Like any highly specialized field of endeavor, investing has its own peculiar language, terms, and jargon. Listed below are twenty-five of the most common investment terms and tools, along with their basic definitions. Take the time to learn these terms; you’ll hear them daily. As you come across more complex investment terminology, use this link to locate their meanings in the advanced glossary.
ASSETS - Resources owned by a company, fund, or individual; i.e. cash, investments, money due, materials, inventories, etc.
BEAR MARKET - A market in which prices are falling, or expected to do so.
BOND - A debt security issued by corporations, governments, or their agencies, in return for cash from lenders and investors. A bond holder is a creditor, not a shareholder.
BULL MARKET - A market in which prices are rising, or expected to do so.
COMMODITY - A tradable item that can generally be further processed and sold; i.e. metals, wheat, coal, etc.
COMPOUND INTEREST - Interest which is calculated on both the principal and interest previously earned.
DIVIDEND - The amount of a corporation’s after-tax earnings that it pays to its shareholders.
DOW JONES INDEX - A leading index of U.S. stock market prices.
FINANCIAL ANALYST - A person trained to advise on the risk and return characteristics of investments and in the management of investment portfolios.
INDEX - A numerical measure of price movement in financial markets.
INVESTMENT - An asset acquired for the purpose of producing income and/or capital gains.
LIQUIDITY - The ability of an investment to be easily converted into cash with little- to no loss of capital and a minimum of delay.
MARKET - A public place where buyers and sellers conduct transactions, either directly or via intermediaries.
http://www.nasdaq.com/ NATIONAL ASSOCIATION OF SECURITIES DEALERS AUTOMATED QUOTATIONS (NASDAQ) - The New York-based U.S. stock exchange that specializes in technology companies.
OPTION - An agreement that conveys the right, but not the obligation, to the holder to buy or sell a particular security at a stipulated price within a stated period of time.
PORTFOLIO - An investor’s collection of investment holdings, usually with reference to its composition.
PROSPECTUS - A legal document, required by the Securities Act of 1933, setting forth the complete history and current status of a security or fund; it must be made available whenever an offer to sell is made to the public.
RETURN - The amount of money received annually from an investment, usually expressed as a percentage.
RISK - The measurable likelihood of loss or less-than-expected returns.
SECURITIES AND EXCHANGE COMMISSION (SEC) - The U.S. regulatory authority for the securities industry.
SECURITY - The paper right to a tradable asset.
SIMPLE INTEREST - Interest that is paid on the initial investment alone.
STOCK - An instrument that signifies an ownership position (equity) in a corporation.
TREND - The current general direction of movement security or commodity prices.
VOLATILITY - The extent of fluctuation in share price, interest rates, etc. The higher the volatility, the less certain an investor is of return; therefore, volatility is one measure of risk.
Friday, December 28, 2007
Getting Started in the Stock Market
When you purchase stock in a company, you become a part-owner, along with other stockholders, of that company. As investors, you are in the position to reap profits if the company does well, or suffer losses if it does poorly. Since 1926, the average stock has a return-on-investment (ROI) of over 10% per year. That fact makes stock a very solid choice for long-term investing.
The proliferation of state lotteries and the media attention focused on the huge jackpots are ample evidence of the get-rich-quick mentality. However, the chances of an individual winning the lottery are remote, to say the least. The odds of winning a grand prize are well over 1 in 10,000,000.
Fortunately, the chances of getting rich investing in the stock market are considerably better. The main requirements for effective long-term investing are common sense and patience. It must be understood that the stock market is not a get-rich-quick vehicle. You can get rich if you develop and maintain a clear objective, concentrate on the long term, build a diversified portfolio of securities, and stick with your plan.
When you’re ready to take the plunge into the market, you’ll want to consider several questions before making your first investment. The answers to these questions can help you to formulate your plan and your direction.
Is capital appreciation your main objective? If it is, look for investments with the potential to grow in value to produce capital gains. You’ll also want to consider reinvestment of dividends and interest.
Is income your main objective? If so, try to identify investments whose primary feature is to provide regular income. Also, is the income distributed in fixed payments, or does the payment stream gradually increase?
What’s the effect of inflation? If the value of the investment is expected to rise at or above the rate of inflation, the investment is said to be inflation-sensitive.
What are the tax considerations? Is the investment to be included in a tax-deferred retirement account, such as an Individual Retirement Account (IRA), 401(k) plan, or other qualified plan?
Can you borrow against it? This concerns the general value of the investment as collateral for a loan. Borrowing can be a way of raising cash when an investment cannot be sold quickly, or when it isn’t the right time to sell.
Always base your investment decisions on your own particular financial position, risk comfort level, and goals. No one cares as much about your financial situation as you do. Therefore, do your homework. Consult with, listen to, and learn from professional people that you trust. But in the end, make your own decisions; or if you don’t, make sure that you trust and are comfortable with the decisions of your advisor. The stock market can be a place of great profit or of great loss. When you approach it with a systematic, common-sense investment plan, your odds of being on the winning side improve dramatically, and you’ll be in a position to watch your nest-egg grow to considerable proportions.
The proliferation of state lotteries and the media attention focused on the huge jackpots are ample evidence of the get-rich-quick mentality. However, the chances of an individual winning the lottery are remote, to say the least. The odds of winning a grand prize are well over 1 in 10,000,000.
Fortunately, the chances of getting rich investing in the stock market are considerably better. The main requirements for effective long-term investing are common sense and patience. It must be understood that the stock market is not a get-rich-quick vehicle. You can get rich if you develop and maintain a clear objective, concentrate on the long term, build a diversified portfolio of securities, and stick with your plan.
When you’re ready to take the plunge into the market, you’ll want to consider several questions before making your first investment. The answers to these questions can help you to formulate your plan and your direction.
Is capital appreciation your main objective? If it is, look for investments with the potential to grow in value to produce capital gains. You’ll also want to consider reinvestment of dividends and interest.
Is income your main objective? If so, try to identify investments whose primary feature is to provide regular income. Also, is the income distributed in fixed payments, or does the payment stream gradually increase?
What’s the effect of inflation? If the value of the investment is expected to rise at or above the rate of inflation, the investment is said to be inflation-sensitive.
What are the tax considerations? Is the investment to be included in a tax-deferred retirement account, such as an Individual Retirement Account (IRA), 401(k) plan, or other qualified plan?
