Alpine Summit

Sunday, July 31, 2005

Investment Crash Course, Part 2.

Okay, so now you have a basic understanding of what stocks and shares are. This post will go over some of the basic strategies investors have to make money off the stock market.

The first thing to do is know why you want to invest. Is this going to be an idle hobby for your own enjoyment, or is this something you want to do as part of a retirement portfolio? How you answer that question will determine your strategies in the stock market. Second, you have to know how much you're willing to invest. Most online brokers require at least $500 to open an account- this is not a lot of money and you'll probably want to have more than that. Finding how much you want to invest also goes along with finding a broker. You should realize that you will be paying money to someone to buy/sell stock for you. Finally I'll talk about the different positions you can take on a stock excluding derivatives (options).

So, why do you want to invest? Is it because of an interest in the stock market? Do you just want the experience? Is this a serious thing you plan to do to have something on which to retire? Whatever the reason, you need to set up the game plan first before you buy any stocks. For me, investing is a bit more of an experiential thing since I'm still in college, but once I graduate and can start making money to keep paying into my account on a monthly basis, I'll start investing for retirement. The key word to investing is "discipline." It's hard to watch a stock you just bought start losing value because that means you won't get as much money back as you spent if you sell it (you lose money). You need to be able to ride out some rough spots and have the ability to take a hit.

Theory and practice are two completely different things and you won't know what I'm talking about until you've actually started to invest. When I first began investing, I would buy a stock and if, in the same day, it started going down I would panic and sell. This was very costly because I wasn't holding onto the stock long enough to make any returns. All the while I was paying a commission to my broker every time I traded. Another thing: don't discount the effect of a commission on your stock price. For example if you buy 20 shares of a stock at 14.10 and you pay $7/trade (Scottrade, my broker), your stock will need to get to 14.80 to break even- [(14.10*20+14)/20]. It's usually best to do these calculations before you buy the stock so you can guage on whether or not it will reach that target price. You benefit in volume with the more shares you buy. Suppose you buy 3000 shares of stock at the same price and commission, the price will only need to go to 14.10467 to break even. This is something to keep in mind when looking at a stock, too. How much of it can you afford, and will its perceived increase in value cover your costs of buying it? If no, don't buy it.

Now that you have an idea of why you're investing, you need to look at stocks appropriate for your strategy. If you're looking at retiring, you will want to find stable stocks- called blue chips. Blue chip stocks are VERY stable stocks that belong to successful companies that have little or no chance of going bust anytime soon. These kinds of companies would include Microsoft, IBM, 3M, etc. There are a lot of them. The Dow Jones Industrial Average, that you see on the news all the time (AKA: "The Dow") is an index made up of these blue chips and are supposed to represent how the market performs overall from day to day. It's not usually accurate, though, because while blue chips may have had a bad day, there are plenty of other stocks that had a good day.

Anyway, if you're planning for retirement, these are the kind of stocks you want to buy. They usually have a dividend associated with them (that's a share of the profits of the company for a period of time given back to investors, usually in a fiscal year) and pay out consistently. These are great stocks to have if you're looking to retire on them because they give dividends at different times and a well constructed portfolio can pay a dividend to you on a monthly basis depending on what stocks you invest in.

Mutual Funds are funds set up where they buy a "basket" of stocks and build their own portfolio and individuals can then invest in the fund. The value of their shares of the fund depend on how well the stocks of the fund do. These are great to use if you don't want to make your own portfolio, or deal with all the fun parts (IMO) of investing, though funds tend to have returns that track with the market in the long run; but can still lose money. The difference is that you have to pay a fee, usually part of your profit, to the fund so that those working FOR the fund will continue to maintain it. Again, it offers no guarantees and I've always been more of a do-it-yourselfer.

For the hobbyist, there are many options. You can day trade, swing trade, or do long-term investing. Hobbyists tend to speculate more and aren't as concerned with the 5-year forecasts like a "serious" investor would be. Day trading is speculating on a stock's value during a given trading day.

