Everything You Always Wanted to Know About Investing*
When it comes to the psychological fears of stock investors, Mark Twain perhaps said it best:
“October. This is one of the peculiarly dangerous months to speculate in stocks. Other dangerous months are July, January, September, April, November, May, March, June, December, August and February.”
We wouldn’t go that far. But as the steep stock declines of this month have reminded us, the financial markets can still humble even the most seasoned investor.
For now, let’s put aside the more complex terms about the stock market. Here’s a list of facts — call it “Stock Investing 101” — that every investor wishes that he or she knew about the stock market, but felt too self-conscious to actually ask.
This article isn’t just for novices. The following list encompasses basic concepts that even many sophisticated, experienced stock investors have either forgotten, thought they knew, or never knew to begin with.
If I were to test you on these terms, without letting you first read the definitions, how would you score? I thought so.
Although hardly a comprehensive list, I chose crucial terms that, according to my experience, are neglected or misunderstood, but nonetheless form the basis of sound stock investing knowledge:
- The ease with which you can buy or sell shares is called market liquidity.
- Volume is how many shares are traded over a given period of time. The higher the volume, the greater the liquidity.
- Companies often launch stock splits to boost liquidity.
- The larger markets have market makers, who buy and sell to keep trading liquid.
- The ask is the amount at which a market maker will sell to you.
- The bid is the amount at which a market maker will buy from you.
- The spread is the difference between the ask and the bid prices, and it’s how the market maker profits.
- A dividend is a return of money to shareholders. Dividends are taxed at a lower rate than other gains.
- The dividend yield is the percentage of invested money that will be returned to the investor every year in dividends.
- Ex-dividend date is the date at which you must own the stock, to get the next dividend.
- Payout ratio is the percentage of cash flow or earnings that a dividend will consume.
- Stock shares are often categorized into certain groups, typically known as Class A and Class B stock. They’re usually identical, except the holders exercise different voting rights.
- Preferred shares largely lack voting rights, but holders get their dividend first. If the dividend is missed, it must be paid in full before common stock receives its dividend.
- Market cap is a company’s worth if purchased completely from outstanding shares. The formula to determine market cap: share price times outstanding shares.
- Fundamental traders and analysts subscribe to the investing philosophy that a stock price’s worth is tied to the underlying metrics of the company, the company’s sector, and the broader economy.
- Technical traders and analysts act according to the theory that everything you need to know about a particular stock is priced into that stock, and the vicissitudes of the price are more revealing about the future price than the underlying business and economic fundamentals. (Smart investors are non-dogmatic about these two schools of thought and blend the two philosophies into a hybrid one.)
- Resistance is the price point that appears to impede the rise of a stock price.
- Support is a price point that appears to halt a stock price’s decline.
- Exchange-traded funds (ETFs) are baskets of stocks, representing a variety of securities, that you can buy and sell on common exchanges.
- Exchange-traded notes (ETNs) are senior, unsecured, unsubordinated debt security issued by an underwriting bank. ETNs have a maturity date and are backed only by the credit of the issuer.
Letters to the Editor
“Wall Street pundits note that Vanguard index funds aren’t influenced by the VIX index. Are ETFs influenced by the VIX? Are both influenced by algorithms and program trading?” — Grant P.
The vast majority of put and call index options that comprise the CBOE Volatility Index (VIX) are traded by institutional investors as insurance against a stock market crash. Consequently, the VIX tends to overstate downside risk during a correction and overstate optimism during a bull market.
Indirectly, both the VIX and most ETFs are influenced by algorithms, since selling begets more selling due to the triggering of stop-loss orders. Short sellers pile on and program trading by index ETFs must mimic the weighting of the index, which is constantly changing.
Keep in mind, the VIX is a measure of fear in the stock market. But it’s a poor predictor of the market’s future direction.
The Chicago Board Options Exchange created the VIX as a gauge of “implied volatility” in the market. It’s based on the amount of trading in near-term put and call options on the S&P 500 index.
The VIX rises when demand for put options outweighs demand for calls. Put options increase in value when the S&P 500 declines in value. The VIX falls when demand for call options outstrips demand for puts. Call options increase in value when the index goes higher.
The VIX is not a leading indicator, as many investors mistakenly believe. The VIX measures current market fear, of which there has been plenty in recent days.
Questions about the VIX? Drop me a line: email@example.com
John Persinos is managing editor of Personal Finance and chief investment strategist of Breakthrough Tech Profits.