Can you borrow against it? This concerns the general value of the investment as collateral for a loan. Borrowing can be a way of raising cash when an investment cannot be sold quickly, or when it isn’t the right time to sell.
Always base your investment decisions on your own particular financial position, risk comfort level, and goals. No one cares as much about your financial situation as you do. Therefore, do your homework. Consult with, listen to, and learn from professional people that you trust. But in the end, make your own decisions; or if you don’t, make sure that you trust and are comfortable with the decisions of your advisor. The stock market can be a place of great profit or of great loss. When you approach it with a systematic, common-sense investment plan, your odds of being on the winning side improve dramatically, and you’ll be in a position to watch your nest-egg grow to considerable proportions.
Global Diversification
In the past United States citizens have often been somewhat narrow-minded when it came to investment opportunities. At least part of this is attitude has no doubt been due to the fact that the U.S. is fairly isolated geographically, along with the dominant position that America has enjoyed both politically and economically. Another reason for this myopia is that investors in the U.S. stock and bond markets have historically benefited from very strong returns and, as a result, have often seen little benefit of diversifying their portfolios internationally. However, in recent years, things have taken a dramatic swing away from such nationalistic viewpoints. The fact is that non-dollar markets have currently (and significantly) outperformed – and will likely continue to do so – the United States market. This turn of events can be attributed to a number of causes.
The first reason overseas markets often provide investors with a higher return potential is that many overseas economies are growing at a faster rate than the U.S. economy. Naturally, the faster the rate of local economic growth, the greater the growth potential is for the companies that operate in those markets. This faster growth rate can be attributed to several factor, including a faster rate of population growth relative to that of the United States, the transformation of these often less-than-technically-advanced economies into more modern and productive markets, and the widespread adoption of democracy, capitalism, and the rule of law among these nations. As long as these trends continue, the emerging markets will continue to enjoy a faster rate of economic growth than the U.S., which is a mature market by comparison.
Another reason for higher rates of growth abroad is that overseas companies are typically subject to less government regulation. U.S.-based businesses face a formidable amount of government regulation, which covers virtually every aspect of creating and operating a business. While no one would argue that many of these regulations are beneficial and even necessary, they do nevertheless often put United States businesses at a competitive disadvantage relative to their foreign competitors. Companies operating outside the United States often face far less government regulation and, as a result, lower operating costs.
One of the principal advantages that non-U.S. companies (as well as domestic companies that operate overseas facilities) enjoy is markedly lower labor costs. These lower costs include both wage and benefit expenses. In many emerging markets, there's no health, dental, disability or unemployment insurance, not to mention company-sponsored retirement plans. Additionally, laws such as the federal Family and Medical Leave Act – which guarantees that U.S. workers who take time off to care for newborn children or sick family members will not lose their jobs – are unheard of in many overseas markets. However, low labor costs alone will not build a viable economy unless the work force is also well educated and equipped with a strong work ethic. In many countries, the school year is longer and the curriculum more rigorous than that in the United States. And the work ethic among blue-collar workers in numerous foreign countries is either equal to or (more likely) greater than that of the average U.S. blue-collar worker.
Internationally, governments often take a very active role in promoting and protecting business – unlike the U.S. market, where the relationship between government and business can frequently be more antagonistic than cooperative. Additionally, one of the favorite tools of United States foreign policy-makers is the trade embargo. While the government considers these embargoes to be an effective tool to promote U.S. national interests, such tactics typically hurt United States companies. Since domestic entities are prohibited from doing business with or in nations that are embargoed, non-U.S. companies will naturally step in and fill the void.
But while non-dollar markets do have a number of advantages, they also have disadvantages that should not be overlooked. For instance, many foreign securities markets are considerably less well-regulated than their U.S. counterparts. And while that is not to suggest that the United States markets are completely free of illicit manipulation, it's certainly less of a problem than in many other markets, where market manipulation is sometimes rampant. Other disadvantages include:
Lower liquidity. In the U.S. market, daily trading volume is extremely high, resulting in excellent liquidity, especially for the smaller investor. In other markets, volume can sometimes drop to alarmingly low levels. Low liquidity can force investors to accept a lower price when they sell their securities or pay a premium when they buy.
Higher trading and transaction costs. The lower liquidity and the lack of automation in some overseas markets can dramatically raise trading costs. The cost of trading in the U.S. is only a few cents per share; in other markets the expense may be many times higher. This not only reduces investment profits but also works to limits investors' flexibility.
Less required financial disclosure. United States companies that issue publicly-traded stocks have rigorous reporting requirements. Overseas companies, on the other hand, often enjoy more flexible requirements. These may include, for example, the ability to maintain undisclosed reserve accounts. As such, investors who buy non-dollar stocks may run a greater risk of unpleasant financial revelations.
Stockholders are a lower priority. In the U.S., heads of public corporations know that their major (and sometimes only) priority is to enrich the shareholders to whom they report. In other markets, enriching shareholders is often only one of the business's priorities – and not necessarily one of the highest. As a matter of fact, some foreign governments have clearly stated that they expect corporate shareholder returns to take a back seat to social progress and wealth redistribution.
Higher short-term volatility. While non-dollar markets may offer a higher rate of return, they also tend to come with higher short-term volatility. Large short-term price swings, both up and down, can reasonably be expected. These swings are the result of both changes in the valuation of the stocks in their native currencies, as well as swings in the U.S. dollar-versus- the native currency foreign exchange rate. Investors not able to tolerate such high volatility should avoid such markets, even if it reduces their total return.
The first reason overseas markets often provide investors with a higher return potential is that many overseas economies are growing at a faster rate than the U.S. economy. Naturally, the faster the rate of local economic growth, the greater the growth potential is for the companies that operate in those markets. This faster growth rate can be attributed to several factor, including a faster rate of population growth relative to that of the United States, the transformation of these often less-than-technically-advanced economies into more modern and productive markets, and the widespread adoption of democracy, capitalism, and the rule of law among these nations. As long as these trends continue, the emerging markets will continue to enjoy a faster rate of economic growth than the U.S., which is a mature market by comparison.
Another reason for higher rates of growth abroad is that overseas companies are typically subject to less government regulation. U.S.-based businesses face a formidable amount of government regulation, which covers virtually every aspect of creating and operating a business. While no one would argue that many of these regulations are beneficial and even necessary, they do nevertheless often put United States businesses at a competitive disadvantage relative to their foreign competitors. Companies operating outside the United States often face far less government regulation and, as a result, lower operating costs.
