People, in general, overgrow their desire to undertake certain risky sports or activities, such as hang-gliding, sailing, car-racing or even taking backpacking trips to exotic lands. Youth brings with it the adrenaline drive to risk life, limb and property; whereas age succumbs to the comfort and safety of less-challenging and more family-oriented diversions.
Nevertheless, while majority of us improve our skills at evaluating risk as we mature, we somehow fail to assess financial risk as much as we should. In seems that in the stock market, we remain like tots unaware of the dangers that lurk in the forest.
Until the winds blow high and hard upon us, we feel unconcerned about the risks even to the point that we totally give up on investing.
Appreciating your risk tolerance is vital. Beginner investors often take so little risk and end up with un-invested and unproductive money lying around. Meaning to say, your money grows at a lower rate or is earning nothing whatsoever. The loss of time is a loss of opportunity which might never be recovered in the future.
This is exactly what happens to those who try to recover lost time in their later years by saving and trying to make up for the lost time. This results in the investor tending to take more risk than necessary, endangering their investment and their personal future.
Just like people who have beginner’s luck, an investor can be lulled into thinking that a few early successes prove one’s ability to make future consistent gains. Blind luck does not mean solid investment skills. You will realize this when your luck runs out. And then we put the blame on others except ourselves -- the markets, the banks, the government and everyone else.
How do you measure your risk tolerance? You may be surprised how easy it is. Ask yourself these four essential questions and see how financial experts do it:
- When will you need the money?
If your time frame is, say 30 years in which you save and invest, you have high chances of weathering a few setbacks along the way. But if you are five years away from retiring, the assumption will drastically change.
- How many years will you spend in productive work? How many years in retirement?
Many people reach retirement age unable to quit working because they have no savings. For those who plan to work during retirement, they make have higher risk levels compared to those who will not.
Likewise, consider how long you might end up living in retirement. Oftentimes, running out of money in your later years is inevitable.
- How do you respond when markets rise?
Do you celebrate and go on a shopping binge? People forget that they have not even made money on their investments, not until they sell those assets many years from now. Also, there are investors who see a rising market as a go-signal to invest more heavily, not realizing they are actually buying at much higher prices.
- How do you respond when markets fall?
Do you feel depressed? Or fearful? In the same token, why should you feel down when you have not lost any money until you sell at a lower price than that at which you bought the stocks? Moreover, investors do not take the opportunity to buy as stock prices decrease, not the applying the vital rule to “buy low and sell high”.
Properly assessing investment risk and determining your risk tolerance level is a crucial factor in any long-term retirement strategy. But if you learn the basic tricks, you can protect yourself from the common emotional trading pitfalls that retirement savers often experience.
As a novice investor, you will receive a lot of confusing and even conflicting advices on how to invest your precious money. Ignoring most of those well-intentioned advices and educating yourself with the valuable practices of investors who successfully built their wealth not just for a few days, months, or quarters but for many years, will favor your success. Read as many books as you can in the area of value investing.
From such books, the common theme that stands out is that to become a successful investor you must look at buying stocks as investing in businesses; for in essence, that is what it really is. Businesses are launched through the use of funds from some form of private or venture-capital money. Once it reaches a certain size, its management might decide to raise capital from public markets to pay off the original financial supporters and to enhance business growth. The company does this by issuing shares to the public through the process of an Initial Public Offering, giving these shares ticker symbols such as DVR or MORN. From there on, they begin trading on the exchanges, such as the New York Stock Exchange or NASDAQ. These stock exchanges enable stock owners to buy and sell their ownership shares in companies, hence, the investment term “trading”.
Buying and selling private businesses can be quite cumbersome; however, stocks of publicly-traded firms can be traded with just a click of a mouse. Although this convenience and liquidity can benefit investors who get easy access to cash, it can eventually tempt investors to turn into speculators or, worse, gamblers.
To give an example: If you owned a thriving business, would you sell your business like you were selling an old car? Probably not. In fact, you might keep you business for years, if not for the rest of your life and even pass it on to your children who will enjoy the rewards of owning the profitable business. However, since stock exchanges enable investors to trade in a matter of seconds, this often turns them into opportunistic investors who neglect the realities of the business and, as a result, think of nothing else but how to make a killing in the stock market. Subsequently, they readily abandon their ownership any time adverse news about the company is reported. On the other hand, an individual business-owner will never bail out by selling the business merely because the government increased interest rates or China’s GDP went down drastically.
