Last Updated on 3 November, 2022 by Samuelsson
Whether it’s from the internet, financial news channels, social media, traditional news media, or even your colleagues at work, it is almost impossible for a day to pass without hearing a thing or two about stocks. While you may be conversant with the stock market and even invested in it, do you know what a stock is?
A stock represents all the shares into which the ownership of a company is divided, while the fractional unit of ownership is known as a share — though, both terms are often used interchangeably. Investing in stocks offers you the right to get dividends from the companies that issue the stocks you bought, and you also gain when the stocks appreciate in market value.
There are a lot of things to learn about stocks, so we prepared this comprehensive guide to teach you the basic things you need to know. In this guide, you will learn the following:
- The history of stocks
- What stocks are
- The difference between penny stocks and normal stocks
- When and why companies issue stocks
- What splits and mergers are
- How to make money from stocks
- The stock portfolio
- How to buy stocks
- How to invest in stock market indexes
- The difference between stocks and bonds
History of Stocks
In recent times, stocks are playing huge roles in peoples’ wealth growth plans, but it wasn’t that way in the beginning. Today, we’re going to take a look at how the idea of stocks came about and how it has developed over the years. Hee, we will discuss the history of stocks in three stages:
- Before the Common Era
- During the modern era
- The recent development
Before Common Era
Although it is still debated in some quarters, there seems to be some evidence that there were elements of stock trading in the Roman Republic, which existed between 510 BC and 27 AD. It appeared that the Romans, as at then, had joint-stock companies that the citizen could buy into, directly as individuals or indirectly through cooperatives.
The government of the day would lease out its services to private corporations. Those private companies that hold government contracts were called publicani (as a group) or societas publicanorum (individually), in Latin. The companies were not very different from the types of companies we have now, as they were similar in so many aspects.
For instance, it is believed that they issued shares. There were two types of shares then — partes and particulae. Partes was the name for the type of shares issued to large cooperatives, while particulae was the type of small shares that individuals could buy over the counter. So by being a member of a cooperative group, individuals also had access to partes, though indirectly.
These semblances of stocks traded throughout the Republic, and there was evidence that their prices fluctuated from time to time. Individuals and cooperatives would buy these stocks from the companies and later resell their ownership to other citizens. People were buying those shares to participate in government contracts, and almost all eligible citizens participated in trading those stocks.
In the modern era
The first modern type of stock didn’t arrive until the early part of the 17th century when the Dutch East India Company — one of the most popular joint-stock companies of that time — issued the stock of its company to the public. However, history showed that during the medieval period, there were some forms of modern companies that had stocks.
About the year 1250 at Toulouse in France, Bazacle Milling Company had 96 shares whose value were trading according to the profits made from the company’s mills. Similarly, by 1288, it was documented that the Swedish mining and forestry product company, Stora, made a stock transfer to the bishop of Vasteras.
The company transferred a 12.5% interest in a copper mine (the Great Copper Mountain) it owned to the bishop of Vasteras in exchange for one of the estates owned by the bishop. While the sale may not have happened on a stock exchange, and it may not have been presented in share units, it showed there’s an exchange of part ownership in a company — stock trading.
In the 1600s, the imperial governments in Europe — the British, Dutch, and French — granted charters to companies operating in the East Indies. The British East India Company was granted an English Royal Charter by Queen Elizabeth I on the 31st of December 1600, making it one of the earliest recognized joint-stock company in the post-medieval period. The charter gave the company a monopoly on all trades in the East Indies for 15 years.
The French and Dutch East India companies were formed about the same time. Their business operations involved sailing to the far-away Indian subcontinent, which is associated with a lot of risks — pirates, weather risks, and poor navigation.
On discovering the East Indies and its riches, lots of explorers sailed there, but only a few of the voyages made it back home. Many ships were lost and fortunes squandered. Shipowners realized that they had to do something to reduce the risk of ruining their fortunes when ships are lost. They started forming limited liability companies for each voyage to share their risks and returns with others — those were the precursors of the East India companies.
Related reading: How Do Stocks Make Money?
The financiers would seek investors who would contribute money for a voyage in return for a percentage of the profits from the voyage. Realizing how dangerous it was to put all their investment on one voyage, investors started betting on several of those voyages at the same time, to improve the odds of making profits. For instance, let’s assume that a voyage had a 35% chance of being lost. Rather than staking all his money in one company, an investor would invest in four or more companies at the same time. So if one of the ships could not make it back home, the investor would still make some profit from the others.
The formation of the British, French, and Dutch East India companies changed the entire business model. In 1602, the Dutch East India Company, for the first time, issued its shares to the public on the Amsterdam Stock Exchange, thereby becoming the first publicly traded company in the world.
Soon after, other East India companies also issued their stocks and bonds to willing investors. Rather than sharing profits voyage by voyage, these companies issued their companies’ shares and paid dividends to their stockholder on all the voyages the companies undertook. The East India companies, therefore, became the first modern joint-stock companies, and with the type of monopoly they enjoyed, they grew very big and build larger ships — growing the value of their stocks.
The stock certificates of those companies were handwritten on a piece of paper, so investors were able to trade these papers with other investors in coffee shops. Since there no physical exchange buildings in England as at then, an investor would have to look for a broker to conduct a trade. Most times, an investor would get a broker in a coffee shop, and they would conduct their transactions there. With time, a few coffee shops in London became associated with stock trading. Stock papers would be written and posted on coffee shops’ doors, and investors would come there to trade their stocks.
In those days, people were still new to the idea of stock trading, and there’s no regulations or requirement before issuing stocks — no way to distinguish a legitimate company from fraudulent ones. Anyone could set up a business and issue stocks for nonexistent voyages, making thousands of pounds. Unfortunately, the financial bubble burst as companies couldn’t meet up with their dividend promises, and the government of England outlawed issuing of stocks until 1825.
Meanwhile, the Amsterdam Stock Exchange was still thriving, and new bourses were established in Paris and other parts of the world. The Paris Stock Exchange was founded in 1724; the Philadelphia Stock Exchange was established in 1790; and despite the ban on issuing stocks in London, the London Stock Exchange was established in 1801.
Finally, in 1817, the New York Stock Exchange (NYSE) was formed and quickly rose to become the biggest stock exchange in the world. With its office in Wall Street — which is at the heart of the business district of Lower Manhattan — the NYSE attracted a lot of companies very early and became the most influential stock exchange in the US.
With the establishment of regulated exchanges, the stock market grew rapidly to become a very important part of the global financial system that countries depend on for economic growth. Owing to the growing importance of the stock market, efforts are continually made to improve the efficiency of the market and make stock trading much easier. While there have been many innovations in the market since its inception, we will focus on these three:
- Stock indexes
- Stock derivatives
- Trading platforms
Equity indexes are carefully weighted baskets of stocks that represent a segment or the entire stock market. Investors use them to measure the performance of an entire stock market or a section of it. The first equity index published for stocks on the NYSE was the Dow Jones Industrial Average, which was first calculated on May 26, 1896. It measures the performance of 30 large-cap companies in the U.S. stock market.
