In the last few weeks, I have received some feedback saying that I have put the cart before the horse, and that some readers first need to understand the basic ideas and concepts of investing. I strongly believe in strengthening financial literacy, so I immediately thought about discussing important vocabulary terms for the new investor, who will hopefully become a solid investor.
This discussion will not follow a strictly ABC approach but rather focus on the order in which a new investor encounters such wording.
So, if we have any savings or free money that we don’t know what to do with, a good choice would be to invest. Why? Through investing we will probably increase the amount of money we have. Investment means allocating some money today so that we can benefit in the future.
Investment can take many different shapes. We can invest in real estate, a start-up, or we can even buy a cryptocurrency, but most people invest only in the house they live in and have free money available to invest in Securities, which are tradable financial assets, including stocks, bonds, and other derivatives:
- Stock represents ownership in a company. For instance, if company A has 1,000 shares of stocks and investor B holds 500 of them, he owns 50% of the company. Shareholder rights vary among companies based on a company’s legal documents, but having 50% generally gives the investor 50% of the voting rights in the company; therefore, no major decision involving the company can be made without this investor’s approval. The investor also enjoys Dividends, which are payments made by the company to its shareholders out of the company’s profits. Capital Appreciation represents an increase in the value of a company and thus the value of its stock. If investor B in the above example purchased his 500 shares of stock at $1 per share and each share is now valued at $2 per share, then he has a 100% capital gain (which is taxable).
- A bond is usually a form of a loan that the bond issuer borrows from the loan creditor. Bonds are usually issued by countries, municipalities, and companies, and the creditors could be anyone. In exchange for the loan, the creditor is expected to receive two gifts: Interest (a payment from a borrower to a lender) will be paid to him during the period of the loan, and at the end of the period, he will receive his money back with a Yield (for instance, if he pays $80 for a bond and receives $100 back, the calculation would be 100/80 = 1.25, which means he has received a yield of 25%). The period of the loan is usually prefixed.
- A derivative is something that derives its value from an asset similar to the securities above or other assets. The most familiar derivative is an Option, which is a contract that gives the buyer the right to buy an asset. For instance, instead of buying stock of company A, you could buy an option that gives you the right (but not the obligation) to buy its stock at a certain price. Derivatives are used less often by regular investors.
Stocks, bonds, and derivatives can be traded directly between people (I can buy from a friend some stock in his store), but most people have easy access to Marketable Securities—only those that are traded on public exchanges—which can be either a stock exchange or a bond exchange. A Stock Exchange is where you could buy or sell stocks and bonds. Trading is made through a Broker, which is a financial institution that facilitates the trade between a buyer and a seller.
Besides stocks, one can invest in other instruments, such as ETFs and mutual funds. An ETF is a marketable security that can track any sort of index of stocks or bonds. A Mutual Fund is a professionally managed investment fund that pools money from many investors to purchase securities, usually with a theme for the fund, such as an ETF. The major difference between mutual funds and ETFs is that ETFs are tradable at all times, and their value changes throughout the trading day, whereas mutual funds are tradable only at the end of each day.
To limit your risk in the market, you will need to create diversification in your portfolio (your basket of assets). Diversification is a way to mix your portfolio and thus handle specific risks for each company. You will still be exposed to market risk, e.g., when the stock market crashes, almost all stocks get wet, but you will be less exposed to risks inherent in one of your invested companies. To limit market risk, you will need to invest in Anti-Cyclical stocks or Non-Cyclical stocks, which are less affected by fluctuations in the economy; for example, a company that sells junk food is not necessarily hurt by a recession, since junk food is cheap, and people still have to eat.
So, when you invest, you can invest in an Index, which includes stocks from a specific sector of a country or you can pick stocks. Picking a stock is risky for the reasons mentioned above, as one stock might not correlate with market performance. As companies become bigger, they usually correlate better with the stock market and the economy overall. Blue-Chip Stock is a stock of well-known companies that lead their market and which usually have a high Market Capitalization (total value of a company’s stock).
If your portfolio is correlated with market performance, you should hope we are in a Bull Market, which is a market in which stock prices are rising as opposed to a Bear Market. In a bull market, most stocks are going up, but before investing you should understand what you’re investing in. To do so, you can either get advice from a professional in the industry or study the market and try to manage your money on your own, which can lower your fees, and evaluate the companies yourself.
The Valuation of a company can be determined in a few different ways, as I briefly mention here, and I will probably write a more detailed post about it later, but essentially, the price of a company in the stock market (Market Value) can be lower than its valuation, which increases the profitability of the proposed valuation. According to some academic theories, the market is efficient and expected to reflect all the data in the market, but every investor knows that some stocks are traded at discounted prices (or premium prices) for whatever reasons.
After you have decided to buy a stock, you need to put in a Bid/Buy order (your offer for the stock) on the stock through your broker. Your bid will be facilitated if it matches the Ask/Sell price, which is the price a stockholder is willing to sell the stock. All pending buy/sell orders are shown in the Book, which is an electronic record.
The difference between the highest price of a buy order and the lowest price of a sell order is called the Spread. For instance, if you offer to buy Company A stock for $29.99 and the lowest sell order is for $30.01, the spread is $0.02. In trading a high Volume of stock (the amount of stock traded in a trading session), the spread is usually negligible, but stocks of small companies usually suffer from a low volume of trading, which makes it harder to get rid of stock at a price near its trading price.
Many more terms are often used in discussing the stock market, but those mentioned above are the most important. To summarize, sell high, buy low, enjoy the bull market, may the market capitalization of your stocks rise, diversify your portfolio, and pay low fees. The rest will follow.