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Economics 12
[Stock Market]
Introduction
What is a stock?
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A stock represents partial ownership of a corporation. When
you buy shares of a stock, you effectively own a small
fraction of that company. Stocks of public companies are
traded on stock exchanges like the NYSE or the NASDAQ.
Owning a stock entitles you to share in the future profits of
the company. The value of a company is essentially the
value of its future cash flows. So the value of a stock is the
value of a fraction of the future cash flows of the company.
Some companies pay out part of their profits through
dividends. You can also benefit from a price increase of the
company stock.
Buying stocks is a risky investment, as neither dividends
not price increases are certain and the stock can even lose
part or all of its value.
Why Do Companies Issue Stocks?
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Companies can decide to make the transition from the private
market to the public market for several reasons. When a company
"goes public," its first offering of stock is called an Initial Public
Offering or IPO. Once a company is public it can also decide to
issue more stock.
Stocks consist of two markets: primary and secondary. The
primary market, also known as the new-issues market, allows
new or growing businesses to sell stock to raise money. Investors
in IPOs can later sell the new stocks in the secondary market,
allowing buyers and sellers to trade stocks quickly and effectively.
The New York Stock Exchange (NYSE) and Nasdaq are the major
secondary markets in the United States. On these exchanges,
investors trade stocks that they already own, and the company
which initially issued new stock doesn't receive any additional
money from this activity.
When a company issues stock it raises money that it can use to
expand its business. For instance, a company might build a new
factory or hire additional employees with this money. As a result,
the business becomes more profitable.
Why Do Companies Issue Stocks?
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The reasons that a company might want to raise money by issuing
stock are:
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To
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To
To
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To
develop new products
buy more advanced equipment
pay for new buildings and inventories
hire more employees
provide for a merger or acquisition
decrease debt
give company owners greater flexibility
place a value on the company
An investment banker usually manages the offering of a
company's shares and serves as the link between companies and
possible investors.
When a company goes public, it also takes on several new
responsibilities and must comply with the federal and state
regulations for publicly traded companies. In addition, a lot of
company information, such as earnings, must be publicly available
and a great deal of effort is expended keeping investors informed
about the company. The company must also pay independent
underwriters, attorneys, and accountants.
Shareholder’s Rights
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A shareholder rights plan states the rights of shareholders for a
company. The management of the company usually proposes the
plans, and the shareholders approve them. Shareholders obtain
rights when they purchase shares and transfer the rights when
the shares are sold. A change of a shareholder rights plan is
usually printed in the annual proxy statement and announced
publicly. For example, IBM's board adopted a shareholder rights
plan under which the company will issue a dividend of one right
for each common share held by holders.
If you buy a share or shares of stock in a public company, you
become a part owner of that company. As a shareholder of one
share of Microsoft, you enjoy the same basic privileges and rights
as Bill Gates, who owns millions of shares. Most companies use a
one-vote-one-share system. Even though your one share of
Microsoft does not count much against Mr. Gates' millions of
votes, the company takes each vote seriously.
Shareholder’s Rights
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As a shareholder, you have the privilege to receive quarterly
reports and an annual report informing you of the financial health
of the company. The quarterly reports inform shareholders how
much money the company has made or lost during the reporting
period, and also reviews the business activities that have taken
place. The annual report is a combination of all quarterly reports
and is often published with elaborate charts and photographs. It
too provides detailed business and financial information about the
company.
As a shareholder, you will be invited each year to attend the
annual shareholders' meeting, where you can interact with
executive management and vote on matters that come before the
board. If you cannot go to the annual shareholders' meeting, the
company will send you an absentee ballot, allowing you to vote by
proxy.
The responsibility of the company's board and management is to
realize the inherent value in the company's business and
maximize shareholders' value. The shareholder rights plan
protects the interest of investors.
The Role of the Stock Market
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Stock Markets are an integral part of all
major Western economies. They provide
unique services and benefits to
corporations, individual investors and
governments.
Benefits for Corporations
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Raising Capital
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A corporation able to make an Initial Public
Offering (IPO) on the stock exchange gains
access to a huge universe of investors and a
ready supply of new capital for their business.
Once listed there is the opportunity for further
issuance if needed. Access to the stock
markets also facilitates growth by merger or
acquisition through share purchases.
