Dumb’s Guide to Understanding Stocks and Stock Market

For a new investor, the stock market can feel a lot like legalized gambling. “Ladies and gentlemen, place your bets! But what do you see common between all of us -No one likes to lose money.If you’re considering an investment in the stock market and the thought of a loss upsets you, you probably shouldn’t invest. However, when you invest there are several things you should know to increase your chances of winning. The stock market is as reliable a form of investment as a game of roulette. But the more you learn about stocks, and the more you understand the true nature of stock market investment, the better and smarter you’ll manage your money.

What are stocks?

Stocks are the equities which a person owns in a company. Suppose, you own 10 shares of a company X, then it means that you own a part of this company and your equity is decided based upon the ratio of the shares owned by you to the total shares issued by the company to the general public.Stock is a general term which can be used to describe ownership certificates of any company or group of companies, while shares represents the actual ownership of a particular company. Owning stocks gives you the right to vote on members of the board of directors and other important matters before the company. If the company distributes profits to shareholders, you will likely receive a proportionate share.

One of the unique features of stock ownership is the notion of limited liability. If the company loses a lawsuit and must pay a huge judgment, the worse that can happen is your stock becomes worthless. The creditors can’t come after your personal assets. That’s not necessarily true in private-held companies.

There are two types of stock:

• Common stock
  • Common stock represents the majority of stock held by the public. It has voting rights, along with the right to share in dividends. When you hear or read about “stocks” being up or down, it always refers to common stock.Most of the stock held by individuals is common stock.
• Preferred stock
  • Despite its name, preferred stock has fewer rights than common stock, except in one important area – dividends. Companies that issue preferred stocks usually pay consistent dividends and preferred stock has first call on dividends over common stock.Investors buy preferred stock for its current income from dividends, so look for companies that make big profits to use preferred stock to return some of those profits via dividends.

Read More on Dumb’s Guide to Understand the Balance Sheet

What is a Stock Market?

The stock market is a complex system where shares of publicly-traded companies are issued, bought and sold.

Modern stock exchanges make buying and selling easy. You don’t have to actually travel to New York to visit the New York Stock Exchange. You can call a stock broker who does business with the NYSE, or you can buy and sell stocks online for a small fee.

There are three big stock exchanges in the United States:

To some it is a nebulous, dark chasm where people gamble. Actually, it is not gambling at all. Why? Let’s say you put $100 on one roll of the dice. If you win, you win $X. If you lose, you lose the entire $100. When you invest in stocks, you will win $X or lose $Y. It’s rare to lose it all, unless of course you invest in a company that goes bust. You could say that the stock market is a group of people pitting their expertise against one another. We’ll touch on that in the next section.

Note that If these exchanges didn’t exist, buying or selling stock would be a lot harder. You’d have to place a classified ad in the newspaper, wait for a call and haggle on a price whenever you wanted to sell stock. With an exchange in place, you can buy and sell shares instantly.

The Stock Market is an Adversarial System of Trading

The stock market is a collection of millions of investors with diametrically opposing views. This is because when one investor sells a particular security, someone else must be willing to buy it. Since both investors cannot be correct, it is an adversarial system. In short, one investor will profit and the other will suffer loss. Therefore, it’s important to become well versed on the investment you are considering.

What is Stock Trading

The owners of the shares of the company are referred to as ‘Shareholders’. The stocks can be transferred from one share holder to the other through various medium such as exchanges. Most jurisdictions have laws governing the rules and regulations involving stock transfers. Imagine, how difficult would it be if you want to sell a stock had the exchanges not have been there, you would have to roam around the markets, it would have been a difficult task! Exchanges provide a common place, where investors can come in and meet each other to sell or buy stocks and other securities.

In terms of Market Capitalization, New York Stock Exchange (NYSE) is the world’s no. one stock exchange and has a market cap of $ 19.22 bn. This is followed by NASDAQ and London Stock Exchange of The United States and England at $ 6.83 bn and $ 6.18 bn respectively. India’s Bombay Stock exchange and National Stock exchanged are ranked 11th and 12th at $ 1.68 bn and $ 1.64 bn respectively.