In order to succeed in investing, you have to look at yourself as not just a buyer of stocks but part owner or a virtual participant in the companies that these stocks symbolize. But there is more to it than meets the eye. For instance, a Lexus is not an ordinary car any one can buy and own. Neither would you buy it for any price. Based on the year model, you would pay what you think its value is. So it is with businesses – they also have values. If a business, say Acme, makes a higher profit than another business, say Buttons, Acme obviously has a higher value than Buttons. Hence, you would not pay above a price which represents the value of either company. This is because when you need to sell, for whatever reason there is, it would be difficult to find another gullible person who will pay more than you for your business.
Nevertheless, this logic is more often neglected than followed by most investors. People get excited when stock prices go up and get depressed when they go down. And when they are in a high state, they tend to buy businesses when prices are high; and they turn sad when the same businesses are cheaper. It is difficult to accept that investing can be such an illogical world.
The secret to successful investing is quite simple: you are buying not just stocks but businesses; buy them to become an owner then; buy them at the most sensible price; and give time for your investment to grow. As simple and stress-free as that! Yet, to some, it appears too simple. The investment industry will certainly not follow this approach because how else would most investment experts justify their asking exorbitant fees in comparison to its horrible investment performance?
Since the end of World War II the average large stock has returned close to 10% a year -- well ahead of inflation, and the return of bonds, real estate and other savings vehicles. As a result, stocks are the best way to save money for long-term goals.
What is a stock?
When you own a share of stock, you are a part owner in the company with a claim -- however small it may be -- on every asset and every penny in earnings. As a company's earnings improve, investors are willing to pay more for the stock.
How do I buy stocks?
You can easily open a low-cost brokerage account online, at sites like Fidelity, Charles Schwab, TDAmeritrade or Scotrade. You can move money electronically into your account and start trading. Most discount broker sites charge a set fee of around $10 per trade.
What different types of stocks are there?
There are thousands of stocks to choose from, so investors usually put stocks into different categories: size, style and sector.
A company's size refers to its market capitalization, which is the current share price times the total number of shares outstanding. It's how much investors think the whole company is worth.
Companies with large market capitalizations, or "large-cap" companies tend to be established and stable, but because of their size, they have lower growth potential than small caps.
Over the long run, small-cap stocks have tended to rise at a faster pace. With less developed management structures, small caps are more likely to run into trouble as they grow.
Mid-caps, or medium-sized companies, fall somewhere in the middle.
A "growth" company is one that is expanding at an above-average rate, much as tech companies did in the 1990s. Catch a successful growth stock early on, and the ride can be spectacular. But again, the greater the potential, the bigger the risk. Growth stocks race higher when times are good, but as soon as growth slows, those stocks tank.
The opposite of growth is "value." There is no one definition of a value stock, but in general, it trades at a lower-than-average earnings multiple than the overall market. Maybe the company has messed up, causing the stock to plummet -- a value investor might think the underlying business is still sound and its true worth not reflected in the depressed stock price.
A "cyclical" company makes something that isn't in constant demand throughout the business cycle. For example, steel makers see sales rise when the economy heats up, spurring builders to put up new skyscrapers and consumers to buy new cars.
But when the economy slows, their sales lag too. Cyclical stocks bounce around a lot as investors try to guess when the next upturn and downturn will come.
Standard & Poor's breaks stocks into 10 sectors and dozens of industries. Generally speaking, different sectors are affected by different things. So at any given time, some are doing well while others are not.
In most cases, finance, health care and technology tend to be the fastest growing sectors, while consumer staples and utilities offer stability with moderate growth. The other sectors tend to be cyclical, expanding quickly in good times and contracting during recessions.
How do I choose?
Although there are more than 6,000 publicly traded companies, the core of your stock portfolio should consist of financially strong companies with above-average earnings growth.
There are only about 200 stocks that fit that description. A well-balanced stock portfolio should consist of 15 to 20 stocks, across seven or more different industries.
As a general rule, stocks with moderately above-average growth rates and reasonable valuations are the best buys. Statistically, high-growth stocks are usually overpriced and have a harder time meeting inflated investor expectations.
The first thing to look at is the stock's price/earnings ratio compared with its projected total return. Ideally, the P/E should be less than double the projected return (a P/E of no more than 30 for a stock with 15% total return potential).
Contributed by Timothy Sykes
I hear this all the time: “Tim, I want to learn stock trading, but I don’t have any money. What can I do?” And what the people asking this forget is that I was once exactly where they are. I didn’t have a mentor, and I didn’t have some special training program to help me uncover the trading patterns that have made me successful.