One of the principal advantages that non-U.S. companies (as well as domestic companies that operate overseas facilities) enjoy is markedly lower labor costs. These lower costs include both wage and benefit expenses. In many emerging markets, there's no health, dental, disability or unemployment insurance, not to mention company-sponsored retirement plans. Additionally, laws such as the federal Family and Medical Leave Act – which guarantees that U.S. workers who take time off to care for newborn children or sick family members will not lose their jobs – are unheard of in many overseas markets. However, low labor costs alone will not build a viable economy unless the work force is also well educated and equipped with a strong work ethic. In many countries, the school year is longer and the curriculum more rigorous than that in the United States. And the work ethic among blue-collar workers in numerous foreign countries is either equal to or (more likely) greater than that of the average U.S. blue-collar worker.
Internationally, governments often take a very active role in promoting and protecting business – unlike the U.S. market, where the relationship between government and business can frequently be more antagonistic than cooperative. Additionally, one of the favorite tools of United States foreign policy-makers is the trade embargo. While the government considers these embargoes to be an effective tool to promote U.S. national interests, such tactics typically hurt United States companies. Since domestic entities are prohibited from doing business with or in nations that are embargoed, non-U.S. companies will naturally step in and fill the void.
But while non-dollar markets do have a number of advantages, they also have disadvantages that should not be overlooked. For instance, many foreign securities markets are considerably less well-regulated than their U.S. counterparts. And while that is not to suggest that the United States markets are completely free of illicit manipulation, it's certainly less of a problem than in many other markets, where market manipulation is sometimes rampant. Other disadvantages include:
Lower liquidity. In the U.S. market, daily trading volume is extremely high, resulting in excellent liquidity, especially for the smaller investor. In other markets, volume can sometimes drop to alarmingly low levels. Low liquidity can force investors to accept a lower price when they sell their securities or pay a premium when they buy.
Higher trading and transaction costs. The lower liquidity and the lack of automation in some overseas markets can dramatically raise trading costs. The cost of trading in the U.S. is only a few cents per share; in other markets the expense may be many times higher. This not only reduces investment profits but also works to limits investors' flexibility.
Less required financial disclosure. United States companies that issue publicly-traded stocks have rigorous reporting requirements. Overseas companies, on the other hand, often enjoy more flexible requirements. These may include, for example, the ability to maintain undisclosed reserve accounts. As such, investors who buy non-dollar stocks may run a greater risk of unpleasant financial revelations.
Stockholders are a lower priority. In the U.S., heads of public corporations know that their major (and sometimes only) priority is to enrich the shareholders to whom they report. In other markets, enriching shareholders is often only one of the business's priorities – and not necessarily one of the highest. As a matter of fact, some foreign governments have clearly stated that they expect corporate shareholder returns to take a back seat to social progress and wealth redistribution.
Higher short-term volatility. While non-dollar markets may offer a higher rate of return, they also tend to come with higher short-term volatility. Large short-term price swings, both up and down, can reasonably be expected. These swings are the result of both changes in the valuation of the stocks in their native currencies, as well as swings in the U.S. dollar-versus- the native currency foreign exchange rate. Investors not able to tolerate such high volatility should avoid such markets, even if it reduces their total return.
How Events affect Perception and Investor Confidence
There are times when a company's earnings history and projections are the only solid data that you have on which to base a decision about its stock. Although that may be enough, you must nonetheless constantly monitor your stocks for events that can change either a company's market perception or investor confidence; because, as we learned in the article Why do Stock Prices Move?, these two factors are crucial to price changes and the valuation of every stock.
Let's take a look at just a few events that can change the perception of a stock's future earnings and the confidence level about those earnings. The different strategies that you may use in implementing your investment program should closely monitor these factors.
Earnings announcements. A company's quarterly earnings are the primary factor in altering market perception and investor confidence, although the direction of the change may not always be what's expected. For example, the just-announced earnings figures could actually be record-setting, but the market may have expected an even larger number, one based on 'whisper numbers' (which are those unofficial earnings estimates that are spoken of by brokers and analysts in phone calls and informal settings a week or two before a company's earnings announcement is released; although unofficial, these figures are the market's true expectations of the company's earnings). Consequently, what appears to be positive news is perceived as negative, and the stock price declines. A company's failure to meet its whisper numbers is often viewed as an early warning that future earnings and the accompanying expected growth rate might not be reached. However, if a company announces earnings that meet or exceed the market's expectations (especially if it has a history of doing so), the perception of a strong future along with investor confidence that it can be achieved can boost a stock to record levels.
Revising estimates. One of the most accurate forecasters of positive or negative moves in a stock's price is the one-month change in analysts' estimates. Generally speaking, the first research report written by an analyst is positive. This is due to the fact that, frequently, the analyst is performing his or her duty to the firm and looking for good things to say. A revision of those estimates, however, is quite meaningful because it requires a separate initiative by the analyst to admit that he or she was wrong or simply had a change of mind. An upward revision in earnings estimates will likely produce a positive change in the price of a stock. However, a downward revision will tend to have an even more dramatic effect on the stock price than an upward revision; in fact, it could be devastating. It takes a great deal of courage for an analyst to lower an estimate, because in many cases he or she is saying something negative about a client of the firm. Additionally, the number of analysts who make a revision is also highly significant. Several analysts raising or lowering their estimates will have a much greater impact on a stock than just one analyst issuing a revision.
Company warnings. When a company itself advises stockholders that it won't meet its next earnings estimates, the news should be taken very seriously. This kind of announcement automatically causes such a fall in the price of a stock that it's a safe bet the company is telling the truth. Therefore, company disclosures are one of the best ways of knowing what's likely to happen to future earnings.
Interest rate changes. The lowering of interest rates has two potential impacts on stocks, both generally thought to be positive. First, the prevailing sentiment is that lower interest rates give consumers more money to spend, which translates into higher profits for businesses, which in turn makes companies more willing to spend money on inventory, research, new products, and expansion – all of which stimulate the economy. Higher profits are expected to lead to increased earnings, so investors become more confident about the future earnings potential of companies in general. In this way, lower rates are intended to produce a positive ripple effect throughout the economy.