Don’t Miss Our Dumb’s Guide to Investing Money in Stock Market

Why is the Stock Market so Difficult to Predict?

Assuming stock prices have been growing for several years. Investors realize that the market is over valued and a correction will come and stock prices will fall. What we don’t understand is what will trigger the selloff or exactly when it will occur.

But are we sure of this?—- NO!

Therefore, some investors will sit on the sidelines holding cash, waiting for the opportune time to get in. Those who are willing to assume the risk may jump in because the return on cash is so low and it hurts to earn zero while watching stocks move higher. This begs a couple of key questions. If you’re on the sidelines, how will you know when to get in? If you’re already in, how will you know when it’s time to get out? If the stock market was predictable, these questions could easily be answered. However, it is not. There are actually three issues an investor should consider. The first is understanding the point at which stock prices are fairly valued. The second issue is the event that will cause a downturn. The final issue is understanding the human decision-making process. Let’s briefly look at these.

Key Takeaway – For an amateur there is no way you can predict if the stock price will rise or fall with surety.

Stock Valuation

The actual price of a stock is determined by market activity. When making the decision to buy or sell, the investor will often compare a stock’s actual price to its fair value. For example, if a stock is trading at $40 per share and its fair value is $45, it may be worth purchasing. Conversely, if it trades at $40 but its fair value is $30, the stock would be considered overvalued and the investor would be wise to avoid it. What is a stock’s fair value and how do you calculate it? Ideally, it would be based on some standardized formula. However, there are many ways to derive this figure. One method is to combine the value of a company’s assets on its balance sheet, minus depreciation and liabilities. Another is to determine its intrinsic value, which is the net present value of a company’s future earnings. We have briefly discussed two methods. There are a number of others. Because the methods yield a slightly different result, it’s sometimes difficult to know if a stock is overvalued, undervalued, or fairly valued. And even if it is overvalued, that doesn’t mean investors will suddenly sell and the price will fall. Actually, a stock can remain overvalued for quite some time. This is also why it can be problematic to make buy/sell decisions based on where the price of the stock is in relation to some moving average.

Key Takeaway — Dumb’s Guide to Understand the Balance Sheet

Triggering Event

Knowing which event will cause a trend reversal is analogous to seeing around the corner of a solid brick building. Do this need more say? very much similar to travelling ahead to future and finding out the actual stock price.

The Human Decision Process

This is the most interesting of the three. Inside every individual there is a logical and an emotional component. Pepole tend think with both their mind and heart. We may analyze a situation using our logical side but when it’s time to act, we refer to our emotions. For example, when purchasing a car, we might research the engine, fuel efficiency, amenities, or other items. But when it’s time to decide, we often ask other types of questions. Such as, how do I look in the driver’s seat? Does the car match my image? When making investment decisions, since there is an investor on the other side ready to buy what you’re selling or selling what you want to buy, you must be able to process the relevant data and make a good decision. However, it’s impossible to know everything you would need to know and process it without any bias. For these and other reasons, we will make a sub-par decision at times. This will occur even with the most analytical individuals.

When is the Best Time to Buy and Sell?

The two most important decisions an investor will make are when to buy and when to sell. The best time to buy is when others are pessimistic or averse to buy. The best time to sell is when others are actively optimistic averse to sell. When buying, remember that the prospect of a high return is greater if you buy after its price has fallen rather than after it has risen. But caution should be exercised. For example, after the stock of fictitious Company X declined by 30%, 40% or more, the first question to ask is why. Why did the stock fall as it did? Did other stocks in the same industry experience a decline? If so, was it as severe? Did the entire stock market fall? If the broader market or other stocks in the same industry/sector performed relatively well, there may be a problem specific to Company X. It’s best to adopt a buy/sell discipline and adhere to it. Benjamin Graham, the father of value investing, once said, “The buyer of common stocks must assure himself that he is not making his purchase at a time when the general market level is a definitely high one, as judged by established standards of common-stock values.” His reference was to what we discussed as fair value under the section Stock Valuation above.

Key Takeaways —- Buy at lower lows and sell at higher highs