The precursor for the S&P 500 was a 90-stock index first computed by the Standard Statistics Company in 1926. When the company merged with the Poor’s Publishing to form the Standard and Poor’s in 1941, the index became known as the S&P 90 Index. It later expanded to its current 500 stocks on the 4th of March 1957 and became known as the S&P 500 Index.
Despite how early derivative trading started in the commodity markets, equity derivatives would not start trading in the U.S. markets until the second part of the 20th century. Equity futures, especially equity index futures, made their debut in the U.S. market in 1972. Single stocks futures started trading many years after. Options trading on equity indexes only started in 1983.
Initially, stock trading was carried out only at the exchanges, where traders used the open-outcry system to interact. Buyers and sellers stay on the trading floor and yell their bid and offer prices. A trade occurs when any two parties agree on a price.
The advent of the internet and the development of online trading platforms made it possible for stocks to be traded via electronic trading systems, where computers match the buy and sell orders. An example of an electronic marketplace is the NASDAQ.
Buy limit and sell limit orders are queued up in the computer — the sell limit order with the lowest price will be the current ask price, while the buy limit order with the highest price will be the bid price. The difference between the current ask price and the bid price is known as the spread. A trade occurs whenever a buy market order matches the ask price or a sell market order matches a bid price.
With electronic trading, investors can buy and sell share online through their online brokers’ platforms in a matter of seconds, unlike before when one had to dial the broker to place a trade order. In fact, day trading in the stock market became possible because of the availability of electronic trading platforms.
What are stocks?
Stocks are the type of investment that represents proportionate ownership in the companies that issued the stocks. Also known as equity, a stock refers to the shares of a company trading on a stock exchange. In other words, when you buy any number of shares of a company, you have bought the stock of that company, and when you buy shares in various companies, you can say you bought stocks of various companies.
Although the term stocks and shares are often used to mean the same thing, especially in the US, a share is the basic unit of ownership that can be bought in a company, while a stock is the collection of shares of a company. For example, if you buy 100 shares of Company A, you have bought just one stock — Company A stock. But if you buy 40 shares of Company A, 35 shares of Company B, and 25 shares of Company C, then, you have a portfolio of three stocks — Company A, Company B, and Company C stocks.
Buying the stock of a company entitles you to a portion of the company’s earnings and the proceeds from its assets (in the event of liquidation) — in accordance with the percentage of ownership you have in the company. The percentage of ownership you have in a company depends on the number of shares of the company you own relative to the total number of the company’s shares.
For instance, if the company has 100,000 shares outstanding and you own 5000 of those shares, you effectively have a 5% stake in the company, so you are entitled to 5% of the company’s distributed earnings. And if the company liquidates, you can claim 5% of the proceed from the company’s assets, after creditors and preference shareholders have been paid.
In addition to all those, owing a stock may give you the right to vote in the general meetings of the company’s shareholders — depending on the type of stock you own. The voting right offers you the opportunity to influence how the company is run, but the level of influence you can exert depends on the number of shares you own.
The primary reason people buy stocks is to earn a return on their investment. Generally, the return comes in the form of capital appreciation, whereby the price of the stock rises higher than what it was bought at, and dividend income, which is the portion of the company’s earnings shared to stockholders according to their stakes in the company.
With an average annual return of about 10%, stock investments have historically performed better than most other investment vehicles. However, you should note that the 10% average historical return is for the S&P 500 Index, which is a basket of 500 biggest stocks in the U.S. stock market. Individual stocks may post different kinds of returns — some higher, others lower.
For the most part, companies issue stocks to raise funds to run their businesses. When it comes to raising funds to finance their projects, companies have two options: borrow (in the form of bonds or bank loans) or issues stocks and share their ownership with willing investors. Companies that are still in their growth stages tend to prefer the stock option because it doesn’t come with the burden of debt servicing or a payback period.
Where to buy stocks: the primary and secondary markets
The capital market — the part of the financial system through which corporation can raise capital from stocks and bonds — is generally divided into two sections: the primary market and the secondary market. New securities are created in the primary market, while existing securities are traded in the secondary market. An investor can buy stocks from both the primary and secondary markets.
Also known as the new issue market, the primary market is where a company creates shares, bonds, or debentures and sells to the public. It is in the primary market that companies offer their stocks and bonds to the public for the first time — thus, an initial public offering (IPO) is done in the primary market.
Apart from IPOs, other issues companies make in the primary market include right offering, issue of IDR, bonus issue, offer for sale, and others. The key thing about the primary market is that companies, through their appointed representatives (underwriters), directly sell their securities to the investors. In the case of an IPO, the issuing company is known as the issuer, and the underwriters are mostly investment banks.
For instance, let’s say company RT wants to raise money from the public to expand its business, and it decides to do so via an IPO. It can hire about three underwriting banks to determine the appropriate price for the stock. The underwriting firms may fix the issue price at $30 and sell all the stipulated shares directly to the investors at that fixed price.
By buying stocks from the primary market, investors contribute capital to the issuing company. The funds a company generates from the sale of its shares on the primary market make up its equity capital. If the company wishes to raise additional equity capital after its IPO, it can do that through a right offering or private placement.
The secondary market is what we refer to as the stock exchanges or the stock market. Examples include the New York Stock Exchange, NASDAQ, London Stock Exchange, and all stock exchanges in the world. The secondary market is where existing stocks, bonds, debentures, and other securities are traded.
One main feature of the secondary market is that investors trade previously issued stocks without the direct involvement of the companies that issued the stocks. So investors buy and sell the stocks among themselves — existing stockholders sell their stocks to raise money for personal needs while aspiring investors buy to gain part ownership in the companies that issued the stocks.
For example, if you buy Apple stock (AAPL) on the NYSE or NASDAQ through your broker, you are buying from another investor who owns Apple shares, and Apple Inc. is not involved in that transaction.
Generally, the secondary market is of two types: the auction market and the dealer market. In the auction market, the trading members of an exchange come together on the floor of the exchange to announce their buy and sell prices — the open-outcry system. The NYSE is a good example. On the other hand, trading in the dealer market is carried out through electronic networks. An example is the NASDAQ.