The second positive impact of lowering interest rates has nothing to do with market perception of future earnings or investor confidence at all. Lower rates simply make investors less likely to buy debt instruments (bonds) and more likely to buy equities (stocks), thereby driving up stock prices across the board.
Conversely, an increase in interest rates has precisely the opposite effect. Higher rates cut into business profits and act as a restraint on consumer and company spending, all of which work to slow down the economy. And higher interest rates siphon money out of the equity markets and direct it toward debt instruments.
Insider trading. If company insiders use their own money to buy stock on the open market, it's a pretty good sign that they believe their company's future earnings are going to be better than the market expects. At minimum, it indicates that they feel the company's stock price is too low at that time. And company insiders should know the company's prospects best (of course, insiders aren't always right).
On the other hand, insider selling, while not a good sign, may not necessarily be as bad as it first seems. Many companies base executive compensation programs on stock, which leaves insiders with no practical way of buying new homes or sending their children to college other than by selling their holdings. Furthermore, insiders often have only a few weeks each quarter in which to accomplish these transactions. This is to prevent them from trading on information that hasn't yet been released to the public. Having said that, insider selling generally does not imply confidence in a company's future; and if they're selling in large quantities, that's a very poor signal indeed.
Of course, the abovementioned events are only a very abbreviated list of factors that can affect market perceptions of future earnings or investors' confidence that earnings will be met. Regardless of the investment strategy or style that you employ, be aware that these issues must always be taken into account.
Let's take a look at just a few events that can change the perception of a stock's future earnings and the confidence level about those earnings. The different strategies that you may use in implementing your investment program should closely monitor these factors.
Earnings announcements. A company's quarterly earnings are the primary factor in altering market perception and investor confidence, although the direction of the change may not always be what's expected. For example, the just-announced earnings figures could actually be record-setting, but the market may have expected an even larger number, one based on 'whisper numbers' (which are those unofficial earnings estimates that are spoken of by brokers and analysts in phone calls and informal settings a week or two before a company's earnings announcement is released; although unofficial, these figures are the market's true expectations of the company's earnings). Consequently, what appears to be positive news is perceived as negative, and the stock price declines. A company's failure to meet its whisper numbers is often viewed as an early warning that future earnings and the accompanying expected growth rate might not be reached. However, if a company announces earnings that meet or exceed the market's expectations (especially if it has a history of doing so), the perception of a strong future along with investor confidence that it can be achieved can boost a stock to record levels.
Revising estimates. One of the most accurate forecasters of positive or negative moves in a stock's price is the one-month change in analysts' estimates. Generally speaking, the first research report written by an analyst is positive. This is due to the fact that, frequently, the analyst is performing his or her duty to the firm and looking for good things to say. A revision of those estimates, however, is quite meaningful because it requires a separate initiative by the analyst to admit that he or she was wrong or simply had a change of mind. An upward revision in earnings estimates will likely produce a positive change in the price of a stock. However, a downward revision will tend to have an even more dramatic effect on the stock price than an upward revision; in fact, it could be devastating. It takes a great deal of courage for an analyst to lower an estimate, because in many cases he or she is saying something negative about a client of the firm. Additionally, the number of analysts who make a revision is also highly significant. Several analysts raising or lowering their estimates will have a much greater impact on a stock than just one analyst issuing a revision.
Company warnings. When a company itself advises stockholders that it won't meet its next earnings estimates, the news should be taken very seriously. This kind of announcement automatically causes such a fall in the price of a stock that it's a safe bet the company is telling the truth. Therefore, company disclosures are one of the best ways of knowing what's likely to happen to future earnings.
Interest rate changes. The lowering of interest rates has two potential impacts on stocks, both generally thought to be positive. First, the prevailing sentiment is that lower interest rates give consumers more money to spend, which translates into higher profits for businesses, which in turn makes companies more willing to spend money on inventory, research, new products, and expansion – all of which stimulate the economy. Higher profits are expected to lead to increased earnings, so investors become more confident about the future earnings potential of companies in general. In this way, lower rates are intended to produce a positive ripple effect throughout the economy.
The second positive impact of lowering interest rates has nothing to do with market perception of future earnings or investor confidence at all. Lower rates simply make investors less likely to buy debt instruments (bonds) and more likely to buy equities (stocks), thereby driving up stock prices across the board.
Conversely, an increase in interest rates has precisely the opposite effect. Higher rates cut into business profits and act as a restraint on consumer and company spending, all of which work to slow down the economy. And higher interest rates siphon money out of the equity markets and direct it toward debt instruments.
Insider trading. If company insiders use their own money to buy stock on the open market, it's a pretty good sign that they believe their company's future earnings are going to be better than the market expects. At minimum, it indicates that they feel the company's stock price is too low at that time. And company insiders should know the company's prospects best (of course, insiders aren't always right).
On the other hand, insider selling, while not a good sign, may not necessarily be as bad as it first seems. Many companies base executive compensation programs on stock, which leaves insiders with no practical way of buying new homes or sending their children to college other than by selling their holdings. Furthermore, insiders often have only a few weeks each quarter in which to accomplish these transactions. This is to prevent them from trading on information that hasn't yet been released to the public. Having said that, insider selling generally does not imply confidence in a company's future; and if they're selling in large quantities, that's a very poor signal indeed.
Of course, the abovementioned events are only a very abbreviated list of factors that can affect market perceptions of future earnings or investors' confidence that earnings will be met. Regardless of the investment strategy or style that you employ, be aware that these issues must always be taken into account.
How a Securities Trade is implemented
Securities transactions take place either on an exchange or in the over-the-counter (OTC) market. While the purpose of both is to match securities buyers and sellers, the way that they carry this out is very different. For instance, let's look first at the country's oldest and most prestigious exchange, the New York Stock Exchange (NYSE).
When a customer wants to buy or sell a stock that trades on the NYSE, he or she places an order with a firm that's a member of the exchange. Only member firms can transact business on the exchange. Being a member of an exchange is referred to as "owning a seat" on that exchange. The customer's order is transmitted electronically to the floor clerk at the firm's clerk booth. The floor clerk gives the order to a floor broker who proceeds out to the trading post (the specific location on the trading floor where that particular stock is traded). Each stock trades at only one trading post on the exchange floor.
