Personal Finance Questions: Stock Investing Basics

Question: Tell how your understanding of efficient markets helps with investing
My understanding tells me several things worth knowing, which include:
- There is no foolproof system for beating the market; invest for the long-term.
- Do not try to time the market to take advantage; stay with your plan.
- Focus on the asset allocation process based on your age in the financial life cycle.
- Keep down the commissions that are paid to brokers and professionals.
- Diversify and seek help if you do not feel comfortable.


Question: What is an efficient market and can you beat the market?
an efficient market is a market in which all relevant information about stocks is reflected in the stock price
- The market is efficient in degrees
- There are at times undervalued securities and some people are able to take advantage of them while others lose
- It is very tough to consistently beat the market
- On average, half the time you should expect to outperform the market, and half the time underperform it
- The bottom line here is that you should keep to your plan and invest for the long term
- If we try to time the market, we are just as likely to miss an upswing as we are to avoid a downswing.


Question: Differentiate between primary and secondary security markets.
A primary market is one in which newly issued, as opposed to previously issued, securities are sold (or offered)
- They come in one of two types: initial public offerings and seasoned new issues.
IPO means it is the first time the company has offered its stock to the public for sale.
Seasoned new offerings are made by companies that already have common stock being traded.


Question: Name the major organizations regulating the stock market and tell why they came about.
A federal agency, called The Securities and Exchange Commission, provides general regulation of the markets
- The National Association of Security Dealers regulates the OTC market
- The exchanges themselves are engaged in much self-regulation
- Regulation came about because of the great stock market crash of 1929 and because of fraudulent information
- The Securities Exchange Act of 1934 is the cornerstone of the major acts to regulate hinge on disclosing adequate relevant information relating to the offering of securities to make intelligent choices
- Acts to regulate insider trading and market abuses have been enacted more recently.


Question: Which organization would handle frequently traded OTC stock, bonds, and foreign stock?
The over the counter market handles frequently traded stock in secondary markets.
Bonds, in the secondary market, are traded by bond dealers who buy and sell bonds out of their own holdings
- Over 300 foreign companies' stock is sold on the NYSE, AMEX, and NASDAQ
- Many others can be traded (purchased and sold) through American
- Depository Receipts
- [Of course, ADRs are traded on NYSE, Amex, Nasdaq.]


Question: Compare and contrast organized exchanges and OTC markets - List the nine major U.S. - stock exchanges in the secondary market.
An organized exchange occupies a physical location (building) where trading occurs.

Over-the-counter transactions do not require you to go to a physical site
- They are handled over the phone or via a computer hookup.

The nine major organized exchanges are:
- NYSE
- AMEX
- Pacific
- Chicago
- Philadelphia
- Cincinnati
- Intermountain
- Spokane
- Boston


Question: Explain the bid and ask price system when trading in stocks
The OTC market is a network of broker dealers who actually buy and sell various securities themselves
- Since it is not an 'auction' like the organized markets are where supply and demand determine the market price, the dealers need to communicate to investors what price they are willing to trade the securities at.
The bid price is what the Dealer is willing to bid to purchase a share of stock from an investor wishing to sell their stock
- They publish the bid price so that someone wishing to sell their stock can determine if they are willing to sell to the Dealer at the bid price.
The asking price is the price that the Dealer is asking for the shares that they own
- They publish this price so that potential purchasers know what price they will have to pay in order to purchase the stock from the Dealer's inventory.


Question: Should the average investor consider using short selling techniques? Why or why not?
Given the fact that the long-term trend of the stock market is upward, selling short is very risky and is not something you should become involved in
- You can lose a bundle because you may get caught selling low and later buying high.


Question: Describe the typical order characteristics you will encounter
You will want to order in either round or odd lots
- A round lot is a group of 100 shares of common stocks
- Round lot trading occurs on the NYSE
- An odd lot is an order of less than 100 shares of stock
- If you want your order to be filled only on the day it was given, be sure to use a day order
- If you want the order to remain effective until it is filled, use an open or good-till-canceled order.
Use a market order to buy or sell securities immediately at the best price available
- You use a limit order when you specify that the trade is to be only at a certain price or better.
Use a stop or stop-loss order to sell if the price drops below a specified level or to buy if the price climbs above a specified level
- They are used to protect your profits.


Question: What personal characteristics should you look for in a full-service broker and why are they important?
- a reputation for integrity, intelligence, and efficiency
- experience in both up and down markets
- one who understands your investment philosophy
- one who allows you to say 'no' without undue pressure
- one who is upfront with total costs
All of these qualities are important in representing my best interests and not the interests of the broker or brokerage firm
- It is crucial for a broker to know the markets over the long term as well as the short term
- He or she must understand what my goals are, not just his or hers
- A broker must be an efficient and cost-saving person to allow me to continue to trade
- All of these qualities point to an ethical person who will be around for a long time to assist me and many others.