Difference between primary and secondary markets
|Basis||Primary market||Secondary market|
|Meaning||This is the market where stocks are created and sold to the public via initial public offerings, rights issues, bonus issues, and private placement.||Often referred to as the stock exchange, this is where a stock can be traded after the issuing company has sold its shares on the primary market.|
|Other names||Because it is the market where new stocks are issued, it is also called the new issue market.||Since stock trade here after it has been issued by the company, it is called the after market. Generally, it is referred to as the stock exchange or, simply, the stock market.|
|Function||It helps the issuing company to raise funds to finance its business projects.||It helps existing stockholders to raise money to solve their personal needs.|
|How many times does trading happen?||Generally, trading happens only once, but a company can raise funds again from the market through a rights offer.||Trading happens all the time, as long as there are stockholders, who are willing to sell their stocks, and investors willing to buy the stocks.|
|Parties to the transaction||The investors buy shares directly from the issuing company.||Here, the investors buy and sell stocks among themselves|
|intermediary||The underwriters (investment bankers) act on behalf of the issuing company.||Investors trade stocks through their brokers.|
|Nature of price||Investors buy at the price fixed by the underwriters. That is, the price of the stock is fixed.||Stock prices fluctuate all the time, based on the levels of demand and supply|
|The marketplace||There is no physical marketplace where the stocks are transacted.||There are physical marketplaces for trading stocks, such as the NYSE, NASDAQ, and the London Stock Exchange.|
|Regulations||Stock market regulators, such as the Security and Exchange Commission (SEC), provide strict criteria for companies that want to issue stocks to the public, and only the companies that meet the criteria are allowed to sell to the public.||Companies whose stocks are trading here are required to report their earnings quarterly and also make public all significant events that concern their operations.|
What does it mean to be a stockholder?
As a stockholder, you do not own the assets of the company whose stock you have acquired; you only own the shares of the company. Any publicly traded companies is a C corporation, so it has a separate legal identity from its owners. That is to say that a corporation can file its taxes, be sued as an entity, can borrow money in its name, and is able to acquire assets and properties for itself.
The law sees a corporation as a legal person with the above-listed rights, including the right to keep its own properties. So the computers in a company’s office belong to the company and not the stockholders. A company’s assets and properties belong to it throughout the life of the company.
The fact that stockholders are entitled to portions of a company’s assets comes to effect after winding up. It is only at liquidation that a corporation loses those legal rights. When a company is liquidated, shareholders are entitled to proportionate amounts of the company’s asset (or rather proceeds from the assets).
It is very important that you get this distinction clearly — corporations are separate legal entities from the shareholders, and each person’s liabilities are limited to that person. If a corporation is highly indebted, its assets may be sold, but shareholders personal assets cannot be touched. Similarly, if a shareholder is in need of money, he can’t sell the company’s assets to raise money.
Types of stocks
Stocks are usually classified into two main groups, namely:
- Common stock
- Preferred stock
Also known as equity share, voting share, or ordinary share, common stock is the type of corporate equity ownership that gives the stockholder the right to vote in shareholders general meetings, in addition to the right to share in the company’s earnings.
Generally speaking, holders of common stocks can vote on matters that have to do with policy and altering the composition of the members of the board of directors. Through their votes, these investors can influence how the company is managed. The level of influence a shareholder can have depends on his voting rights which, in turn, is dependent on the type and number of shares he has.
Unlike preferred stocks, which are usually arranged between a company and an investor, common stocks are traded freely on the exchanges. Common stockholders can make money when the stock appreciates in value. They also earn when the company shares dividends, but they don’t get paid dividends until all preferred stock dividends have been fully paid.
Furthermore, in the event of liquidation, holders of common stocks are the last to receive payment from the proceeds of liquidation. Employees, creditors (including bondholders), and preferred stockholders are paid first, and whatever is left, is shared to the common stockholders.
Different classes of common stock
While common stocks carry voting rights, not all common stocks have the same voting right in some companies. In certain companies, different classes of common stocks are created to concentrate the voting power to a select group of investors. So, depending on the number of voting right assigned to a stock, common stocks may be divided into:
- Class A stock
- Class B stock
Class A stock: Class A stock is a group of common shares that carry a higher number of voting rights. A company may decide to assign 10 voting rights per Class A share, while a Class B share has only one voting right. There is no specific rule on how to classify common stock; each company is at liberty to structure its stock the way it wants.
Class B stock: Class B stock refers to common shares that carry less number of voting right. Shares in Class B stock may carry one voting right each, compared to Class A shares that carry 10 voting rights. But there is no hard and fast rule about this; a company can structure its stock as it pleases.
Apart from the aspect of voting rights, the different classes of common stock entitle the holders the same right to share in the company’s earnings. Most investors don’t even bother about the voting rights, provided the people who have the majority voting rights are leading the company in the right direction.
A good example of a company that designates its common shares into Class A and Class B stock is the Berkshire Hathaway, the company run by one of the greatest investors of all times — Warren Buffett. The Class B stock of the Berkshire Hathaway has 1/1500th voting power and value of the Class A stock.
While designating common stocks into different classes may be common in the US, it may not be allowed in some countries where there are laws against such.
Preferred stock is the type of stock a company issues to certain investors, which usually come with fixed dividend payments but carry no voting rights. So, holders of preferred stock cannot influence how the company is run or who the company can employ as a director.
In fact, preferred stock is considered a hybrid instrument, with the features of both an equity and a debt instrument. The common features of preferred stock include the following:
- A fixed dividend that is paid before common stocks are paid
- Settled ahead of common stocks, in event of bankruptcy
- Can be converted to common stocks
- No voting right
- A par value that is affected by interest rates — increases when interest rate decreases and declines when interest rate increases
- Higher dividend yields
- Redeemable after a predetermined date
There are different types of preferred stocks, and these are some of them:
Prior preferred stock: Some companies issue different series of preferred stocks, and one of them is designated highest-priority preferred stock. When it is time to pay dividends, the prior preferred stockholders are paid first before others.
Preference preferred stock: On a seniority basis, the preference preferred stock is the next in line after the prior preferred stock. Holders of this type of preferred stock get preference over other types, with the exception of prior preferred stock.
Exchangeable preferred stock: This is the type of preferred stock that comes with an embedded option, which the holder can exercise to exchange the preferred stock with another security, such as bonds, debentures, or other stocks.
Convertible preferred stock: This type of preferred stock can be exchanged for a given number of the company’s common shares. The investor is at liberty to exchange the preferred stock to common stock at any time of his choosing, but once exchanged, the common stock cannot be converted back to preferred stock.
Perpetual preferred stock: In this type of preferred stock, there is no fixed date on which the capital will be returned to the shareholder. The company has the right to redeem the preferred stock, but the redemption date is not fixed.
Cumulative preferred stock: In this type, whenever the dividend is not paid as scheduled, it will accumulate with interest to be paid on a future date.
Non-cumulative preferred stock: For the non-cumulative type of preferred stock, the dividends will not accumulate if they are not paid. This is common in bank preferred stock because the BIS (Bank for International Settlements) rules stipulate that preferred stock must be non-cumulative to be included in Tier 1 capital.