Benefits for the Investors
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Improved Returns =
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Equities have no maturity data and no fixed rate of
return. This makes them a riskier investment than
money markets or bonds. What equities provide is the
prospect of a combination of income and capital gains,
plus a superior rate of return. From the 1930's until
2007 an average return of between 8% and 10% per
annum has been achieved (depending how you account
for dividend payments) compared with around 5% for
bonds. The stock market gives the flexibility to invest
small or large amounts and the choice of a vast number
of different corporations and industries in which to
invest.
Benefits for the Economy
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Putting Peoples' Savings to Work
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If individuals keep their savings in cash, or even a bank
account, there is little or no benefit to the economy.
Investment in stocks, however, is a direct investment in
the success of individual businesses and helps promote
stronger economic growth.
Measure of the Economy's Performance
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Although the health of the economy can not be directly
correlated with the performance of the Stock Market, it
is true that the performance of share prices in general
will be a good indication of it's current condition and of
the confidence of individuals within that economy.
Benefits for the Economy
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Corporate Governance
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The regulations required for a corporation's stock to be
listed on the Stock Exchange and the ongoing
requirements to maintain that listing are a good way to
ensure that management standards and standards of
record keeping within that corporation are maintained at
a high level. There have been notable exceptions, but
generally record keeping of publicly quoted companies
has been shown to be better than that of private
companies.
Access to Funds for Governments
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In addition to corporations, governments themselves
may issue bonds that are quoted on the Stock Market to
raise money for infrastructure, or other major projects.
The stock exchange allows individuals to lend money to
their government to fund their programs.
Trade Types
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At the most basic level, there are only two ways
you can trade stocks; you either buy them or you
sell them.
If you think share prices are going up, you buy.
You close your position by selling the shares.
You can also bet on falling share prices by selling
short. That is, selling shares you do not own. You
essentially borrow shares from your broker and
then sell them. You close your position by buying
back the shares (buy to cover) and giving them
back to your broker. Typically, not all stocks can
be shorted, depending on the inventory of shares
your broker holds.
Commissions
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When trading stocks, the commission charged can make the
difference between a profit and a loss. A full service stockbroker
will charge up to 2% commission on every trade done. That may
not sound much, but it means that if you buy a stock at $20, you
have to sell it at $20.80 just to cover his commission. Although
online brokers are far cheaper, their commissions can still add up,
particularly for an active, or day trading account.
Even with the introduction by at least one major online broking
service of a fixed commission amount, regardless of the number
of shares traded; deal costs can still be a major factor in your
success or failure. This is particularly true for traders executing
smaller deals, meaning the commissions form a larger percentage
of their funds at risk.
An active day trader, or a scalper, doing twenty or thirty trades a
day would need to clear at least $4,000 profit a month just to
cover commissions. Remember you get charged just as much
commission on a losing trade as on a profitable one. The broker is
the one person guaranteed to make money whenever you deal
with him.
Advanced Trade Types
You can use the following trading techniques to improve
your portfolio's. These compare to a market order, which is
executed at the best price available at the time of the
trade. If the market order is placed when the exchange is
closed it is executed at the best price available when the
next trading session opens.
Limit Orders
 To limit the execution price of a trade, you can place a limit
order. This way, you can define a maximum price you will
buy at, or a minimum price you will sell at. Remember that
if nobody is willing to trade at your price, your order will
not be executed. As long as the trade has not been
executed, you can then cancel the order or change the limit
price.
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Advanced Trade Types
Stop Loss
 If you want to protect your profit on an open position, you can
place a stop loss order. If the stock drops below your stop loss
price, your shares will be sold. For example, if you have bought a
stock at $10 and the price has risen to $11, you could place a
stop loss order at $10.50. If the price falls below $10.50 your
selling order will be executed. You are not guaranteed $10.50 as
an execution price, your trade is the next one done after the price
falls to $10.50, so could be lower.
Trailing Stop-Loss
 This is a refinement of the above technique. You set the stop loss
at a variable price, at a discount to the highest price the stock
reaches after you put in the trailing stop loss. For example, you
could set the stop loss at 50 cents below the stock price. As long
as the stock price rises, the stop loss price does, too. But the stop
loss level never falls, so if the price drops by 50 cents at any time
your stop loss is activated.