A day trader is going to buy shares of a stock, a very large volume, at once, and sell it off before the market closes that day. These people tend to be the "black sheep" of the stock market. I'm not entirely sure why, but I think it may have something to do with throwing off predictions by the long-term people. Either way, day trading is extremely risky because the shorter time period you look at for a stock, the more random the price fluxuation. People have committed suicide because of day trades gone wrong, so if you plan to do this kind of trading, I suggest it be with money you won't lament losing. Also, you should really know what you're doing with this form of trading and be willing to watch the stock constantly from 9:30-4:00 ET. If not, I suggest staying away from this form of investing.

A swing trader is someone who will buy shares of a stock and will have a price target in mind and won't sell the stock until it hits that price. They're actually defined by the trading behavior, though. They will buy a stock, but then sell it within a few weeks or months... short-term, but not within the day usually, but before a year. This is more my style of investing as it has the fun of day trading with the risk closer to long-term holding (that is, it's lower risk).

Finally, the long-term investor seeks stocks he/she plans on holding for at least a year. This is the least risky form of investing because stocks, for the most part, have been proven to go up in value in the long-run. Whenever speaking of the "long-run" or "long-term" in investing, it means "more than one year." A long-term investor could be looking for returns from the stock price going up, or they could be looking to collect a dividend. Again, it all depends.

An investor can also speculate. Most experts recommend some amount of speculation in a portfolio. Speculative stocks are stocks for companies that aren't really on firm ground, new to the game, selling a new product, or otherwise not proven in the market yet. Microsoft was a speculative stock back in the late 8o's (you can check historical prices on MSFT back then and weep that you didn't buy any). The risk of losing money is pretty great with these, but their reward is great, too. Some investors do nothing but speculate, while others merely supplement their portfolio with some speculative stocks and still others stay away from them like grim death. It's really up to the person and how much risk they're willing to take on.

Positions investors can take can be confusing. The "long" (or positive) position means buying a stock at one price and selling at another. Fairly simple. It's like buying a comic book, holding onto it until it gains in value then selling it back. There is also something called the "short" (or negative) position which is a little more confusing.

When you sell a stock short you expect the stock value to go down, but want to make money on it. So, you call up your broker and say "I want to sell X shares of stock XYZ short." The broker will then take X number of shares of stock XYZ from another client who has promised to hold onto those shares for a period of time and "give" them to you. Now, you don't owe the broker the money for the stock, you owe him/her the stock itself. This is where it gets confusing. You take the stock and sell it immediately on the open market. You then have all the money from the sale that you then just sit on until the price goes down or the owner of the stock you sold wants their stock back. There is a time limit to how long you can have this debt to the broker before he starts hitting you with credit reports and ugly letters... mainly because they weren't your shares.

I got off-topic a bit again, but whatever. Anyway, the plan is to sell the shares at a high price, sit on the money, wait for the price to drop, then buy back those same shares at a lower price. You won't need to spend as much money buying the shares back as you got selling the shares to begin with. After buying the shares back, you turn them over to the broker and he/she gives them back to the investor. You get to pocket the difference in how much was recieved by selling the shares and how much was lost buying them back. You only make a profit if the stock price drops in this case and you put your credit rating on the line if you can't afford to buy the stock back if its value goes up. You usually need to guarantee a reserve cash amount with your broker before they'll let you do this kind of trading because it's fairly risky for them.

Knowing the strategies is only part of the battle. An investor needs to know when to implement what strategy. For example, you aren't going to put sunblock on if it's snowing outside. Similarly, you don't want to buy a stock when it's at its peak price for the year. But how do you know when to buy or sell? When to hold on to a stock longer? How to treat the stock... sell short or buy? These questions can only be answered with research of the stock. My next installment will involve the tools investors use to analyze a stock to see what the best thing to do with that stock is.