Putable preferred stock: This type of preferred stock carries a ‘put’ option, so the holder of such preferred stock can, in certain situations, force the issuing corporation to redeem the stock.
Participating preferred stock: With this type of preferred stock, the holder can receive extra dividends if the company meets a predetermined financial goal. The regular dividends are paid regardless of how the company performed, but when it performs up to the predetermined level, it pays extra dividends to the holders of this type of preferred stock.
Monthly income preferred stock (MIPS): This type combines the features of preferred stock with those of subordinated debt. It is structured in a way that the borrower services it as a debt (interest payment from pretax income), but the investors receive the payment as dividends.
Private company stocks vs. public company stocks
A private company is a company that is owned and managed by its founders, alone or in conjunction with a few other private investors. Depending on the corporate structure, a private company can issue stock and have a limited number of shareholders. Stocks in private companies differ from those of public companies in so many ways, and these are some of them:
Where the stock is traded
One of the main differences between stocks in private and public companies is where they are traded. To buy the stock of a private company, a qualified investor has to directly buy the stock from the company through private placement or buy directly from individuals who own shares in the private company — over the counter. In other words, there are no exchanges where an investor can buy the stock of a private company.
On the other hand, public company stocks are actively traded on popular public stock exchanges, such as the NYSE and LSE. So any investor can buy or sell the stocks on any of the exchanges through a broker. Being on a public exchange means that the transactions are made public.
Ease of valuations
Since the transactions in privately-held stocks are not made public, it is very difficult to know the last price the stocks traded at. An investor trying to buy the stock will find it tough to determine its market value. Moreover, being private also means that the company has no duty to release its balance sheet and income statement and does not report its quarterly earnings. So, it is almost impossible to calculate the intrinsic value of the stock.
On the other hand, it is far easier to make an informed decision when trading public company stock. All the transactions are public, and the companies are obligated to release their financial statements and report any events that affect their business operations. Thus, a prospective investor can estimate the value of the stocks.
Level of liquidity
Because the stocks of private companies don’t trade on the exchanges, buyers and sellers are not readily available. An investor who wants to buy a private company stock may find it difficult to find a willing seller, and a stockholder who needs money may find it difficult to get a willing buyer.
The situation is different for the stocks of public companies which trade on popular exchanges. Such stocks exchange hands several times in a minute, so the issue of illiquidity does not arise. Investors buy and sell stocks all the time on the exchanges.
Degree of volatility
Owing to the fact that buyers and sellers are not easily available for stocks of private companies, the prices can be very volatile. Moreover, the transactions are negotiated privately, so a desperate seller can be made to accept a ridiculously lower price, while a determined buyer may be forced to pay more.
The volatility in publicly traded stocks is relatively less because there are many willing buyers and sellers ready to transact at a fair price. While there may be price swings, it happens in accordance with the market value of the stock.
While private company stockholders can get some handsome dividends sometimes, the decision to pay or not to pay dividends may rest only on the management. They may not be consistent with their dividend policy, and since their operations are conducted privately, some of the stockholders may be shortchanged.
On the contrary, public companies tend to have a more consistent approach to dividend payments, and the shareholders are carried along in the decision-making process. Their operations and every decision are open to the public. Each share in a class of shares is entitled to the same dividend — no cheating.
Since private companies conduct their dealings privately and are under minimal regulations by the authorities, they may not allow a stockholder, who is unable to attend a stockholders’ meeting, to appoint a proxy to vote for him.
Public companies, on the other hand, are mandated to allow a stockholder appoint a proxy to vote for him in a shareholders’ meeting. A public company has no grounds to refuse a stockholder to exercise that right.
If a stockholder in a private company wants to transfer his shares to someone else, say a relative or spouse, the directors of the private company may refuse to register a transfer of shares.
However, this is unlikely to happen in a publicly traded company. Unless the stock exchange and the regulators allow it, a publicly traded company cannot enforce such kind of restrictions on share transfers. A shareholder can transfer his shares to whomever he wants and get it registered.
Penny stocks vs. normal stocks
A normal stock is a stock that is trading at $5 and above, on one of the major stock exchanges, such as the NYSE, NASDAQ, or the American Stock Exchange (AMEX). They are popular and usually well-capitalized.
A penny stock, on the other hand, is currently defined as a stock that is trading at less than $5 per share. In the past, it was considered any stock trading below $1 per share, but the SEC modified the definition to include all stocks trading for less than $5.
In addition, most penny stocks are traded over the counter on electronic trading marketplaces, such as the OTC Bulletin Board (OTCBB) and the Pink OTC Markets Inc. There are many ways in which normal stocks differ from penny stocks, and these are some of them:
Normal stocks are often well known, and people usually talk about them — analysts discuss them on financial news channels, and traders talk about them on their blogs. Moreover, the exchanges and the SEC often mandate them to make public their financial statements and other necessary information about them.
Penny stocks, on the other hand, are relatively unknown, and you don’t get to hear about them and what they do. Popular financial analysts don’t talk about them. You don’t get to see their earnings reports, balance sheet, and other financial statements. And you need the information to make an informed decision about investing in the stocks.
Most normal stocks that trade on the major exchanges have been in existence for a reasonable period of time; some have been around for many decades and even centuries. For those kinds of stocks, their record is there for everyone to see, and it speaks for them. To have lasted that long, the companies must have been doing something right.
On the other hand, most of the companies behind penny stocks are newly formed private companies that could not meet the criteria for registering on the major exchanges. Some of them are close to bankruptcy. In essence, most penny stocks are stocks of companies with a poor track record or no track record at all.
The fact that normal stocks trade on popular exchanges, where buyers and sellers congregate on a daily basis to transact, means that the issue of liquidity may not be a problem for them. Normal stocks attract big institutional investors, as well as many retail traders who speculate on the short-term price movements.
For penny stocks, the story is different. Only a couple of thousand shares are traded each day. Institutional investors and big retail traders are not attracted to the market because of poor liquidity. There are not be enough orders to meet their normal trading volume.
The volatility in normal stocks is often a reflection of the market value of the stocks and the changing sentiments in the market. Because the market is very liquid, there are enough orders in the market, so prices don’t swing widely. In other words, normal stocks have normal volatility.
Penny stocks, on the other hand, are extremely volatile, and it is often as a result of illiquidity. Since the trading volume is small, any relatively large order can make the price spike in the direction of the trade. With price swinging up and down, it becomes difficult to technically analyze their charts.
This is another thing that contributes to volatility. The spread is the difference between the sellers’ lowest ask price and the buyers’ highest bid price. It tends to be high when the liquidity is low and volatility is high. Since there are few traders in the penny stock market, price quotes are often far apart, making the spread to be very wide. In addition, there are no market makers to provide more liquidity to the market.
Normal stocks, on the other hand, usually have lower spread, and the spread tends to be more stable since there are market makers to provide liquidity.