Trade Execution and Partial Fills
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Many investors think that when they place an order, the
execution is instantaneous, but this is not so. Even when
placing an order on-line that order goes to the office of the
broker, who then places it with the exchange. This means
that, for a market order, the price quoted, or seen on
screen, is not necessarily the price you will trade at.
Your broker has a duty of best execution on any orders
received, which means if he can improve on the price
quoted to you, he will. There is no guarantee he will be able
to do this though. A speedy execution is another part of
this duty. There are circumstances where he may have
several choices of where to execute your order. Some may
take more time but possibly offer a better price. Here, the
chance of the price improvement would have to be weighed
against the slower execution meaning there was more risk
the price will move against you.
Trade Execution and Partial Fills
Partial Fills:
 When placing a market order the risk of only obtaining a
partial fill is removed, as if there is not enough market
depth at the original quote the balance will be traded at the
next best prices available until the order is completed. The
exception would be small or illiquid stocks where there may
only be a few shares bid or offered at any price. In smaller
stocks he risk of market orders is that fills may be obtained
at widely different prices.
 With limit orders a partial fill may occur, as less favourable
prices cannot be accepted. You have the option to leave the
order balance at the same price, cancel it or change the
limit for the remaining shares.
Margin and Margin Calls
Margin is a form of leverage. Margin accounts allow you to
buy stock by borrowing a percentage of the cost from your
brokerage house. The brokerage house will lend you the
money and charge you interest. This increases your buying
power, but also increases your risk. There are minimum
equity levels required in a margin account at all times.
Initial Margin Requirements:
 This is the minimum amount of the security’s purchase
price you are required to have in your margin account at
the time of the trade. Current regulations for stock
purchases require 50% of the cost to be in your account,
with a minimum cash balance of $2,000 required. For a
short sale, the full trade proceeds plus an extra 50% must
be in your account.
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Margin and Margin Calls
Maintenance Margin Requirements:
 After the trade is done a minimum balance must
be maintained in the account at all times. This is
the maintenance margin.
Margin Call:
 When the amount of margin within your account
falls below minimum levels, the broker will ask
you for extra funds to be deposited. This is a
margin call. The alternative is to close some
positions to reduce the margin requirement in the
account.
Investing vs. Trading
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What is the difference between investing
and trading?
Investing
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Investing
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Index Tracker portfolios
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Set up to mirror the Dow Jones or S&P 500 index, they will be
constructed to exactly follow movements in those indices.
High Dividend Portfolios:
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Investing is for the long term. You are buying stocks to exploit
the long-term growth rates generally available in equities.
With the exception of occasional bear markets like the one
seen in 2007-09, that growth rate has consistently beaten
bonds, cash or other mainstream investments. Through
research and fundamental analysis one tries to create a
balanced portfolio of different stocks. Some sorts of portfolios
are:
Made up of stocks with above average dividend yields.
Blue Chip investment portfolios
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Not limited as strictly as the tracker portfolios, but comprising
only the largest and top rated stocks.
Generally strategies will either be focused on maximizing
income or long term capital growth.
Trading
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Trading
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Day Traders
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Make dozens of trades every day and try to make a very small profit
on each. They will also close the position quickly if it goes the wrong
way, to limit losses.
Momentum Traders
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They look to buy a stock at the low point of the day (or sell at the
high) and close that position for a profit the same day. They aim to
have no open positions overnight.
Scalpers
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Trading is a more active, short-term strategy. Buying and selling
frequently to take profits rather than accumulate long term growth.
Some sorts of traders are:
Look for a situation where there is high volume in a stock that is
moving decisively one way or the other and trade in line with that
trend. They will watch for that momentum to ease and then take
profits.
Fundamental, or swing Traders
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Look at a company's fundamentals and will hold positions longer than
the traders above, but are still looking for short to medium term
profits and buy and sell actively in the market.
Investing and Trading Strategies
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Investing
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Income vs. Growth
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Equity investing involves building a portfolio of stocks and monitoring
and managing its performance over time. The main aim will be to
create income, growth, or a combination of the two.
Income portfolios maximize the annual yield or cash flow and
commonly look at stocks with high dividend yields. A growth-targeted
portfolio buys undervalued stocks to obtain high rates of long-term
capital growth for the portfolio. Dividends or other cash flow would
commonly be reinvested to increase this growth rate.