At the trading post, the floor broker will attempt to execute the client's order. The order can be executed either with a floor broker from another firm or with the specialist who is responsible for maintaining an orderly market in that stock. For example, let's assume that the floor broker for ABC Securities has an order to purchase 5,000 shares of Microsoft stock. When the floor broker arrives at the Microsoft trading post, if a floor broker from another firm has 5,000 or more shares for sale, the two would negotiate a price and complete the transaction. (With actively traded stocks, there are usually several floor brokers at the post looking to execute orders.)
If, on the other hand, the floor broker arrives at the trading post and there are no others present with shares to sell, the broker can transact business with the specialist in that stock. The specialist's role is to maintain an orderly market and to provide liquidity to the marketplace. When no one else is available to buy or sell, the specialist stands ready to perform that function.
Obviously, this process tends to be somewhat labor-intensive and therefore only suitable for larger orders. Orders for a relatively few shares are executed automatically at the bid and ask prices posted by the specialist. Therefore, small orders – of a thousand shares or less – can normally be executed instantly.
Any security transaction that does not take place on a security exchange is said to occur in the over-the-counter (OTC) market. Regularly traded in the OTC market are U.S. government and agency securities, corporate and municipal bonds, and small capitalization stocks, to name just a few.
Unlike the centralized trading floors of exchanges, the OTC market has no central location. The actual OTC market is instead a telecommunications market. It consists of firms located throughout the country, any of which can trade with another firm electronically. Since phone lines are available in virtually every part of the country, the OTC market effectively operates without geographical or physical boundaries.
When a customer wants to buy or sell a stock that trades on the NYSE, he or she places an order with a firm that's a member of the exchange. Only member firms can transact business on the exchange. Being a member of an exchange is referred to as "owning a seat" on that exchange. The customer's order is transmitted electronically to the floor clerk at the firm's clerk booth. The floor clerk gives the order to a floor broker who proceeds out to the trading post (the specific location on the trading floor where that particular stock is traded). Each stock trades at only one trading post on the exchange floor.
At the trading post, the floor broker will attempt to execute the client's order. The order can be executed either with a floor broker from another firm or with the specialist who is responsible for maintaining an orderly market in that stock. For example, let's assume that the floor broker for ABC Securities has an order to purchase 5,000 shares of Microsoft stock. When the floor broker arrives at the Microsoft trading post, if a floor broker from another firm has 5,000 or more shares for sale, the two would negotiate a price and complete the transaction. (With actively traded stocks, there are usually several floor brokers at the post looking to execute orders.)
If, on the other hand, the floor broker arrives at the trading post and there are no others present with shares to sell, the broker can transact business with the specialist in that stock. The specialist's role is to maintain an orderly market and to provide liquidity to the marketplace. When no one else is available to buy or sell, the specialist stands ready to perform that function.
Obviously, this process tends to be somewhat labor-intensive and therefore only suitable for larger orders. Orders for a relatively few shares are executed automatically at the bid and ask prices posted by the specialist. Therefore, small orders – of a thousand shares or less – can normally be executed instantly.
Any security transaction that does not take place on a security exchange is said to occur in the over-the-counter (OTC) market. Regularly traded in the OTC market are U.S. government and agency securities, corporate and municipal bonds, and small capitalization stocks, to name just a few.
Unlike the centralized trading floors of exchanges, the OTC market has no central location. The actual OTC market is instead a telecommunications market. It consists of firms located throughout the country, any of which can trade with another firm electronically. Since phone lines are available in virtually every part of the country, the OTC market effectively operates without geographical or physical boundaries.
How Globalization affects U.S. Companies
The notion of a global marketplace is no longer a trend of the future – it's here now. No longer are corporate behemoths such as Coca-Cola, Ford or Sony the only global enterprises. Today, companies that operate with just a few employees and an Internet presence can, and do, compete effectively on the global stage. As such, even individuals who choose not to invest in security instruments denominated in currencies other than their own reference currency must still be aware of how the fluctuation of currency values will affect the performance of their investments. To illustrate this point, let's consider the possibilities of how American investors who purchase stock in domestic companies are affected by foreign exchange (or FX) risks if the companies that they invest in either import, export, have overseas operations, or have foreign competitors.
U.S. companies that import raw materials or goods from overseas are exposed to the risk that the U.S. dollar will decline. If it does, the cost of the imported goods will rise when valued in terms of the dollar.
U.S. companies that export raw materials or goods overseas are exposed to the risk that the dollar may increase in value. If the dollar gets stronger, the revenue that the company generates in other currencies will, in turn, buy fewer dollars.
U.S. companies that have overseas operations are exposed to the risk that either the dollar will strengthen or weaken, depending upon whether they're making overseas investments or bringing profits back home. If the company is investing overseas, the risk is that of a declining dollar. If repatriating its profits, the company would prefer not to see a strengthening dollar. Take a look at the following situation:
An American company enters into a contract to build a new manufacturing plant in France. It will take a full three years to complete the plant, bring it online, and have it become profitable. During those three years, the U.S. company will be converting dollars into francs, and will be exposed to the risk that the dollar will decline, thereby buying fewer francs. After the plant becomes profitable, the company will be converting francs into dollars and the risk will be that the dollar will get stronger (less dollars bought by the francs).
Even United States companies that don't import, export, or have overseas operations – but only have foreign competitors – are often exposed to FX risk. Let's examine the scenario of an American company that is not engaged nor has any interest in importing or exporting goods; all of their products are sold in the U.S. A foreign competitor, however, does have an interest in doing business internationally. For instance, if the dollar were to rise sharply against the foreign company's home currency, it would be able to charge less dollars for its goods sold in America while still maintaining its profit margin. This is because the company's expenses are denominated in its reference currency – which the strengthened dollar would now buy more of. As such, the viability of the U.S. company could be threatened by the FX risk.
The changing value of the United States dollar affects virtually every American company to one degree or another. Therefore, even U.S. investors who restrict themselves to buying only domestic investments need to be aware of how changing FX rates affect their portfolios. In order to do this, investors should understand some of the reasons that foreign exchange rates change.
U.S. companies that import raw materials or goods from overseas are exposed to the risk that the U.S. dollar will decline. If it does, the cost of the imported goods will rise when valued in terms of the dollar.
U.S. companies that export raw materials or goods overseas are exposed to the risk that the dollar may increase in value. If the dollar gets stronger, the revenue that the company generates in other currencies will, in turn, buy fewer dollars.
