tail-end of an 18-year upswing (or bull market) in stocks. (See Chapter 15 for more information on bull markets.) Investment activity in the United States is a great example of the popularity that stocks experienced during that time period. By 1999, over half of U.S. households became participants in the stock market. Yet millions lost money when the stock market fell big time (the bear market - see Chapter 15) during 2000-2002. People invested. Yet they really didn't know exactly what they were investing in. If they had a rudimentary understanding of what stock really is, perhaps they could have avoided some expensive mistakes. The purpose of this book is not only to tell you about the basics of stock investing but also to let you in on some solid strategies that can help you profit from the stock market. Before you invest your first dollar, you need to understand the basics of stock investing.
Understanding the Basics
The basics are so basic that few people are doing them. Perhaps the most basic (and therefore most important) thing to grasp is the risk you face whenever you do anything (like putting your hard-earned money in an investment like a stock). When you lose track of the basics, you lose track of why you invested to begin with. Find out more about risk (and the different kinds of risk) in Chapter 4.
When the late comedian Henny Youngman was asked "How is your wife?" he responded "Compared to what?" This applies to stocks. When you are asked "how is your stock?" you can very well respond that it's doing well especially when compared to an acceptable "yardstick" such as a stock index (such as the S&P 500). Find out more about indexes in Chapter 5.
The bottom line is that the first thing you do in stock investing is not send your money to a brokerage account or go to a Web site to click "buy stock." The first thing you do is find out as much as you can about what stocks are and how to use them to achieve your wealth-building goals.
Getting Prepared before You Get Started
Gathering information is critical in your stock-investing pursuits. There are two times to gather information on your stock picks: before you invest ... and after. You obviously should become more informed before you invest your first dollar. But you also need to stay informed about what's happening to the company whose stock you are buying and also about the industry and the general economy. To find the best information sources, check out Chapter 6.
When you are ready to invest, you will need a brokerage account. How do you know which broker to use? Chapter 7 provides some answers and resources to help you choose a broker.
Knowing How to Pick Winners
Once you get past the basics, you can get to the "meat" of stock picking. Successful stock picking is not mysterious, but it does take some time, effort, and analysis. It's worth it since stocks are a convenient and important part of most investors' portfolios. Read the following section and be sure to "leap frog" to the relevant chapters to get the inside scoop on "hot stocks."
Recognizing stock value
Imagine that you like eggs and you're willing to buy them at the grocery store. In this example, the eggs are like companies, and the prices represent the prices that you would pay for the companies' stock. The grocery store is the stock market. What if two brands of eggs are very similar, but one costs 50 cents while the other costs 75 cents? Which would you choose? Odds are that you would look at both brands, judge their quality, and, if they were indeed similar, take the cheaper eggs. The eggs at 75 cents are overpriced. The same is true of stocks. What if you compare two companies that are similar in every respect but have different share prices? All things being equal, the cheaper price has greater value for the investor. But the egg example has another side.
What if the quality of the two brands of eggs is significantly different but their prices are the same? If one brand of eggs is stale, of poor quality, and priced at 50 cents and the other brand is fresh, of superior quality, and also priced at 50 cents, which would you get? I'd take the good brand because they're better eggs. Perhaps the lesser eggs are an acceptable purchase at 10 cents, but they're definitely overpriced at 50 cents. The same example works with stocks. A badly run company isn't a good choice if you can buy a better company in the marketplace at the same - or a better - price.
Comparing the value of eggs may seem overly simplistic, but doing so does cut to the heart of stock investing. Eggs and egg prices can be as varied as companies and stock prices. As an investor, you must make it your job to find the best value for your investment dollars. (Otherwise you get egg on your face. You saw that one coming, right?)
Understanding how market capitalization affects stock value
You can determine the value of a company (and thus the value of its stock) in many ways. The most basic way to measure this value is to look at a company's market value, also known as market capitalization (or market cap). Market capitalization is simply the value you get when you multiply all the outstanding shares of a stock by the price of a single share.
Calculating the market cap is easy. It's the number of shares outstanding multiplied by the current share price. If the company has 1 million shares outstanding and its share price is $10, the market cap is $10 million.
Small cap, mid cap, and large cap aren't references to headgear; they're references to how large the company is as measured by its market value. Here are the five basic stock categories of market capitalization:
Micro cap (under $250 million): These stocks are the smallest and hence the riskiest available.
Small cap ($250 million to $1 billion): These stocks fare better than the microcaps and still have plenty of growth potential. The key word here is "potential."
Mid cap ($1 billion to $5 billion): For many investors, this category offers a good compromise between small caps and large caps. These stocks have some of the safety of large caps while retaining some of the growth potential of small caps.
Large cap ($5 billion to $25 billion): This category is usually best reserved for conservative stock investors who want steady appreciation with greater safety. Stocks in this category are frequently referred to as "blue chips."
Ultra cap (over $25 billion): These stocks are also called "mega caps" and obviously refer to companies that are the biggest of the big. Stocks such as General Electric and Exxon Mobil are examples.
REMEMBER
From a safety point of view, the company's size and market value do matter. All things being equal, large cap stocks are considered safer than small cap stocks. However, small cap stocks have greater potential for growth. Compare these stocks to trees: Which tree is sturdier - a giant California redwood or a small oak tree that's just a year old? In a great storm, the redwood holds up well, while the smaller tree has a rough time. But you also have to ask yourself which tree has more opportunity for growth. The redwood may not have much growth left, but the small oak tree has plenty of growth to look forward to.