Active or Passive Management
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Passively managed portfolios
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As few investment decisions as possible are made and trading is kept to a
minimum. The most popular sort of passive portfolio is an index portfolio,
which tracks movements in a stock market index like the S&P 500. Long
term performance is more predictable is the sense that it will be close to the
performance of the index tracked.
Actively managed portfolios
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Actively managed portfolios will trade more often, exploiting anomalies and
inefficiencies in market pricing to outperform the indices. Performance is
less certain as it depends on the quality of decision making by the portfolio
manager.
Investing and Trading Strategies
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Trading
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Individual Stock Picking
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Whether singly, or within a portfolio, analyzing individual stocks to
pick the cheapest to buy or overvalued stocks to short to beat market
performance.
Stocks vs. Index
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Trading focuses on short to medium term gains, rather than long-term
growth. Whether a day trader, holding zero risk by each market close,
or willing to hold positions longer, a trader is looking to take profits
frequently.
This may be done in individual stocks or within a larger portfolio.
Holding core long or short positions in a stock index, or index based
portfolio and taking a contrary view in individual stocks that will
outperform, or underperform, the index to increase returns.
Market neutral trading
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Taking opposing positions in pairs of stocks. As the price of your long
position outperforms your short, you make a profit. This keeps your
cash position low (or at zero) and your exposure to overall market
moves to a minimum, whilst exploiting pricing anomalies in the
market.
Fundamental Analysis
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Investors use fundamental analysis is to determine the value of a stock and predict
its likely future market performance.
The process can be carried out on three levels: macro, sector and individual stock
analysis.
Macro
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Sector Analysis
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Examines the global and domestic economic factors and overall market trends to determine
likely directions for stock markets as a whole. Factors such as GDP, economic growth,
inflation, interest rates and energy prices will be considered. The analyst will then move on to:
Identifies which sectors of the economy will outperform in the current macro economic
conditions. This may be based on regional or industry specific factors. Finally, the focus moves
to:
Individual Stock Analysis
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Which business within the selected region or industry will show the best performance?
The method of starting with macro economic factors and working down to individual
businesses is called the top-down approach. If the order in which the research is done is
reversed, that is the bottom- up approach.
Once the analysis is focused on individual stocks the financial and business health of that
company will be considered and compared to its peer group. The assumption behind
fundamental analysis is that markets can incorrectly price a security in the short term, but in
the longer term these anomalies will be corrected and the stock re-priced. The goal is to
identify these situations and exploit them.
The main alternative to fundamental analysis is technical analysis, which is discussed here.
Technical Analysis
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Technical analysts, also known as chartists, maintain that all relevant information is
already reflected in a share price. This differs from fundamental analysis, which seeks
to exploit pricing anomalies. Technical analysts believe that analyzing outside factors
and ratios is irrelevant. Instead they look at the history of the price movement of a
stock and at indications of current market trends to determine when to buy and sell.
The assumptions are that historical movements will repeat themselves as they are
indications of behaviour to set circumstances.
Here are some of the most popular trends and indicators that chartists will study.
Head and Shoulders:
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Double top, or double bottom:
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Where a price twice falls back from, or bounces up from, the same level. This suggests strong
support or resistance exists at those levels. The trend suggested is for the price to continue to
move away from those levels, rather than breaking through.
Moving Averages:
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This is formed when a share price peaks and falls back three times, with the second peak
being at the highest level. When seen on a chart, this looks like a head and two shoulders.
This is a bearish price trend, suggesting the third fall back will continue through the "neckline"
indicated by the price troughs and on to lower levels.
When the share price, usually measured as the price of the stock at close of business on a
trading day, breaks through the average closing price from a set number of previous days
(say 50) then that is an indication that the price trend is in that direction. Sometimes two
averages are used, for instance, 5 day and 50 day and the trend is set by the shorter average
breaking through the longer one.
Relative Strength Index:
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This index measures whether a stock is overbought or oversold. The RSI measures the stock
movement from one close to the next and therefore, the strength of the prevailing stock
trend.
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Stock Dividends
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Dividends are like a small reward that a company pays you for
owning shares of its stock. Each year, many companies return a
portion of their earnings to their shareholders through dividends.