While several short-term traders play the normal stock market for speculative purposes, most of the trading that occur in normal stocks are carried out by investors, who wish to grow their wealth, along with the underlying companies, over the long term.
On the other hand, the majority of the players in the penny stock market are there for speculation only. But who would blame the traders? There is no way to estimate the values of those stock with the little or no information available, so they are not good for investment purposes.
The SEC, as well as the exchanges themselves, has a set of criteria a company must meet before offering its stock to the public. And when the stock is trading on the exchange, the company is required to report its earnings quarterly and provide the public with all the information about its operations, else it will be suspended.
Penny stocks that trade on the OTC marketplaces don’t have such regulations. The SEC pays little or no attention to them, and the platforms they trade on don’t have a minimum standard that a stock must keep to. Penny stock companies don’t make their financial situation public.
Manipulation and scams
Since normal stocks are highly regulated, the incidence of scams and manipulations are minimized. Also, the huge liquidity in normal stocks makes it difficult for individual traders to manipulate the activities in the market.
On the other hand, penny stocks are associated with all sorts of scams and manipulations. Because of the low liquidity and lack of regulation, they are very easy to manipulate. One of the popular scam schemes in penny stocks is the pump and dump scheme. Fraudulent traders would buy a penny stock and then promote it to lure unsuspecting investors. When enough investors come in to buy the stock, they dump their shares and move on. Other scams associated with penny stocks include chop stock, dump and dilute, and know it all.
You can trade normal stocks through a traditional and online broker. Traditional brokers have no issues with trading normal stocks, provided you meet all the requirements.
Penny stocks, on the other hand, can only be traded through a few online brokers that allow them. Most traditional brokers don’t allow their clients to trade penny stocks.
Because normal stocks are priced higher than penny stocks, investing in normal stocks requires more capital than trading penny stocks. A small investor can acquire thousands of shares in a penny stock with a few hundred dollars.
While trading penny stock may be very risky, it has the potential to generate huge profits in a shorter period than what is obtainable in normal stocks. Because they are lowly priced, it is easier for them to double or triple in price than normal stocks.
For example, it is easier for a $0.5 stock to rise to $1 or $1.5 than a $50 stock to get to $100 or $150. Moreover, due to high volatility, penny stocks can make their moves in a few hours to days, unlike normal stocks that will take weeks or months to appreciate.
When and why do companies issue stocks?
Companies issue stocks when they need to raise money to finance their businesses. There are so many aspects of a company’s operations that can make it want to seek fund outside, and they include some of the following:
- Developing new products
- Acquiring new equipment
- Enlarging facilities or building new ones
- Expanding into new markets or regions
- Buying new office buildings
- Paying off debt
While a company can get funds by taking loans, debt financing is not healthy for a growing company because of the need to pay back the borrowed amount plus interest. So most companies opt to issue stocks when they are in need of money. In fact, companies can even issue stocks to offset their debt.
Why companies go public
A company that wants to expand its business may wish to do that by listing its stock on a stock exchange and offering its share to the public. Although it can issue its share privately, private markets may not be able to provide the kind of financing it needs. Thus listing on a public exchange and going through an initial public offering (IPO) may be the best way to raise the required capital.
An IPO is a process through which a private company issues its shares to interested investors and becomes listed on a stock exchange. It helps the company to raise money from the investors and gives the investors the opportunity to buy into the company. The process consists of two main stages:
- the premarketing stage, when the company shops for underwriters
- the initial public offering proper.
A company that wants to go public will ask several underwriters to submit their bids. After reviewing their proposals, it may choose one or several of them. The underwriters will then create an IPO team that will include lawyers, SEC experts, and certified public accountants. The team takes care of all the necessary paperwork and sets a date for stock issuance. It also takes care of any necessary post-IPO services.
Benefits of going public
There are many benefits a company can gain from going public, and these are some of them:
Raising capital: A company can raise all the money it needs to finance its operations by issuing its shares to the public. The beauty of equity financing is that there is no obligation to pay back the investors. By going public, a company is not only able to raise money through the initial public offering but also has access to the market where it can raise money in the future by offering new shares, bonds, or debentures.
Risk distribution: By selling a portion of the company to public investors, the initial owners of the company have passed off a portion of their risk to the investors. So in the event that the company fails, they won’t lose all their initial investments in the company.
Providing liquidity: Going public provides liquidity to the company’s shares. It provides the company’s founding owners and initial investors with a ready market where they can trade their shares to raise cash for personal needs.
Gaining greater visibility: Trading on a popular stock exchange offers a company better visibility. Analysts and investors will get to talk about the company, and consumers may get to learn about their products from those analysts.
Easier payment options: When making big business deals, like mergers and acquisitions, a publicly traded company may decide to pay with its shares instead of cash.
Improving creditworthiness: Being a publicly traded company improves the prestige of a company, but more importantly, it improves the financial stability of the company since it is able to meet up with all the regulatory requirements. So, creditors may rate it high, which increases the chances of getting loans with lower interest rates.
Disadvantages of being a public company
While there are many benefits to going public, there are also some disadvantages, and here are some of them:
Loss of control: By going public, the founding owners sell a portion of their ownership in the company to public investors. Every unit of ownership sold affects the position of the founding owners. Sometimes, it may be difficult for the founding owners to raise the amount of capital they need and still keep up to 51% of the shares needed to retain control of the company. But even if they retain majority shares, the founders cannot run the company as they want, because other shareholders must have a say in how the company is run. Moreover, the law requires that a public company must have an independent board of directors that regulate the company’s management.
Expenses: The process of taking a company public can be very expensive and time-consuming. Apart from that, the cost of complying with all the regulatory requirements for running a public company can be very high.
Limited operational options: The increased regulatory oversight puts some limitations on what a public company can do. By law, the company is obligated to maximize shareholders wealth, disclose operational information, and seek shareholders’ approval before making certain investments. Some of these may make it tough for management to run the company effectively.
The regulatory requirement for going public
For a company to issue its stock to the public, it must have grown to a stage where it can handle the rigors of SEC regulations, as well as the responsibilities to public shareholders. To the venture capitalists, all unicorn startups (valued at $1 billion) are in this category, but it is not necessary for a company to reach that valuation to qualify for an IPO.
Any private company that has strong and consistent revenue, proven potentials for making profits, significant growth potentials, and the necessary cash to fund the IPO process is qualified to file for an IPO if it can meet the regulatory requirements, which includes the following:
- Filing the S-1Registration Statement with the SEC: This consist of two parts:
- the prospectus, which is the document that will be offered to prospective investors, which accurately details the nature of the business, its financial health, management, and associated risks
- the privately held filing information that gives the SEC more financial details about the company
- Meeting the requirement of the exchange: Every exchange has its listing requirements which an intending company must meet, and the requirements include:
- the initial stock price
- number of shares
- number of shareholders
- total market value
- Picking the right ticker symbol: A company must choose a symbol that meets the exchange’s rules, the SEC requirements, and does not duplicate an existing symbol on the exchange
- Getting an underwriter: This is the intermediary between the company and the investors. The underwriter often buys the entire stock and then resell to the public investors.