Question: Explain the purpose of a brokerage account and the 3 types of brokers.
A brokerage account represents the money (cash) or investments (securities) you have at a brokerage firm
- This is an account to use in the buying and selling of securities on a regular or semi-regular basis.
A full-service broker gives advice and direction to the client
- This broker is paid a commission based upon the sales volume generated
- Discount brokers execute trades without giving advice and charge 50% to 70% less than a full-service broker
- A deep-discount broker undercuts the dominant discount brokers and will execute some trades for up to 90% off the price of a full-service broker.


Question: Generally, day trading should be avoided - If you decide to participate in day trading, what should you keep in mind?
Be prepared to suffer severe financial losses.
- Don't confuse day trading with investing–they aren't the same
- Day traders aren't interested in value, but in how the stock might perform in the next few hours or day.
- Don't believe claims of easy profits
- Investors have a tendency to talk more about when they make money, but not about when they lose it
- In fact, day trading has been called 'a trading method for transferring wealth from unsophisticated investors to sophisticated investors.'
- Watch out for 'hot tips' and 'expert advice' from newsletters and websites catering to day traders
- There's no question that someone makes money from day trading; unfortunately, in the vast majority of cases, it isn't the investor


Question: There are several sources of information available to help you make intelligent choices about buying and selling stock? If you choose a corporation's annual report to base your decisions on, what should you look for?
Remember that an annual report is written to give real attention to public relations; that is, it puts the firm in as favorable a light as possible
- Concern yourself with the trends in sales, profits, and dividends
- Notice how well the company performed last year by comparing its financial ratios to the industry norm
- What does the management project for the future? Is it positive or negative?

Question: How does overconfidence affect investors?
Investors tend to be overconfident
- Simply put, people think they know more than they do
- This overconfidence applies to their abilities, their knowledge, and the future
- In effect, most investors think they can beat the market
- Overconfidence also leads to trading too often
- Of course, there is the chance that those who trade more frequently earn higher returns
- Overconfidence afflicts men more often than women, and it also leads men to trade too often.


Question: List some helpful investment tips
Answer: Systems don't beat the market
- It's long-term investing that works.

Stick to your investment plan and don't try to time the market.

Focus on the asset allocation process
- You should spend your energy on the appropriate asset allocation, taking into consideration your goals, your plan, and where you are in your financial life cycle.

Recognize the time dimension of investing
- Your asset allocation strategy should reflect your investment horizon.

Keep the commissions down
- Because it's difficult to beat the market, make sure you don't give away too much of your return.

- Diversify, diversify, diversify! The benefits of diversification have yet to be challenged.
If you don't feel comfortable, seek the help of a qualified financial advisor
- Don't let the fear of investing keep you out of the game.


Question: Explain the common stock features and rights as though you are speaking to a novice.
common stocks have limited liability; that is, if the company goes bankrupt your liability is limited to the amount of your investment
- The claim on income is not certain because the corporation is not obligated to pay any dividends
- Dividends are paid only after all debt and other obligations have been paid, such as reinvesting the leftover earnings back into the company
- On the other hand, if the company has a booming year the stockholders will make a bundle.
Should a company go bankrupt, the creditors have claim on its assets before the stockholders do, and therefore the stockholders may be out of luck
- Stockholders are entitled to elect the company's officers and sometimes vote on policy
- The number of votes depends upon the number of shares owned
- When a firm thinks its stock price is too high for the smaller investor, the officers will 'split' it into more shares
- Sometimes a firm will repurchase shares so that each stockholder will own a larger proportion of the firm.
Common stock has book value, a return (dividend yield), earnings per share, and a market-to-book ratio.


Question: Explain the purpose and value of the dividend yield ratio
The dividend yield ratio is a tool that allows investors to compare the potential income return on various investment opportunities
- For example, a share with a dividend yield of 3% would produce the same amount of income as a CD with a 3% yield
- Investors with an income investment goal would value the dividend yield a lot.


Question: What factors can effect the market price of a stock?
There are many factors that can effect the market value of a firm's stock price
- The price of the stock reflects the firm's potential to earn profits
- Anything that increases the chances of the firm making higher profits is most likely to cause the market price of the stock to rise
- Examples such as lower market rates of interest, lower production costs, successful price increases, new and innovative products, increase in market share, favorable tax breaks or government regulations
- Anything that reduces or hinders the firm's ability to make profits will negatively effect the market price of the stock
- Examples include rising market rates of interests, rising energy costs, rising costs of production, fading popularity or obsolete products, bad publicly, losing market share to competition, unfavorable taxes or newer, tougher government regulations.


Question: Is a positive stock split good for the current share holders?
Yes, for the most part a positive stock split is a bullish signal to the market about the success and growth of the profit potential for the firm
- When a firm's profits are rising, the demand for their stock increases causing the market price of the stock to increase.
- When the share price gets to high then the company can effectively lower the share price by doing a stock split
- Since a stock split increases the number of shares shareholders own, then they will eventually end up with more dividends and capital gains if the company continues to prosper
- The market price of the stock effects the liquidity of the stock also
- It is much easier to sell stock at $40 per share than $120 per share since more people can afford the lower price.