In general, a company that has a slow growth rate pays high
dividends. On the other hand, a company with a high growth rate
usually pays no dividends at all.
Historically, large corporations and utility stocks have paid regular
dividends. Companies with a growth rate of less than 10%, for
instance, might have a high cash flow but a slowly appreciating
stock. They choose to pay dividends to investors in order to
attract income because stocks that pay dividends are very
appealing to certain investors.
In contrast, some large corporations with high growth rates and
stock prices that appreciate rapidly probably do not pay dividends.
The reason is that these companies reinvest their earnings into
the company to grow their businesses.
The board of directors votes on the various aspects of dividends
such as their approval and dates of distribution. Dividends are
usually paid quarterly and sometimes annually or semiannually.
However, many companies don't pay dividends at all. Older stocks
are more likely to pay dividends than the latest IPO.
Stock Dividends
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If the board of directors does decide to issue dividends, it
will be announced at a set amount and will be paid to the
shareholders as of a record date. Dividends will be paid on
the distribution date, sometimes called the payable date. In
order to receive the dividend, you must own shares of the
stock on the record date.
An increasing number of public companies offer a dividend
reinvestment program (DRIP). It automatically uses your
cash dividends to purchase additional shares of the stock
without a broker. Shareholders not participating in a DRIP
will receive a check from the company when the dividends
are distributed.
The importance of dividends depends on your investing
strategy. If your main objective is to find stocks that are
likely to appreciate quickly, dividends probably will not play
a large role in your investment decisions. On the other
hand, if your objective is to generate a steady return on
your investment, stocks that pay dividends could become a
central part of your strategy.
Stock Splits
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Stock splits occur when a public company issues more shares of stock to existing
shareholders. In a 2-for-1 stock split, a company issues another share for every one
already sold. After the split, 1 pre-split share will be replaced with 2 shares, and the
share price is halved. For example, pretend you own 100 shares of IBM trading at
$120. If IBM announces a 2-for-1 split, then you would now have 200 shares at a
stock price of $60. A stock split doesn't change the value of the shares you own. A
stock split is just like trading in a dollar for 4 quarters.
Splits can either be "ordinary" or "reversed". In ordinary splits, the share price lowers
while the number of outstanding shares increases. A 2-for-1 split, for instance, is an
ordinary split. Companies usually perform ordinary splits to reward the shareholders.
In reverse splits, the share price increases while the number of outstanding shares
decreases. A low-priced stock may have a reverse split so it looks like a more
valuable company.
A company may also perform a reverse split to eliminate small shareholders. For
example, a penny stock worth $1 may have a 1-for-10 split and be worth $10. After
the split, 10 old shares would be needed to equal 1 new share. Ordinary splits usually
occur among high-growth technology stocks, while reverse splits happen among lowpriced stocks.
For accounting purposes, a stock split is a non-event because the market value of the
company stays the same, and each shareholder's total fraction of the company
owned remains the same. In general, the share price of a company goes up after a
split. The split happens in the first place because of a high stock price. After the stock
split, investors may anticipate more upside in the share price.
Mergers and De-listings
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In order to be listed on a major stock exchange here are certain minimum conditions
that must be met. These vary by exchange, but typically include: minimum number
of shares outstanding, minimum market capitalization and/or minimum annual
income of the corporation.
A prolonged breach of any of these conditions can cause a delisting of that
corporation's stock.
Some of the main reasons for de-listings are:
Mergers & Takeovers:
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Share Price falls:
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If a corporation fails to file the necessary forms, earning statements or similar documentation
with the SEC, then delisting of their stock is one punitive measure that can be taken.
Bankruptcy:
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In addition to minimum market capitalization requirements, major exchanges like the New
York Stock Exchange and the NASDAQ will de-list a company whose share price stays below
$1 for more than a set period of time.
Breach of Regulations:
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Once completed, the listing of the company that was subject to the takeover or merger must
be de-listed and the shares of that corporation are no longer publicly traded. These shares will
have been exchanged for cash, shares in the corporation making the bid, or shares in the new
company formed by the deal, dependant on the terms of the deal. Details are sent to all
stockholders confirming the terms of the deal, its success and what they are required to do
with their holdings of the de-listed company.