I worked hard, and I did it on a budget. Here are three ways you can do the same:
- Take advantage of free resources.
There are so many great training videos, blogs and other resources that will help you get started that you have absolutely no excuse for not jumping in today.
Can you imagine where you’d be as a trader if you took the time to go through all of those videos? Say you took two hours a day to study my stock-trading advice. You’d get through the videos in under two months, and I guarantee you’d be in a better position than the people out there who buy into big-ticket courses, then never act on the information they’ve purchased.
I wish I could show you all the hours I spent when I was first getting started, sitting at my computer and studying stock charts until my eyes glazed over. I started from “square one,” too -- and I didn’t have access to nearly as many resources as you do. Fifteen years ago, the Internet was a totally different place. If I could pull it off with my limited access, you can do much better now, with all the different resources out there today.
- Set up a practice account.
With all the different free resources out there, I want you to go crazy. Read every blog post or book you can get your hands on and watch every video. Learn about the fundamentals of stock trading, what it means to watch price action and how to execute trades.
But I also want to caution you that there’s a point where you have to translate all that education you’ve invested into action. Reading about trading isn’t enough. You aren’t a trader until you, well . . . trade.
If you don’t yet have the money to open your first brokerage account, at least start practicing. Find a website online that lets you set up a practice account and actually execute a few test trades. Practice the strategies I teach, but do it in a low-risk way. While practice portfolios aren’t perfect mirrors of real-world accounts, they’ll at least get you used to the feeling of researching and executing a trade.
- Start saving for your brokerage account
As you research and run trades in your practice account, take a look at the brokers I use, because I want you to think ahead for the future. One of the great things about penny-stock trading is that you can get started with a small account. Let’s say you’ve got just $2,000 to invest. With that money, you could buy about 16 shares of Apple stock at $120 a share or you could buy 2,000 shares of a stock trading at $1 a share.
And since you make money when you enter and/or exit a stock based on the number of shares you hold, which of these options do you think will help grow your account the fastest?
Penny stocks are a great fit for beginners, but I do want to caution you on one thing: Don’t use your last $2,000 to open your brokerage account. Set it up with money you can afford to lose. If you don’t have a few hundred dollars or a few thousand you regard in that way, cut your expenses or earn a little extra pocket change until you do.
When you’re ready to start actively trading, find a mentor who'll help you make the most of the money you’ve been able to save. While that isn’t always free, the amount you’ll save by not making stupid mistakes and avoiding unnecessary losses will help start you out on the right foot toward long-term profitability.
Stock investing can be arcane. Like any specialized pursuit, there is jargon to master, gatekeepers to pass and multiple barriers designed to keep “ordinary people” from infiltrating the business.
Some of this is for good reason. Uninformed investors are a huge danger, mostly to themselves. There are regulations around stock investing meant to protect novices from being fleeced. They work, for the most part.
But investing in stocks also has been made unnecessarily difficult in part to benefit a small band of interested parties: brokers, financial advisers and the like, folks who would prefer that investors stay ignorant and pay exorbitant fees without question.
So, here’s a simple breakdown on stock investing I hope will give you a little more gumption when it comes to your own investing, particularly for retirement purposes:
- Owning stock is owning a company
That’s right, you are now an owner. As such, you have rights and responsibilities. You have a right, for instance, to be informed of material changes to the company’s prospects for growth and its risk of failure. And the responsibility to read that information.
- Stocks grow two ways
Most people think about stocks in terms of capital appreciation. They buy it at one price hoping to sell it in the future at a higher price. But stocks also often pay dividends, cash income you collect for being an owner. Combined, capital appreciation and dividends is called “total return.”
- Stocks rise and fall in value
It seems a strange point to make, but what goes up can, in fact, come down. And going up is meaningless if the increase doesn’t outpace inflation. Buying a stock whose price seems irrationally (one assumes temporarily) depressed is known as “value” investing. Buying a stock that’s rising in hopes that more buyers will jump in is known as “momentum” investing. Both approaches work sometimes, for some stocks, in some years.
- You will pay taxes
Unless you own your stocks inside a qualified retirement account you will pay taxes on the gains as you sell and on dividends you collect along the way. So your total return has to beat both inflation and the cost of those taxes, too.
- Stocks can be volatile
This is a key point, and different from No. 3 on this list. Volatility is when an investment rises and falls by a broad percentage in a short period of time. Stocks are generally more volatile than, say, bonds. They also tend to appreciate more over long periods.