U.S. companies that have overseas operations are exposed to the risk that either the dollar will strengthen or weaken, depending upon whether they're making overseas investments or bringing profits back home. If the company is investing overseas, the risk is that of a declining dollar. If repatriating its profits, the company would prefer not to see a strengthening dollar. Take a look at the following situation:
An American company enters into a contract to build a new manufacturing plant in France. It will take a full three years to complete the plant, bring it online, and have it become profitable. During those three years, the U.S. company will be converting dollars into francs, and will be exposed to the risk that the dollar will decline, thereby buying fewer francs. After the plant becomes profitable, the company will be converting francs into dollars and the risk will be that the dollar will get stronger (less dollars bought by the francs).
Even United States companies that don't import, export, or have overseas operations – but only have foreign competitors – are often exposed to FX risk. Let's examine the scenario of an American company that is not engaged nor has any interest in importing or exporting goods; all of their products are sold in the U.S. A foreign competitor, however, does have an interest in doing business internationally. For instance, if the dollar were to rise sharply against the foreign company's home currency, it would be able to charge less dollars for its goods sold in America while still maintaining its profit margin. This is because the company's expenses are denominated in its reference currency – which the strengthened dollar would now buy more of. As such, the viability of the U.S. company could be threatened by the FX risk.
The changing value of the United States dollar affects virtually every American company to one degree or another. Therefore, even U.S. investors who restrict themselves to buying only domestic investments need to be aware of how changing FX rates affect their portfolios. In order to do this, investors should understand some of the reasons that foreign exchange rates change.
How Economic Cycles affect Investing
Economic cycles have been with us since the beginning of recorded history. In ancient agrarian times, they were identified by periods of bumper crops followed by episodes of drought or pestilence. Today, we track these cycles by the relative strength or weakness of our current medium of exchange, money. In times of economic boon – which typically last an average of about four or five years – people often become lulled into a false sense of security, believing that the good times will go on forever. Jobs are abundant. Workers ask for and receive higher wages, making more cash available for the purchase of goods and services. Additionally, more people invest in the stock market, causing it to go up – a direct reflection of the public's rising expectations.
More investor purchases work to create more demand, which pushes prices even higher. Because of this, every investor believes that he or she will be able to sell at a profit to someone else later on (the so-called "greater fool theory" in action). They begin to ignore the fundamental value of what they're purchasing, thinking that they're buying future profits. Then, when high expectations are no longer being met, prices begin to drop. Investors who are unsure of themselves or their assets panic and start dumping them. This pushes prices down even further. Eventually, the economy finally runs out of steam and begins to falter.
There are a number of causes that might precipitate these occurrences. For instance, labor or material shortages and demands for increased wages could slow down business productivity. External factors, such as economic embargoes, might create additional shortages. And acts of Congress (such as tax increases) or the Federal Reserve (in regulating the nation's money supply and interest rates in an effort to slow down the economy or stave off a contraction) can dramatically affect economic cycles.
Since the post-World War II era began, economic contractions (more commonly known as recessions) have lasted an average of less than three years. During this cyclic downturn, the greater and more widespread the public's pessimism, the lower prices sink. Once prices have nearly bottomed out, most investors typically find that they either have no money left (because they've lost it in the market's fall) or, if they do have money, they're too pessimistic or scared to invest further. Only after the market has made a recovery and prices begin to rebound does the general investing public come back. When that happens, the cycle begins all over again.
It's important to note that, historically, each subsequent boon has reached a higher level than the previous one. The savvy investor realizes this and maintains a long-term perspective. In good times he or she will act conservatively by avoiding the speculative fervor of the masses, and in bad times will adopt the attitude that investment opportunities are being created for long-term gains. In this manner, the careful investor will avoid getting hurt during temporary economic downturns, and may even build a position to take advantage of them. Over the long haul, his or her assets will grow in value along with the overall net growth of the economy. Many financial advisors emphasize the wisdom of long-term investment for this very reason.
More investor purchases work to create more demand, which pushes prices even higher. Because of this, every investor believes that he or she will be able to sell at a profit to someone else later on (the so-called "greater fool theory" in action). They begin to ignore the fundamental value of what they're purchasing, thinking that they're buying future profits. Then, when high expectations are no longer being met, prices begin to drop. Investors who are unsure of themselves or their assets panic and start dumping them. This pushes prices down even further. Eventually, the economy finally runs out of steam and begins to falter.
There are a number of causes that might precipitate these occurrences. For instance, labor or material shortages and demands for increased wages could slow down business productivity. External factors, such as economic embargoes, might create additional shortages. And acts of Congress (such as tax increases) or the Federal Reserve (in regulating the nation's money supply and interest rates in an effort to slow down the economy or stave off a contraction) can dramatically affect economic cycles.
Since the post-World War II era began, economic contractions (more commonly known as recessions) have lasted an average of less than three years. During this cyclic downturn, the greater and more widespread the public's pessimism, the lower prices sink. Once prices have nearly bottomed out, most investors typically find that they either have no money left (because they've lost it in the market's fall) or, if they do have money, they're too pessimistic or scared to invest further. Only after the market has made a recovery and prices begin to rebound does the general investing public come back. When that happens, the cycle begins all over again.
It's important to note that, historically, each subsequent boon has reached a higher level than the previous one. The savvy investor realizes this and maintains a long-term perspective. In good times he or she will act conservatively by avoiding the speculative fervor of the masses, and in bad times will adopt the attitude that investment opportunities are being created for long-term gains. In this manner, the careful investor will avoid getting hurt during temporary economic downturns, and may even build a position to take advantage of them. Over the long haul, his or her assets will grow in value along with the overall net growth of the economy. Many financial advisors emphasize the wisdom of long-term investment for this very reason.
Investing 101
It’s never too early to begin thinking of your financial future, whether you’re nearing retirement or just getting started. As a matter of fact, the longer you wait before you begin implementing a financial plan to reach your goals, the farther behind the curve you’ll be. It’s also very tough to catch up, and getting tougher by the day. With the value of the dollar continuing to erode, it’s obvious that it will take more of them later to do the same job that they are doing now. It’s also becoming clearer that in order to fund your retirement adequately, investing has ceased being a luxury of the well-to-do. It’s become a requirement for anyone wishing to maintain a comfortable lifestyle in their later years.