Often, stocks will be de-listed well before bankruptcy occurs. Any such circumstances resulting
in a business ceasing to trade will result in suspension from trading on exchanges, followed by
delisting.
Voluntary De-Listing:
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On occasion, a corporation may decide that being publicly traded is not the right course for
them. They may wish to consolidate the company's ownership, change the nature of their
business or carry out a corporate restructuring. They may opt to buy back shares, de-list and
take the company private. As with bankruptcy, removing a stock from the exchange for this
reason does not allow trading in "over the counter" markets after the delisting is complete.
Types of Stock
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Stocks may seem complicated, but they can be broken down into two
basic groups: common and preferred stock. In addition to these two
groups, a company may issue classes of stock, sometimes Class A and B.
Common stock is the most common form of stock you will encounter. It
represents fractional ownership of a company. Common stocks are easy to
transfer. When the market opens, a common stock may be sold or bought
at whatever price another investor is willing to pay. Common stockholders
usually have voting rights and have a higher potential for return than
preferred stockholders.
The second type of stock is preferred stock. It not only represents partial
ownership of a company (like common stock) but also pays dividends at
specified rates. In addition, dividends are paid to preferred stockholders
before common stockholders. Also, if a company is performing poorly,
common stock dividends are usually removed first. Moreover, if a
company sells its assets because of bankruptcy, preferred stockholders
have a claim on the assets before common stockholders. However,
preferred stockholders do not usually have voting rights, and the
dividends on preferred shares are not increased if the company performs
well. Companies sometimes offer "convertible preferred stocks" which
allow shareholders to convert their shares to common stocks at a set
price.
Types of Stock
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In addition to common and preferred stock, a
company may have classes of stock, usually
Class A or Class B. Classes of stock are used to
separate ownership and control. A company may
issue a new class of stock for a specific purpose,
such as financing an acquisition or merger. Some
classes of stock may not come with voting rights.
Stocks can be broken down into common and
preferred or even Class A and Class B. Owning
any type means you are a part owner of a
business, but some classes have limited
privileges.
Blue Chip Stocks v. Penny Stocks
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Blue chips, like in poker and other card games, are the
most expensive chips. Similarly, blue chip stocks are worth
the most and come from larger companies. Penny stocks
are very low priced stocks that trade anywhere from a
fraction of a cent to a few dollars.
Blue chip stocks are the most valuable stocks on Wall
Street and are usually from companies that are household
names, such as AT&T, McDonald's, and Starbucks and tend
to be large or mid-cap stocks. Blue chips have a long
operating history, steady earnings, and a good reputation.
They also have high liquidity, or the ability to trade large
amounts of a stock without any problems. Blue chips are
considered safe bets, especially if the market is falling.
However, some blue chips do not always perform well.
Penny stocks often belong to newer companies with little
operating history and tend to be small-cap or even minicap stocks. They are usually indicated with an .OB or OTC
(over-the-counter) after the stock symbol, which means
that their shares are not traded on the major exchanges.
Blue Chip Stocks v. Penny Stocks
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Penny stocks can be difficult to trade because of low liquidity and
volume issues, but they can still attract investment capital from
certain types of investors. Penny stocks are a very risky
investment and there is no guarantee against bankruptcy, but
they represent an interesting opportunity to speculators who
benefit from the incredibly low share price and the potential for
enormous upside.
Not all large-cap stocks are considered blue chip stocks. Shares of
the high-flying Internet stock VA Linux went up 300% on the date
of the initial public offering (IPO) and had a high enough market
capitalization to be considered large cap, but it didn't have a long
enough operating history to be considered blue chip. In addition,
numerous IPOs start out strong but drop drastically in the
following months.
Blue chips and penny stocks are basically opposites, but there is
no guarantee that either one is a great investment at a given
time. Investors must always be careful when buying any kind of
stock. Investors sometimes have the misconception that penny
stocks are cheap and therefore will eventually have upside
potential. A low share price does not actually mean that a stock is
cheap. Only by researching a company's earnings reports is it
possible to determine whether a stock's current price over- or
under-valued.