Finally, investors should be wary of concentration risk. Most companies do not fail. But when they do their investors lose everything. Owning a large number of individual stocks is one way to reduce the risk of loss from bankruptcy or a corporate collapse.
Managing your securities allows you the option to use any of various multiple systems. On top of the list of choices are physical certificates and book entry. But which is the best among all the choices? Knowing how these top two systems differ and what advantages each provides will help you make a well-informed decision as to which fits your particular requirements the most.
Physical certificates consist of paper stock and bond certificates that serve as proof of your possession of the securities in your name or company. Such certificates require you to pay a fee for their issuance, including a replacement fee in case you lose the document or it is stolen. Considering that these documents are valuable, like land titles, these physical certificates must be kept safely in secure places for the opportune time when you can trade them.
Physical certificates offer certain traditional advantages. They put you in a position to become the point-person to be contacted for all company reports and information. Moreover, such documents are handy instruments you can use or submit as collaterals for a loan application.
On the other hand, the book entry system allows electronic storage of your securities; hence, removing the use of paper certificates. In addition, this system removes the possibility of loss or pilferage, unlike physical certificates. This digital storage system also simplifies the process of trading the securities, whether through sales or transfer. The complex and tedious task of preparing and mailing documents is removed through this modern digital process.
Have you made the final choice so far? If not, take more time to study your options. In spite of the apparent desirability of the book entry system because of the greater convenience and safety it provides, you may want to inquire from your transfer agent about the real benefits of the two systems and how they will enhance your specific financial needs.
Do you know what do these acronyms mean: NYSE, NASDAQ, and AMEX? They may seem like some challenging medical terms to you; but they are actually trading platforms any new client or professional in the industry must get to know as a first and fundamental lesson. Eventually, like the rest, these words will become ordinary as you use them regularly in your job. For every platform possesses a specific character, characteristics, requirements and way of operating on its own.
To help you along in this initial encounter, here is a short reference guide:
Founded in 1817 in New York City, the New York Stock Exchange (NYSE) is the world’s largest stock exchange based on market capitalization. NYSE is often referred to as “the Big Board” – just like the “Big Apple”! NYSE works on a continuous auction format in which traders can make transactions for investors or their clients at any time.
As its nickname suggests, a big bulk of American securities, about 80%, are traded through the NYSE. For a company to be traded on this platform, it must satisfy certain requirements before entering into the exchange. Zacks states that a company must have a minimum of “400 shareholders who own more than 100 shares of stock, have at least 1.1 million shares of publicly traded stock and have a market value of public shares of at least $40 million”. Moreover, it must have a stock price of $4 per share or more. The NYSE operates Monday through Friday, 9:30 a.m. until 4:00 pm. (ET).
The second largest stock exchange in the world is the National Association of Securities Dealers
Automated Quotations or NASDAQ, which was initiated in 1971 by the National Association of Securities Dealers. It was, however, only in 2006 that the system was transformed into a licensed national securities exchange, being a computerized system which provides price quotations on securities traded over-the-counter (OTC).
A NASDAQ-affiliated company must be registered with the U.S. Securities and Exchange Commission (SEC), must possess a minimum of three (3) companies serving as security brokers and must also satisfy minimum values of assets, capital, etc. NASDAQ provides three separate sessions throughout the day: a pre-market session (4:00 till 9:30 a.m. ET), a normal trading session (9:30 a.m. till 4:00 p.m. ET) and a post-market session (4:00 till 8:00 p.m. ET)
AMEX stands for American Stock Exchange, which initially served as an alternative to the Big Board --NYSE. Although it operates like the NYSE through its own trading floor and system, it caters more to small and mid-cap stocks which do not comply with the stricter NYSE requirements. Eventually, AMEX was acquired by NASDAQ’s founding company in 1998; but both exchanges have continued to operate separately.
Over-the-Counter (OTC) Exchanges
In some cases, companies do not need a trading floor to do securities trading. We refer to this system generically as “OTC exchanges”, although it can denote many other forms in the current market environment, since the meaning has evolved several times in the past. Likewise, it can describe other systems of trading done beyond a formal exchange. While we mentioned that the NASDAQ can be considered an OTC exchange, this kind of platform usually consists of penny stock and other stocks which stay on the fringes of the mainstream. As such, this type of exchange is considered risky by some investors. OTC stocks are often unstable and, because of their nominal volumes, are not often traded.
For more information on basic industry terminology, check out a complete glossary of the industry and other valuable resources online.