For the average person, however, the subject of investing can quite daunting. It’s a culture that has its own complete vocabulary. The stock market, the Dow Jones, the symbols and countless graphs, needless to say, can keep one hopelessly confused. But with a little time and elbow grease, you’ll become familiar with the jargon of investors. Take a few moments to familiarize yourself with some basic terms in our Investment Glossary. Then do a little studying. A good beginning overview can be found here, entitled Investing Lessons and Quizzes.
Keep in mind that you don’t have to be an expert in order to get into the game. And you don’t need a lot of money to get started. Just make sure that you’re comfortable with the amount that you’re going to invest. If you are, then you’re ready to take the first step in building your investment portfolio, which is to open a brokerage account. This account will allow you to trade stocks, bonds, mutual funds, and other investments by paying professionals to buy or sell the items that you direct them to.
The fee that you pay for this service is called a commission, and can range from as low as $5 to several hundred dollars and up. The price difference arises when you choose between either a discount or traditional broker. Traditional brokerage houses provide a wider range of services, and charge accordingly. They can generally be thought of as professional money managers who can offer advice as to what investments might be right for you. Discount brokers, on the other hand, are tailored to the more self-directed investor; they don't offer counsel as to what to put your money into, leaving you to make your own financial decisions and charging you much less than traditional brokerage firms. Some companies offer both types of service, allowing their clients to choose the format that’s most comfortable for them.
When opening a new account, the minimum investment can vary, usually ranging from $500-$1,000 (although some accounts can be opened for as little as $100). Many firms allow the process to be conducted online. Once your account is open, you can begin investing. All brokerages give you the option of setting up automatic monthly deposits, which will transfer an amount that you specify each month from your savings or checking account to your brokerage account, helping you to build your equity easily and conveniently.
Begin slowly and carefully, and make a commitment to invest for the long term. With proper training, planning and experience, you can build a portfolio that will enable your financial future to be solid.
For the average person, however, the subject of investing can quite daunting. It’s a culture that has its own complete vocabulary. The stock market, the Dow Jones, the symbols and countless graphs, needless to say, can keep one hopelessly confused. But with a little time and elbow grease, you’ll become familiar with the jargon of investors. Take a few moments to familiarize yourself with some basic terms in our Investment Glossary. Then do a little studying. A good beginning overview can be found here, entitled Investing Lessons and Quizzes.
Keep in mind that you don’t have to be an expert in order to get into the game. And you don’t need a lot of money to get started. Just make sure that you’re comfortable with the amount that you’re going to invest. If you are, then you’re ready to take the first step in building your investment portfolio, which is to open a brokerage account. This account will allow you to trade stocks, bonds, mutual funds, and other investments by paying professionals to buy or sell the items that you direct them to.
The fee that you pay for this service is called a commission, and can range from as low as $5 to several hundred dollars and up. The price difference arises when you choose between either a discount or traditional broker. Traditional brokerage houses provide a wider range of services, and charge accordingly. They can generally be thought of as professional money managers who can offer advice as to what investments might be right for you. Discount brokers, on the other hand, are tailored to the more self-directed investor; they don't offer counsel as to what to put your money into, leaving you to make your own financial decisions and charging you much less than traditional brokerage firms. Some companies offer both types of service, allowing their clients to choose the format that’s most comfortable for them.
When opening a new account, the minimum investment can vary, usually ranging from $500-$1,000 (although some accounts can be opened for as little as $100). Many firms allow the process to be conducted online. Once your account is open, you can begin investing. All brokerages give you the option of setting up automatic monthly deposits, which will transfer an amount that you specify each month from your savings or checking account to your brokerage account, helping you to build your equity easily and conveniently.
Begin slowly and carefully, and make a commitment to invest for the long term. With proper training, planning and experience, you can build a portfolio that will enable your financial future to be solid.
Keep Watch over your Investments
Risk can creep up on even vigilant investors. For instance, your holdings in a retirement plan may grow more quickly than you realize, particularly if you make regular contributions or reinvest your returns. But along with this success comes a problem. Growth in one asset can throw your portfolio out of balance if other investments don't keep up. If a prolonged bull market boosts the value of your stockholdings, you may need to sell some shares to restore the balance between stocks and other assets. Similarly, when a single stock does extremely well, you might need to twist your own arm in order to bring yourself to unload some shares. And be especially wary of loading up on your employer's company stock through retirement and savings plans. If the company runs into difficulties, both your job and your stock could be endangered at the same time. Furthermore, if you live in a very small one-company town, the value of your home could also be indirectly tied to the fortunes of that organization. So keep a watchful eye on changes in your own investment portfolio. Carefully scrutinize your investments and other aspects of your finances from time to time. Here's a rundown of the strengths and weaknesses of some types of assets:
Stocks are vulnerable to the possibility that nervous investors will panic for some reason and drive share prices down as a whole – an example of market risk. But risks related to inflation, interest rates or economic growth might vary considerably from one stock to another. For example, a sharp increase in the rate of inflation could drive stock prices down by reducing the purchasing power of future shareholder dividends. Additionally, inflation generally travels with higher interest rates, which tend to draw investors from stocks into bonds. Because firms such as retailers, consumer product manufacturers and service companies can pass cost increases along to customers with relative ease, they're typically more likely to prosper during periods of high inflation.
On the other hand, slowing economic growth can hurt some businesses more than others. For instance, manufacturing companies that have high overhead costs can't easily cut their expenses when a recession reduces sales, so their earnings quickly fall off. Many emerging growth companies also require an expanding economy to sustain their earnings growth and stock prices. In contrast, however, firms that sell staple necessities such as food or clothing often continue to operate largely unaffected in a weak economy, and their shares tend to hold their value relatively well.
Stocks also carry specific risks – those that are unique to a single company or industry. Poor management, for example, can have a dramatically negative effect on earnings, even to the point of bankrupting a business. And growth stocks are particularly vulnerable to projected earnings shortfalls. One way to reduce such risks is to buy shares that appear to be undervalued because they're selling at comparatively low price-to-earnings (P/E) ratios.
Bond prices fall when interest rates rise. But the extent of a particular bond's drop depends upon its maturity and the amount of its coupon (the bond's stated interest rate). Short-term bonds fall slightly when interest rates move upward, and a high coupon also offers a degree of protection against climbing rates. Zero-coupon bonds, on the other hand, fall sharply when rates move higher.
A recession generally brings with it lower interest rates, which boost bond prices. But some bond issues react negatively to an economic downturn. Junk bonds, in particular, may suffer because investors fear that financially weak companies will default and fail to make their scheduled payments to bondholders on time. U.S. Treasury and high-grade corporate bonds gain the most during hard times because income investors often flock to them as safe havens.
