Curious about investing in the stock market but still confused by its strange terms and conflicting headlines and advice? Here’s the straight talk on 10 common questions novice investors usually ask.
1. Is there factual evidence that I’ll make money buying stocks?
According to Standard & Poor’s data
, total annualized return of stocks from 1926 through 2013 was 9.9%. With the potential for those returns, however, comes greater risk. Despite all the expert advice you’ll no doubt come across when researching specific stocks, there are no guarantees as to how a stock will perform; the broader market is impacted by so many forces that are uncontrollable and unpredictable -- including consumer emotion, political events, and natural disasters. That said, long-term historical market performance data demonstrates the potential benefit of investing in stocks. This is particularly true for long-term investors who can minimize their exposure to market volatility and avoid buying based on emotion and reacting to market downturns in a panic.
2. What are the most important indicators of a stock's health?
All publicly traded companies issue quarterly earnings reports to the Securities and Exchange Commission (SEC). You can find a few key pieces of data in the reports to evaluate a stock’s health:
Earnings per share (EPS): Ratio of total earnings divided by the total investor shares. You can compare stocks with this number.
Price/Earnings ratio (P/E): What customers are paying for a dollar of the company’s earnings. According to FINRA, the long-term average number has been about 15. A stock with a high P/E might mean that the future looks bright -- but it will have to work harder to maintain the performance. A low P/E might mean that a price increase is on the way -- or that a company is in trouble.
Price/Book ratio (P/B): When you’re evaluating a few stocks in the same category (like tech or finance), this ratio can indicate what shareholders are willing to pay compared to the company’s reported value. Generally, a value of less than 1.0 could indicate that the price is trading lower than the actual value of the company, signaling an opportunity to buy low (though it may also mean the company is struggling). Because P/B varies greatly by industry, this metric is a gauge most appropriate for comparing “apples to apples” stocks.
Though some figures can be more telling than others when evaluating a stock’s health, your assessment can’t be isolated to one or two metrics; the appropriate stock picks for your portfolio rest largely on your objective. If you seek high returns and can absorb high risk, stocks poised to increase significantly over a short time period will appeal. If you are looking for less risk and moderate growth, stick to stocks whose price ranges over the past 52 weeks have been steadier. Conduct independent research and form your own educated opinions: Do you think the company/product will be in demand 10 years from now, and do you believe in the company’s strategy in relation to the competition? Scour the annual reports of the stocks you’re considering buying to learn more about what the stock’s past performance entailed, growth strategy, and how much debt it carries.
3. Where can I find analyst research and recommendations on a particular company's stock?
In addition to your own research and metrics, seek out the opinions of analysts who cover the stock to understand more about its industry, and what the experts think will happen to the stock and why. Analyst research can be found online through several reputable, independent sources like Morningstar
, Zacks Investment Research
, and Yahoo Finance
If you intend to trade through a major brokerage firm, most provide customer access to analyst recommendations free of charge. As for an analyst’s record for picking winners, Zacks “All-Star” Analyst Portfolio
provides insight as to which analyst recommendations proved most profitable for investors in the year prior.
4. What is a dividend?
Not all companies pay dividends, which is a portion of the company’s profits paid to investors -- typically on a quarterly basis -- per share, and whether they do or don’t doesn’t indicate the health of the company. That said, dividends are essentially an extra incentive that a company uses to entice investors to become shareholders. Though some investors use dividends as a long-term strategy, a higher dividend yield isn’t necessarily favorable, because there may be little room for more growth. Instead of looking for high dividends, you might consider dividend stocks in sectors with room for growth as the economy improves, like health care and technology.
5. If I hear about an upcoming Initial Public Offering (IPO), how can I buy into it?
Not all IPO shares are open for purchase by the masses; many are reserved for large-scale investors only. If the sale is open to the public, look at the "Underwriting" section in a company's SEC registration (published at the SEC’s EDGAR
database) to find the names of the financial institutions involved in an IPO. Then, look for a broker (or a discount brokerage firm) who is affiliated with that financial institution.
6. I always hear about investors shorting a stock. What does that mean?
Investors short stocks when the stock’s current trading price is thought to be overvalued. In the shorting process, the investor essentially “borrows” the stock from a brokerage house and sells to another buyer. If the stock price goes lower, the investor who shorted the stock profits from the difference in the buy/sell prices, after repaying whatever is owed to the brokerage house (also called trading on margin). To short a stock, you must trade through a broker using a margin account, which lends you more money to trade than you actually have in the account, at a fixed interest rate. Shorting stocks is an aggressive investment strategy; you must replace the lost money in the margin account quickly if your bet proves incorrect. On the contrary, “longing a stock” means buying and holding a stock for an undetermined amount of time.
7. What are the differences between preferred and common stocks?
Common stocks are ownership interests in a publicly traded business; owners of those interests are shareholders. If a stock’s price increases from the price a shareholder purchased it for, he or she benefits. Preferred stocks, on the other hand, are a longer-term form of fixed-income investing. The company pays dividends to preferred stockholders at regular intervals, which can be fixed or floating. That said, the preferred stockholder doesn’t instantly benefit if a stock’s price increases, like a common shareholder would. If a company becomes insolvent, preferred stockholders are entitled to whatever assets are left to distribute after the other debt holders are paid; common stockholders are essentially last in line for repayment if a company goes bankrupt, and may not recoup any value from their lost shares.
8. What is a decent return for non-professional investors?
Over the past 100 years, the stock market has realized close to an average 10% rate of return. Adjusted for inflation, that means stocks could potentially double the value of your money in just over ten years at their average long-term return rate. Keep in mind, however, that figure doesn’t mean you are actually earning 10% per year on your money. Further, real expected rate of return is a topic that is frequently debated (and disagreed upon) among financial professionals. Conservatively, you might assume an expected rate of return closer to the 7-8% range.
9. Should I invest in a hedge fund?
Because many hedge funds purchase financial products that are not regulated by the SEC, it can be difficult to establish a real value for the products and maintain liquidity (according to the New York Stock Exchange
). That said, investing in hedge funds isn’t an appropriate move for the novice investor. Additionally, they are an option only for those meeting the financial criteria required to become an “accredited investor,” defined by a net worth that exceeds $1 million at the time of the purchase (not including primary residence), or an income of $200,000 in each of the two most recent years (or joint income with spouse exceeding $300,000 for those years).
10. What is an ETF -- and should I buy one?
Exchange-traded funds (ETFs) combine the flexibility of a stock with the low costs of a mutual fund, but unlike a managed mutual fund, most ETFs trade on stock indices. As such, their price is constantly changing, and you can buy and sell them at any time, based on the current price. (When you own a mutual fund, you can only buy/sell at the end of day, at the closing price). Because there are many types of ETFs, it’s critical that you understand the ETF's goal, and how it fits into your financial objectives. If you’re rolling over an IRA or investing a large sum of money, for example, an ETF may be a good investment option; if your portfolio is smaller, a mutual fund is probably a smarter bet.
No positions in stocks mentioned.
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