Question: Differentiate between the general classifications of common stock.
Blue-chip stocks are issued by large, nationally known companies with sound financial histories and solid dividend and growth records, such as IBM
- Growth stocks have shown sales and earnings growth well above their industry average
- Income stocks are usually issued by more mature firms that pay relatively high dividends with little increase in earnings.
Speculative stocks have much more variability and risk than do typical stocks
- It is difficult to forecast their direction for investment purposes
- Cyclical stocks move with the economy, up with recoveries and down with slumps
- Defensive stocks are not as affected by swings in the economy and they are not hurt as much in slumps.

Question: Discuss the relationship between growth stocks and income stocks and their P/E ratios.
A growth stock is a company that is actively growing and expanding
- This growth requires a lot of capital so they seldom pay much in dividends, if any
- Instead they plow their earnings back into the growth of the company
- A fast growing company leads to the potential for fast growing earnings per share
- When the market thinks this growth company has good earnings growth, they bid the share price up accordingly representing higher P/E ratios.
Most income stocks are from companies who are relatively large and mature in their industries
- Since they are not in an active growth mode, then they don't need to retain earnings and can instead pay them out to the shareholders in the form of high dividends.
Because they are not expected to have a lot of growth in earnings, then the market does not bid up their market price resulting in relatively low P/E ratios.


Question: Discuss four reasons to invest in stocks
Over time, common stocks outperform all other investments
- Although stocks aren't guaranteed to give you any return, they usually give you a worthwhile return.

Stocks reduce risk through diversification
- When you include in your portfolio different types of investments that don't move (that is, the rate of return doesn't fluctuate) perfectly together over time, you're able to reduce the risk in your portfolio
- Stocks don't move in the same manner as other investments such as bonds, and each stock moves in its own way
- Holding stock from multiple industries can greatly reduce your risk.

Stocks are liquid
- You can't be assured of the price you'll get when you want to sell your stock, but you won't have difficulty selling it
- The secondary markets for common stock are extremely well developed, and as such, you will be able to sell your stock– with minimum transaction costs–whenever you want.
The growth in your investment is determined by more than just interest rates
- With some investments, the potential for price appreciation is largely a function of interest rates going down
- But with common stock, the value isn't a slave to interest rates.

Question: Compare and contrast the Dow Jones Industrial Average and Standard & Poor's 500-Stock Index
The Dow attempts to gauge the well-being of the stock market based on the performance of 30 large industrial firms
- Many investors think it reflects price movements for large firms rather than for the general market
- It weights stocks based upon their relative prices, neglecting other factors that would be indicative
- Nonetheless, it does a relatively good job of reflecting market movements.
The S & P 500 is a much broader index because it is based on the movements of 500 stocks
- It is probably a better representative of movements in the overall market.

Question: What is the importance of the P/E Ratio to investors?
The P/E ratio is a measure of risk and the growth potential of the EPS of the firm
- A low P/E ratio signifies that the company is fairly mature or weak and the market is not pricing in very much earnings growth potential into this stock
- An average P/E ratio signals that this firm is a healthy firm in a healthy industry and this firm has the potential for average or normal earnings growth
- A P/E ratio above the average P/E ratio signals that the market is very optimistic about above average EPS growth potential and that this stock could provide healthy capital gains
- Possibly it is a new firm with a new innovative product and its EPS are fairly small right now but this firm has the potential to explode in sales and profits causing the market value of the stock to explode also
- However, many times a company with a high P/E ratio doesn't work out so well and the stock crashes much faster than it rose in value
- High P/E stocks are very speculative and risky and not appropriate for important investing goals such as retirement.

Question: What are the three factors that explain why stock values fluctuate?
As interest rates rise, the value of the stock decreases
- As the stock's risk increases, so does the investor's required rate of return
- As earnings grow, so does the company's capacity to pay dividends
- This earnings growth is viewed as a cause of dividend increases and stock prices.

Question: Distinguish between the technical analysis and fundamental approaches of valuation of common stock
Technical analysis takes a number of forms, including the interpretation of computer programs, charts, graphs, and mathematical calculations of tracking patterns, all aimed at spotting some trend or direction for stocks
- This is no longer a useful approach because it encourages moving in and out of the market rather than buying and holding stocks.
A fundamental analysis determines the value of a share of stock by focusing on such factors as future earnings and dividends, expected levels of interest rates, and the firm's risk
- An example is the Price/Earnings Ratio which is a measure of a stock's relative value, found by dividing the price per share by the earnings per share
- The higher the ratio the better.

Question: Why is using the P/E ratio a very popular valuation tool?
Many investors use the P/E ratio because it helps to compare the stock's growth potential relative to other firms
- When you purchase a stock, you are not really buying the company as it stands today
- You are actually buying the earnings potential in the future. A healthy, well run company will have innovative products and growing market share leading to growing EPS
- It is the EPS in the future that you are actually buying today
- The P/E ratio communicates how the market feels about the future prospects of the firm. The P/E ratio also communicates a level of risk
- When a stock is 'priced to perfection' with a high P/E ratio, then the firm had better live up to these lofty expectations for future growth
- Any bad news such as disappointing earnings growth or slowing sales growth or competitive or regulatory pressures can cause these stocks to plummet in value to match the new, reduced expectations for earnings growth.