- Applying to the exchange: After the SEC has confirmed the company, it can then apply to the exchange. The following documents must be attached to the application form:
- A letter from the underwriter(s), which confirms that the company meets the listing standards
- A confirmation that the company meets the exchange’s shareholder requirement
- A listing agreement signed by the company’s executives
- A copy of corporate charter and bylaws
- A certificate from the state where the company is charted, which confirms that the firm remains in good standing
When the company’s stock starts trading publicly, the regulators would require the company to report its quarterly and annual earnings and other financial statements, as well as disclose any event that affects its operations.
Please check out: What is an AGM? – Annual General Meeting
One of the benefits of being a publicly traded company is that the company can still come to the market to issue new shares if it wants. One common way public companies issue new shares is through a rights offer.
Also known as a rights issue, a right offer is an invitation a company gives to its existing shareholders to buy additional shares of the company in proportion to their existing holdings, at a discount to the current market price.
A public company can issue a rights offer when it wants to raise additional capital to finance its operations or meet a financial obligation. Sometimes, when a company’s debt burden is rising, it may use rights issues to pay down the debt. But issuing rights offers does not always mean that a company is in financial trouble. A company with a healthy balance sheet can issue rights offers to raise money to fund capital expenditures, such as acquisitions or opening new facilities.
Alternatives to listing on a regulated exchange
Companies that are not big enough to list on a regulated exchange, like the NYSE, NASDAQ, or LSE, can still issue trade their shares with willing public investors through alternative methods.
In the UK, such companies can float their shares on the Alternative Investment Market (AIM), which is a sub-market of the LSE for smaller companies that cannot meet the requirements of the LSE.
For U.S. companies, those that cannot meet the requirements of the regulated exchanges can quote their stocks on the OTC marketplaces, such as the Financial Regulatory Authority’s (FINRA) OTC Bulletin Board (OTCBB) or the OTC Market Group’s OTCQX, OTCQB, and OTC Pink marketplaces.
Splits and mergers
They are corporate actions, which affects the organization of a publicly traded company and can impact the stakeholders, including common shareholder, preferred stockholders, and bondholders.
A split-up refers to the breakup of a company into two or more independently run companies. On the other hand, a merger happens when two or more companies combine to become one company, in accordance with the agreed terms.
Why do companies perform splits and mergers?
Companies perform these types of corporate actions for many different reasons, but most of the time, they do it to improve their business operations and increase shareholders wealth.
A company may decide to split up because it has different business lines that are not related to one another in terms of resources and management. In that case, running them separately may improve their efficiency and profitability. Another reason for a split-up is when the government mandates it to prevent monopolistic practices.
On the other hand, a company may undertake a merger when it wants to expand its business operations. When two or more companies think that by combining their business operations they will enhance their productivity, efficiency, and profitability and add value to their shareholders, they may go for a merger.
How do split and mergers affect stockholders?
When a company splits, shares of the original company are exchanged for shares in either of the new companies, in accordance with the agreed terms. Shareholders are asked to choose which of the new companies they wish to be invested in, and whichever of the daughter companies a shareholder chooses, he is paid with the shares of that company, in accordance with the stated ratio.
Theoretically, a merger should produce a new company with a new stock, and the shareholders of the merging companies are paid with shares of the new company in accordance with the agreed ratio. However, in reality, the merging companies will agree to retain the stock of one of the companies and pay the shareholders of the other companies with shares of the chosen stock, in accordance with an agreed ratio (say two shares of the relinquished stock for one share of the chosen stock).
How to make money from stocks
Stocks are a unique investment vehicle which has outperformed other asset classes over the years. There are different ways someone can make money from stocks, but they are generally grouped into two:
Investing is a more passive approach to making money from stocks. It involves buying stocks with the hope of making some returns in the future. The returns can come in the form of stock prices appreciating in value or from dividend payments. With investing strategies, money is made over the long term.
How much you can make from stocks, as an investor, depends on your approach to stock investing. Over the long term, the average yield of the S&P 500 Index is about 10% per annum. This value includes both the returns from capital appreciation and the returns from dividend payments. After adjusting for inflation, the average return per annum falls to about 8%.
You should know that this historical estimate is just the average across all stocks in the S&P 500 Index. The individual stocks posted different returns over the same period: while some posted superior returns, others posted much less or even failed completely. This is the reason investors build a portfolio of stocks that include stocks in companies from different industries.
If you are passively invested in an index fund or ETF that tracks the S&P 500 Index, your average return, over the long term, would look like that of the market average. So, with an inflation-adjusted average return of 8%, if you invested $10,000 at the turn of the millennium (19 years ago), it would be worth about $43,157 now.
However, investors that personally select the stocks to invest in and actively manage their stock portfolio may make higher returns than the average market return, but it is very difficult to beat the market. Only a few active investors achieve that feat — most active investors perform worse than the market or even lose all their investment.
There are different strategies for actively investing in stocks. These are the most common ones:
Growth investing: Investors who follow this strategy look for growth companies — young companies with above-average potentials for growth in revenue and earnings.
Value investing: Value investors look for stocks that are trading below their intrinsic value, with the hope that the market will eventually recognize their real value.
Buy and hold: Here, an investor buys a stock or an ETF and hold it for a very long time, hoping that the security appreciates over the long term.
Income investing: With this strategy, an investor is only interested in stocks with a history of paying high dividends and regularly increasing dividend payments.
Dollar-cost averaging: Here, an investor buys stocks at a regular interval over a long period of time so as to lower the average cost of the stock.
Whatever the approach and strategy an investor employs when investing in stocks, there are basically two ways to make money from stocks:
- capital appreciation
Also known as capital gain, capital appreciation refers to an increase in the market value of a stock. That is, the stock is currently worth more than what was paid for it. The opposite situation, where a stock’s current price is less than the purchase price, is known as a capital loss.
For example, if you bought a stock at $20 per share six months ago and it is currently trading at $25, the stock has appreciated by $5 ($25 – $20). In other words, it has made a 25% return from capital appreciation.
Conversely, if the stock is currently trading at $15, it would have made a $5 capital loss.
Dividends are regular payments a company makes to its shareholders as a reward for their loyalty. Companies can pay dividends annually, semi-annually, quarterly, or monthly. Dividends are usually distributed from a portion of a company’s earnings, but in some situations, a company may have to borrow money to pay dividends, either to maintain the company’s culture or to fulfill an obligation to preferred stockholders.
