Understanding Stocks

by Michael Sincere

Some companies offer employee stock purchase programs (ESPPs), allowing you to buy stock in the company at a discount.

Here’s how diversification works. Let’s say that you are 100 percent invested (i.e., all of your investable cash is in the stock market). To be fully diversified, you need at least 5 to 10 stocks in various industries. Later you’ll learn about mutual funds and exchange-traded funds (ETFs), which provide instant diversification.

Many financial experts suggest that you own a mixture of growth, value, and income stocks, along with a smattering of international stocks. You might also consider stocks in both large and small companies.

confusing. To do it properly, you need to consider how much risk you are com...

tolerance), your age, your time horizon, and your investment goals. Many suggest that you simply buy stocks and bonds (we discuss bonds in Chapter 15), but doing t...

takes an understanding of how and why diversification works to diversify properly. A mistake that many people make is putting all their money in one sector such as technology and incorrectly thinking that they are diversified. Although putting all your investment dollars in one sector can bring huge profit...

Note: Some people hire financial planners to help with the diversification process. O...

want to be properly diversified so you aren’t exposed to too much risk. On the other hand, you don’t want to be overdiversified (i.e., when you own so many stocks, mutual funds, or ETFs that it’...

Once you have a diversified portfolio, you have to decide what percentage of your money you want to allocate (or distribute) to each investment. For example, if you are 30 years away from retirement, you could invest 65 percent in individual stocks and mutual funds and 25 percent in bonds, and keep 10 percent in cash. This is an example of asset allocation.

In the old days, you were told to subtract your age from 100 to determine the percentage of your assets to put into stocks. For example, if you are 40 years old, 100

40 equals 60. This old formula suggests that you invest 60 percent in stocks ...

if you are a patient investor. It’s called compound interest, and Einstein once wrote that it “was the eighth wonder of the world. He who

understands it, earns it. He who doesn’t . . . pays it.” The idea behind compound interest

a margin or cash account.

advantage of margin is that you are using the brokerage firm’s money to

is called leverage). Leveraging

dreaded margin call.

If the stock is on the Nasdaq, the symbol will usually have four or five letters (but not always). If the stock is on the NYSE, it will have one, two, or three letters.

All stocks have quotes: The bid price is the price at which you can sell stock, and the ask price is the price at which you can buy. To help you remember this, think of

Bid: This

Ask: This

Another example: If you have a $30 stock, you could enter a stop-limit order at $27.90 (a 7 percent stop loss) and a limit price of $27.90 (you can make the two numbers identical). In this example, once the stock hits $27.90, the

The problem with the stop-limit order, as always, is that in a fast-moving market, the order won’t get filled. This is a potential

which is why I suggest making the limit price a few pennies below the trigger price. On the other hand, if the market plunges and then bounces back, you’ll be thankful you are using a stop-limit order rather than a stop loss. Just remember that on the rally, the (now triggered) order will get filled at your limit price. But if you really wanted to get out of the stock, the stop-limit order might not be what you’re looking

Note: In my opinion, the stop-limit order is better than the stop-loss order, b...

The disadvantage of the trailing stop: In a fast market, the trailing stop could trigger because of a temporary market dip. But this is the chance you take when using trailing stops.

Note: It’s also possible to enter a trailing stop-limit order, which can give you even more control over your order. The trailing stop market order will get you out of the stock, while the trailing stop-limit order may not get filled at all. Note: If you want to use trailing stops, ask your brokerage firm what criteria it uses (percentages or dollar amounts), and how to enter the

Money is the scorecard that determines whether your strategy is working.

Exception: There are times when buying on the dip makes sense. First, if leading stocks are temporarily going down along with the entire market, you can buy these stocks at a bargain price. Just know that you may buy too early as stock prices continue to decline. In addition, if you are using short-term trading tactics and a leading stock suddenly plunges because the entire sector is going down, you may be able to make a quick profit if you buy on the dip and get the timing exactly right (but it’s difficult). These are strategies that require experience, and they can work for certain traders.

The fund manager takes pooled money from thousands of investors and uses it to buy stocks (or bonds, or whatever is allowed by the terms of the fund). The advantage is that you leave the buying and selling decisions to the fund manager (although there is an annual fee, and

addition, many mutual funds charge a redemption fee if you sell the mutual fund in less than 30 days. When you buy mutual funds, the idea is to hold them for the long term, and many

fund ratings using an Internet search engine. Type “rate top mutual funds” followed by the current year.

Hint: The website Morningstar (www.morningstar.com) is an excellent resource for mutual fund information. It provides detailed

a rating, and the fund objective. Morningstar is the first place to go if you want to learn more about

Note: There are hundreds of fund families but a few of the largest families with no-load funds include Fidelity, Vanguard, Pimco, T. Rowe Price, and Dodge & Cox, to name a few. Net Asset

mutual fund, which is why they’re called active managers.

Index funds are run differently. Like mutual funds, they use money pooled by investors. But unlike mutual funds,

have active managers. They simply buy the stocks that are included in one of the variou...

For example, you could buy funds that track the performance of the Dow 30 index, the S&P 500 index, the Nasdaq Composite index, the Russell 2000, Wilshire 5000, and more. The idea is that if you can’t beat the indexes, you might

(typically less than 0.50 percent). For these reasons, index funds have become very popular. As mentioned earlier, more than 80 percent of portfolio managers fail to beat the indexes (in some years, the records are even worse). This is why index funds are an excellent alternative.

Investing in Mutual Funds or Index Funds with a 401(k) or

If you leave the company before you retire, you can convert your 401(k) to an IRA (individual retirement account), another type of tax-deferred savings plan. IRA rules are complex, and the rules occasionally change, so seek professional tax advice before participating or making

Bottom line: If you have the opportunity to participate in a 401(k) or an IRA, do so. Many companies match your contributions (up to a specified limit), taxes are deferred, and there are many investment choices (usually mutual funds and index funds, but individual stocks can be bought with some

One of the reasons you are reading this book is to help you understand the stock market. This should help you make better investment choices if you are participating in a 401(k) or

hit, wiping out the accounts of most day traders. So many people lost money that the SEC changed the rules. Now, you must have a minimum of $25,000 in a margin account if you make more than four intraday trades within five business days. For example, if you buy YYY Manufacturing on Monday and sell the

It’s also a challenging strategy. Even with the best equipment and software, only a small percentage of people consistently make money day trading. First, it takes an incredible amount of discipline and knowledge to be a successful day

traders can make money, it is an extremely difficult way to make a living. Although day trading

Note: If you want to learn day trading strategies, you can start by reading my book Start Day Trading Now (Adams Media). In addition to day trading, I discuss other short-term trading strategies where you hold for a few days or a week rather than only a day. Another strategy is to find a stock that is a good candidate for day trading, and trade only that one stock. Basically, you attempt to become an expert on that stock.

In addition to day trading, there are other short-term strategies, which are discussed below.

When you buy a stock and sell it several days later, you are swing trading.