For beginning investors, comparing market cap to trees isn't so far-fetched. You want your money to branch out without becoming a sap.
Although market capitalization is important to consider, don't invest (or not invest) just based on it. It's just one measure of value. As a serious investor, you need to look at numerous factors that can help you determine whether any given stock is a good investment. Keep reading - this book is full of information to help you decide.
Sharpening your investment skills
Investors who analyze the company can better judge the value of the stock and profit from buying and selling it. Your greatest asset in stock investing is knowledge (and a little common sense). To succeed in the world of stock investing, keep in mind these key success factors:
Analyze yourself. What do you want to accomplish with your stock investing? What are your investment goals? Chapter 2 can help you figure it out.
Know where to get information. The decisions you make about your money and what stocks to invest in require quality information. If you want help with information sources, turn to Chapter 3.
Understand why you want to invest in stocks. Are you seeking appreciation (capital gains) or income (dividends)? Look at Chapters 8 and 9 for information on these topics.
Do some research. Look at the company whose stock you're considering to see whether it's a profitable company worthy of your investment dollars. Chapters 10 and 11 help you scrutinize the company.
Choosing a winning stock also means that you choose a winning industry. You'll frequently see stock prices of mediocre companies in "hot" industries rise higher and faster than solid companies in floundering industries. Therefore, choosing the industry is very important. Find out more about analyzing industries in Chapter 12.
Understand how the world affects your stock. Stocks succeed or fail in large part due to the environment in which they operate. Economics and politics make up that world, so you should know something about them. Chapter 14 covers these topics, but also take a look at Chapter 2.
Understand and identify megatrends. Doing so makes it easier for you to make money. This edition spends more time and provides more resources helping you see the opportunities in emerging sectors and even avoid the problem areas (see Chapter 13 for details).
Use investing strategies like the pros do. In other words, how you go about investing can be just as important as what you invest in. Chapter 16 highlights techniques for investing to help you make more money from your stocks.
Keep more of the money you earn. After all your great work in getting the right stocks and making the big bucks, you should know about keeping more of the fruits of your investing. I cover taxes in stock investing in Chapter 20.
Sometimes, what people tell you to do with stocks is not as revealing as what people are actually doing. This is why I like to look at company insiders before I buy or sell that particular stock. To find out more about "insider buying and selling," read Chapter 19.
Actually, every chapter in the book offers you valuable guidance on some essential aspect of the fantastic world of stocks. The knowledge you pick up and apply from these pages has been tested over nearly a century of stock picking. The investment experience of the past - the good, the bad, and some of the ugly - is here for your benefit. Use this information to make a lot of money (and make me proud!). And don't forget to check out the Appendixes!
Boning Up on Strategies and Tactics
Successful investing isn't just what you invest in, it's also the way you invest. I am very big on strategies such as trailing stops and limit orders. You can find out more in Chapter 17.
Buying stocks doesn't always mean that you must buy through a broker and that it must be 100 shares. You can buy stock for as little as $25 using programs such as dividend reinvestment plans. Chapter 18 tells you more.
Getting Some Good Tips
Protecting yourself from downside exposure is what separates investors from speculators, and Chapter 21 gives you ten warning signs regarding a stock's decline. I know that when I see some of these signs that (at the very least) I'll put on a stop loss order (Chapter 17) so that I can sleep at night. Sometimes the return on your money is not as good as the return of your money.
If stocks give off "negative signals," then there must also be "positive" ones as well. Chapter 22 gives you ten of the best signs that are commonly seen before a stock is ready to rise. What better time to jump in?
You should be aware about the risks that fraud presents you. It's tough enough to make money with stocks in an honest market. Yet we must always be aware of those that would take our hard-earned money from us without our consent. That's why I include Chapter 24 - since you and I will always deal with a part of the universe that will always give us problems ... humanity.
Chapter 24 is (I believe) one of the best chapters in the book. It is very important to understand if the environment for a particular stock is good or bad. The best stocks in the world sink in a tough market while the worst stocks can go up in a jubilant and rising market. Ideally, you avoid those stocks that are in the tough market and find good stocks in a good market. This chapter will clue you in regarding those markets.
Stock market schizophrenia
Have you ever noticed a stock going up even though the company is reporting terrible results? How about seeing a stock nosedive despite the fact that the company is doing well? What gives? Well, judging the direction of a stock in a short-term period - over the next few days or weeks - is almost impossible.
Yes, in the short term, stock investing is irrational. The price of a stock and the value of its company seem disconnected and almost schizophrenic. The key phrase to remember is "short term." A stock's price and the company's value become more logical over an extended period of time. The longer a stock is in the public's view, the more rational the performance of the stock's price. In other words, a good company continues to draw attention to itself; hence, more people want its stock, and the share price rises to better match the value of the company. Conversely, a bad company doesn't hold up to continued scrutiny over time. As more and more people see that the company isn't doing well, the share price declines. Over the long run, a stock's share price and the value of the company eventually become equal for the most part.
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Excerpted from Stock Investing For Dummiesby Paul Mladjenovic Copyright © 2006 by Paul Mladjenovic. Excerpted by permission.
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