Stocks are vulnerable to the possibility that nervous investors will panic for some reason and drive share prices down as a whole – an example of market risk. But risks related to inflation, interest rates or economic growth might vary considerably from one stock to another. For example, a sharp increase in the rate of inflation could drive stock prices down by reducing the purchasing power of future shareholder dividends. Additionally, inflation generally travels with higher interest rates, which tend to draw investors from stocks into bonds. Because firms such as retailers, consumer product manufacturers and service companies can pass cost increases along to customers with relative ease, they're typically more likely to prosper during periods of high inflation.
On the other hand, slowing economic growth can hurt some businesses more than others. For instance, manufacturing companies that have high overhead costs can't easily cut their expenses when a recession reduces sales, so their earnings quickly fall off. Many emerging growth companies also require an expanding economy to sustain their earnings growth and stock prices. In contrast, however, firms that sell staple necessities such as food or clothing often continue to operate largely unaffected in a weak economy, and their shares tend to hold their value relatively well.
Stocks also carry specific risks – those that are unique to a single company or industry. Poor management, for example, can have a dramatically negative effect on earnings, even to the point of bankrupting a business. And growth stocks are particularly vulnerable to projected earnings shortfalls. One way to reduce such risks is to buy shares that appear to be undervalued because they're selling at comparatively low price-to-earnings (P/E) ratios.
Bond prices fall when interest rates rise. But the extent of a particular bond's drop depends upon its maturity and the amount of its coupon (the bond's stated interest rate). Short-term bonds fall slightly when interest rates move upward, and a high coupon also offers a degree of protection against climbing rates. Zero-coupon bonds, on the other hand, fall sharply when rates move higher.
A recession generally brings with it lower interest rates, which boost bond prices. But some bond issues react negatively to an economic downturn. Junk bonds, in particular, may suffer because investors fear that financially weak companies will default and fail to make their scheduled payments to bondholders on time. U.S. Treasury and high-grade corporate bonds gain the most during hard times because income investors often flock to them as safe havens.
Let the IRS Help Your Investment Returns
Income taxes can take a serious bite out of your savings and investment plan. Fortunately, the federal government is well aware of this, and gives taxpayers a break in the form of several IRS-approved tax-deferred investment plans. These investment vehicles allow you to put money away for your retirement and not pay any taxes on your gains until you begin to make withdrawals when you’re in your 50’s or later. This allows the magic of compound interest to go to work for you, earning you interest on top of interest. It’s an extremely effective way of building your financial nest egg.
With an Individual Retirement Account (IRA) you can invest up to $4,000 per year in virtually any type of security instrument you choose, from a bank Certificate of Deposit to individual stocks to mutual funds. Just tell the financial institution that you want your investment to be sheltered in an IRA. You must report your investment on your tax return, but you don’t have to pay any taxes on your gains until you begin to withdraw the funds at retirement age. If you have a spouse who doesn’t work, you can also open a Spousal IRA and contribute up to an additional $4,000 per year into it.
The 401(k) is a qualified plan (which means it meets the requirements of the Internal Revenue Code) that’s established by employers into which eligible employees can make salary-deferral contributions. In other words, the contribution comes directly off the top of your paycheck without your ever seeing the money. This makes saving and investing automatic, eliminating the need for you have to decide if you’re going to save each month. The biggest benefit of a 401(k) plan is that many employers will either match or partially match your contribution, which means you get a pretax investment, tax-deferred compounding of your interest earned, and an extra addition to your principal from your company (essentially, free money). This allows the value of your investment to grow at an even faster rate. Nonprofit employers offer a similar plan called the 403(b). It’s basically the same arrangement as the 401(k); the difference in name derives from it being part of a different section of the Tax Code.
An Annuity is a bit like a combination of an IRA and a life insurance policy. Like an IRA, an annuity allows you to earn interest and capital gains on your investment without paying any taxes until you begin to withdraw the funds at retirement age. And like an IRA you’ll face a 10% penalty if you withdraw before your eligible age. But unlike the IRA, you can make virtually unlimited contributions yearly. Those contributions, however, are with after-tax dollars, so you don’t get the tax deduction benefit that’s available with the IRA or 401(k). But since an annuity is basically a quasi-insurance vehicle, once you begin withdrawing your money (or, annuitizing), you’re guaranteed to receive an income for the rest of your life. In other words, you’ll never outlive your retirement funds.
With an Individual Retirement Account (IRA) you can invest up to $4,000 per year in virtually any type of security instrument you choose, from a bank Certificate of Deposit to individual stocks to mutual funds. Just tell the financial institution that you want your investment to be sheltered in an IRA. You must report your investment on your tax return, but you don’t have to pay any taxes on your gains until you begin to withdraw the funds at retirement age. If you have a spouse who doesn’t work, you can also open a Spousal IRA and contribute up to an additional $4,000 per year into it.
The 401(k) is a qualified plan (which means it meets the requirements of the Internal Revenue Code) that’s established by employers into which eligible employees can make salary-deferral contributions. In other words, the contribution comes directly off the top of your paycheck without your ever seeing the money. This makes saving and investing automatic, eliminating the need for you have to decide if you’re going to save each month. The biggest benefit of a 401(k) plan is that many employers will either match or partially match your contribution, which means you get a pretax investment, tax-deferred compounding of your interest earned, and an extra addition to your principal from your company (essentially, free money). This allows the value of your investment to grow at an even faster rate. Nonprofit employers offer a similar plan called the 403(b). It’s basically the same arrangement as the 401(k); the difference in name derives from it being part of a different section of the Tax Code.
An Annuity is a bit like a combination of an IRA and a life insurance policy. Like an IRA, an annuity allows you to earn interest and capital gains on your investment without paying any taxes until you begin to withdraw the funds at retirement age. And like an IRA you’ll face a 10% penalty if you withdraw before your eligible age. But unlike the IRA, you can make virtually unlimited contributions yearly. Those contributions, however, are with after-tax dollars, so you don’t get the tax deduction benefit that’s available with the IRA or 401(k). But since an annuity is basically a quasi-insurance vehicle, once you begin withdrawing your money (or, annuitizing), you’re guaranteed to receive an income for the rest of your life. In other words, you’ll never outlive your retirement funds.
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