Depending on the flexibility of the payment, dividends can be classified into two:
Fixed dividends: A fixed dividend is the type of dividend that remains the same every year, irrespective of how much money the company has made during that period. Preferred stocks usually receive fixed dividends.
Variable dividends: When the amount of dividend paid to shareholders changes from time to time, depending on the company’s earnings and dispositions, the dividend is said to be a variable dividend. Common stockholders are often paid variable dividends.
How dividends affect stock prices
When a company declares a dividend, the price of the stock tends to increase in the days leading up to the ex-dividend date — the last date an investor can purchase the stock to be eligible to receive the dividend. The reason is that investors are competing to buy the stock so as to receive the dividend.
After the ex-dividend date, the price of the stock falls — often by the amount of the declared dividend — because the investors buying the stock then will not receive the declared dividend.
This is an active approach to making money from stocks. It involves frequently buying and selling stocks with the aim of profiting from the up and down swings in price movements. Unlike most investors, a trader can take a position in either direction: long or short. Depending on the duration of the trades, active trading can be classified into four:
Scalping: This is an ultra-short-term style of trading. The trades usually last from a few minutes to a few hours, and a trader can take up to 20 or more trades in a day.
Day trading: Traders that employ this style open and close their position in a day. That is, no position stays over the night — every opened position must be closed before the closing bell.
Swing trading: This style tries to profit from short-term price trend. Here, a trader can hold a position overnight and even through the weekend. Trades tend to last from a few days to a few weeks.
Position trading: Position traders are concerned with the long-term trend. Their trades usually last from several weeks to months or years.
The stock portfolio
A stock portfolio is a collection of all the stocks an investor owns. It is different from an investment portfolio, which contains securities from other asset classes, such as bonds, commodities, real estate, and currencies. While it is good to have an investment portfolio, when it comes to stocks, you need to carefully select the stocks in your holdings.
Your stock portfolio does not only need to be well balanced and diversified but also reflects your investment goals, time horizon, and risk tolerance. While there are general rules for building a diversified stock portfolio, you should know that makes a good portfolio for one person may not be good for another.
Why you need to have a stock portfolio
It is important to spread your stocks across different sectors of the market. This is called diversification. The main reason for diversification is to minimize risk, but it can also improve returns over the long term.
Having a portfolio of carefully selected stocks from different sectors of the economy can reduce your risk exposure. While it does not totally guarantee against loss, as some risks are inherently non-diversifiable, maintaining a well-balanced stock portfolio is the best techniques for minimizing risk.
For example, let’s say you bought only airline stocks. If there is a scarcity of aviation fuel and the price rises for a long time, the share prices of airline stocks will decline and wipe out a significant amount of your investment. But if you had bought stocks from different industries, when the aviation sector is experiencing difficulties, other stocks will be able to counterbalance the loss in the airline stocks.
Apart from reducing risk, another reason to select stocks from different sectors is to maximize profit over the long term. Using our airline stocks example, it would take a long time for your investment to recover from the losses, if at all it will. But with a diversified portfolio, the losses are minimized and your portfolio can continue to grow.
How to build a stock portfolio
There are different ways to build a diversified stock portfolio. One option is to actively select good stocks from different sector to make up your stock portfolio. Another option is to use the passive approach by simply investing in an ETF, index fund, or a mutual fund.
Building a stock portfolio actively
If you intend to actively build your stock portfolio yourself, the following tips might help you:
Know your objectives and how much time you have: Your stock selection should meet your investment goals — capital appreciation or dividend income — which is often dependent on how much time you have. If you’re close to your retirement, your interest should be on stable, dividend-paying stocks. But if you’re just starting your career, you still have time to invest for capital appreciation, so you can select stocks with growth potentials.
Avoid stocks that show correlation: It is important you avoid stocks that show correlation because the same factors affect all of them. An easy way to do this is by not selecting stocks from the same industry.
Building a stock portfolio passively
The easiest way to invest in a diversified stock portfolio is through a mutual fund, index fund, or ETF.
Stock mutual fund: This is a fund managed by an expert. The fund manager actively picks the stocks that make up the fund. By buying a mutual fund, you’re effectively buying a piece of all the stocks the fund invests in.
Exchange-traded funds (ETFs): An ETF is a fund that automatically tracks a basket of stocks that make up the fund. It is not managed by an expert. It trades on the stock exchange like a normal stock and can be bought during the trading hours.
Index fund: This is either a mutual fund that tracks the performance of a market index, such as the S&P 500 Index.
How to know what stocks to buy
Investors and traders employ different approaches in picking the right stocks to invest in, but all of them are based on either technical analysis or fundamental analysis. Some make use of both.
This is a method of predicting the future movement of stock prices by analyzing historical price and volume data. Technical traders use technical analysis methods to select the stocks to trade, when to trade them, and the type of positions to take. Price and volume charts are used to assess the changes in demand and supply of the stock.
Technical analysis involves two approaches: price action analysis and indicator analysis.
Price action analysis: It involves directly studying the price patterns on the chart. The price patterns include the candlestick patterns, (such as the hammer, shooting star, tweezers, and others), as well as chart patterns, like the wedges, double bottom, and triangles. For example, a double bottom pattern may indicate that the stock will soon start to rise.
Indicator analysis: This involves the use of technical indicators, like moving average, stochastic, RSI, and others, in analyzing price movements.
Investors mostly use fundamental analysis to assess the financial health of the companies behind the stocks. Financial analysis is the process of evaluating the economic and managerial factors that can affect the value of a stock. Here are some of the tools used in fundamental analysis:
Earnings per Share (EPS): This refers to a company’s earnings divided by the number of outstanding shares. It shows how much the company earns per share of its stock. The higher a company’s EPS is, the more valuable its stock will be.
Price-to-Earnings ratio (P/E): This is the ratio of a company’s stock price to its EPS. It is used to estimate how a stock is valued in the market — whether it is overvalued or undervalued. The best way to do this is to check a company’s P/E with the average in its industry or the general market. For example, if the average P/E is 18 and most stocks fall within 15 to 21, a stock with a P/E of 35 may be said to be overvalued. Conversely, a stock with a P/E of 5 may be undervalued.
Price-to-Sales ratio (P/S): It compares a company’s market capitalization to its revenue. The lower the value, the more attractive the stock is.
Price-to-Book ratio (P/B): It compares a company’s stock price to its book value per share. The book value is the total asset minus all the liabilities. The lower the P/B ratio, the more attractive the stock.
Free cash flow: This is the cash left after operational and capital expenditure. A positive value shows that the company can generate cash.
Projected Earnings Growth (PEG): This is the expected one-year earnings growth. The higher, the better, but if the actual earnings don’t meet up to the expected, it may be a bad sign.
How to buy stocks
The process of buying stocks for the first time is not that difficult. In fact, with the advent of online brokers, you can do it from the comfort of your home any time you want. Here are the steps to follow as a beginner stock investor:
1. Open a brokerage account: While you can open an account with a traditional broker, it is faster, easier, and cheaper to open an account with an online broker. The two things to consider when choosing an online broker are the commission charges and how much support the broker offers to its clients. After choosing the right broker, you have to decide the type of account you want — a cash account or a margins account. Being a beginner, we will advise starting with a cash account.
2. Pick the stocks you intend to buy: Study the various companies and analyze their financial statements to determine the ones that offer the best investment opportunities. There are some websites that can help you screen stocks, such as Finviz, StockToTrade, and StockRover. If you are good in technical analysis, you can study the charts too.
3. Determine the number of shares for each stock: After selecting the stocks to buy, you have to decide how many shares of each stock you want to buy. It is better to start small and increase the numbers later.
4. Select your order type: Before you place your order, you need to understand the type of order you wish to use. You may see many types of orders on your broker’s website — market order, limit order, stop order, and stop-limit order. You will mostly make use of market and limit orders when placing your trade.
5. Manage your investment: Now, you are invested in stocks. Monitor your stock portfolio and manage your investments the right way. The rule is this — protect your capital.
Direct stock purchase plan
This is a program put in place by some companies to enable individual investors to buy their stocks directly without going through a stockbroker. The direct stock purchase plan offers low fees, and in some cases, retail investors may be able to buy the stocks at a discount.
It is only a few companies that still offer this plan since the emergence of online brokers with competitive fees and more convenience.
Investing in stock market indexes
A stock market index is an imaginary portfolio of stocks representing the broad market or a specific sector in the market. The price of an index is a weighted average of the prices of the stocks that are included in the index. It fluctuates as the prices of the component stocks fluctuate.
Stock market indexes are used to estimate the performance of the entire market or a section of the market. The indexes are just market benchmarks, you can’t directly buy them. However, you can mirror their performance through any of these methods:
- Buying an index ETF: You can buy an ETF that tracks a stock market index, such as the DJIA, on the NYSE, just the same way you can buy any stock.
- Buying an index fund: An index fund is a managed fund whose portfolio mirrors a stock market index. Being a managed fund, index funds charge high management fees. However, the fees are lower than the traditional mutual funds because the fund manager doesn’t spend money on researching the stocks to pick.
- Creating an index stock portfolio: This implies creating a portfolio of stocks that mirrors the weighting of a stock market index, such as the DJIA. Doing this can be capital intensive. So the first two may be your best bet.
S&P 500 Index
The S&P 500 Index is a U.S. stock market index that measures the performance of the stocks of the 500 largest companies listed on the stock exchanges in the United States. Its market value is a weighted average of the constituent stocks.
It is seen as the best representation of the U.S. stock market, and it is one of the most widely followed stock indexes in the world. The easiest way to mirror the performance of the S&P 500 Index is by investing in an S&P 500 index ETF, such as the SPDR S&P 500 (SPY). Alternatively, you can invest in an index fund that tracks the S&P 500, but the management fee may be higher.
Nasdaq Composite Index
The Nasdaq Composite Index is a stock market index of the over 3,300 common stocks and similar securities listed on the NASDAQ Stock Exchange. It is a market capitalization-weighted index of all the constituent securities.
Being a tech-heavy index, the Nasdaq Composite Index is used to measure the performance of the technology sector. To gain exposure to the index, you may invest in Nasdaq-based ETFs, such as the Invesco QQQ Trust (QQQ) or the Fidelity Nasdaq Composite Index ETF (ONEQ). A more expensive alternative is to invest in a managed index fund.
The Dow Jones Industrial Average (DJIA) is a stock market index that tracks the performance of the stocks of 30 largest companies listed on the stock exchanges in the United States. Its market value is a weighted average of the market capitalizations of the constituent stocks.
Created in 1896 by Charles Dow and Edward Jones, the DJIA is one of the oldest broad market indexes in the U.S. stock market. An easy way to mirror the DJIA is to buy DJIA-based ETFs, such as the SPDR Dow Jones Industrial Average ETF (DIA) or the Proshare Ultra Dow30 (DDM).
Euro Stoxx 50 Index
The Euro Stoxx 50 Index is a stock market index that tracks the performance of stocks of the 50 largest European companies operating within Eurozone nations. It is a weighted average, by market capitalization, of the constituent stocks.
The index is used to gauge the performance of the Eurozone stock markets. If you want to gain exposure to the index, you will need to invest in the index ETF, such as the SPDR RURO STOXX 50 ETF (FEZ) or the iShares Core EURO STOXX 50 UCITS ETF.
S&P 500 Asian indexes
These are stock market indexes of some Asian markets created by the Standard and Poors. An example is the S&P China 500 Index, which comprises 500 of the largest Chinese companies. It represents the broad Chinese equity market.
To gain exposure to the index, you may want to invest in the Wisdom Tree ICBCCS S&P China 500 Fund (WCHN).
How management fees can affect your overall return
Investing in an index ETF is better than investing in an index fund managed by a human expert because of the higher management fees associated with the latter. According to Morningstar Investment Research, the average management fee for an ETF is 0.44%, while that of an index fund is 0.74%.
So, for every $1,000 invested, you will spend $4.40 in annual fees if it’s an ETF, or $7.40 if it’s an index fund. While this may not look big, over a long time (say 30 years), the difference will be huge enough to affect your overall return.
Stocks vs. bonds
Stocks and bonds are two of the most common securities an investor can have in his investment portfolios. Both offer an investor the opportunity to diversify his portfolio and improve returns.
For a corporation, both represent alternative ways to raise funds for business operations. While issuing a stock means exchanging a portion of its ownership for money, floating a bond is taking a loan from the investors, which must be paid back with interest.
Stocks are seen as a more risky investment than bonds. The table below shows the main differences between stocks and bonds.
Differences between stocks and bonds
|Basis for comparison||Stocks||Bonds|
|Meaning||Equity instruments which come with ownership rights||Debt instruments which must be paid back with interest|
|Rewards||Dividends||Interests, at a fixed rate|
|Risks||There is no guarantee of rewards, so the short-term risk is higher||Since interests and payback period are guaranteed, the short-term risk is less|
|Other privileges||The right to vote in a shareholders’ meetings||Settled first in the event of bankruptcy|
|Status of holders||Holders have ownership stakes in the issuing company||Holders are more like creditors|
|Who can issue||Corporations||Governments, municipalities, and corporations|
|Factors that affect pricing||Demand and supply||Interest rates, yield, and the bond’s rating|
Stocks are shares of various companies, which gives the holders some ownership stakes in the companies that issued them. Investing in stocks offers you the right to get dividends from the companies that issue the stock, and you also gain when the stocks appreciate in market value.