Market Cap
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As an investor, you have to make decisions about buying stocks in large or small
companies. In the stock quote table on the Internet, a column called market
capitalization indicates the market value of a company. The market capitalization,
also known as market value or market cap, is found by multiplying the share price by
the number of shares outstanding. For example, a company at $10 with 20 million
shares outstanding has a market cap of $200 million. Stock market experts do not
have set numbers for small, mid, and large cap stocks, but the following table gives
you an idea of the market caps for small, medium, and large companies:
Market Capitalization
Small-cap: Under $500 Million
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
Mid-cap: $500 Million-$1 Billion

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Small-cap stocks are usually those with a market cap less than $500 million. Investing in
small-cap stocks can be risky because they are usually newer stocks and their companies
have not proven to be stable or profitable. However, small-cap stocks can have very high
growth potential compared to large-cap stocks. A small-cap stock is much more likely to
double or triple than a large-cap stock. Overall, small-cap stocks have high risk but may result
in high returns.
Mid-cap stocks are those with a market cap usually between $500 million and $1 billion. These
stocks are just in between small and large cap stocks. Mid-cap stocks are not as risky as
small-cap stocks but are not as stable as large-cap stocks. They can provide fair profit in the
long run.
Large-cap: Above $1 Billion

Large-cap stocks are those with a market cap usually above $1 billion. Investing in large-cap
stocks can be quite safe because those companies have proven to produce consistently good
earnings and be very stable in growth. However, large-cap stocks grow more slowly than
small- and mid-cap stocks. In the long run, large-cap stocks have low risk but slow growth.
The tradeoff between small and large cap stocks is between risk and return.
Size Segmentation
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
When constructing a balanced portfolio, an
investor may look at diversifying in various ways:
by industry sector, by cyclical factors, to include
international corporations, or by the size of the
corporation's market capitalization.
Stocks can be divided into the following
categories, based on the size of the corporation:

Blue Chips:

Also known as Bellwether Issues. Not defined by size, a
Blue Chip company is a market leader, one of the safest
investments available. To attain Blue Chip status the
corporation will have produced consistently strong results
over a period of time. By their nature, Blue Chip stocks will
include some of the largest companies traded, such as:
Wal-mart, GE, Coca Cola and IBM. The largest of these are
known as Mega Cap stocks, having a market capitalization
of over $200 billion.
Size Segmentation

Other divisions based on the value of a corporation's market
capitalisation are:

Large Caps:
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
Mid Caps:
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Those between $50 million and $300 million
Nano Caps:


Are capitalized between $300 million and $2 billion.
Micro Cap:


Are capitalized at between $2 billion and $10 billion.
Small Caps:


Defined as a corporation with a market capitalization in excess of $10 billion.
Those under $50 million
Penny Stocks:


A definition based not on market size but on share price, these tend,
however to be amongst the smallest companies traded and are often only
available on over the counter markets. The definition of a penny stock is any
stock trading below $5 a share, regardless of overall capitalization.
Good stock selection between large and smaller cap companies will give
stability to your portfolio, whilst profiting from sharper price movements (in
percentage terms) of outperforming smaller cap issues.
Cyclical Stocks
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
The price of a cyclical stock rises and falls with the business
cycle. Predicting a business cycle is not an easy task, and
cyclical stocks tend to lead the business cycle by six to ten
months. This means that some cyclical stocks will start
doing well six months before the economy comes out of a
recession.
Cyclical stocks usually come from companies whose
products experience flexible demand in market. For
example, automobile stocks can be cyclical because people
do not constantly need to buy cars. If interest rates
increase, buyers will not have enough money to afford the
cars, which causes the profits of automobile companies to
fall. Conversely a non-cyclical stock's product experiences
constant demand. Coca Cola is a non-cyclical stock because
even if interest rates rise, people will probably continue to
buy beverages. The difference between a cyclical and noncyclical stock is tied closely to consumer need and demand.
Cyclical Stocks
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
The business cycle, along with cyclical stocks, involves interest,
inflation, and unemployment rates. If these factors increase,
businesses will do poorly and have lower profits. A decrease in
these factors will cause businesses to expand and have very
strong earnings. This rise and fall can be unpredictable and last
for a constantly changing number of years. A change in the
economy usually happens during election years when the new
president can change policies.
Buying cyclical stocks can have certain risk factors. Investors may
not be able to judge whether the economy will perform well or
poorly. It is very challenging to predict when the next change in
the business cycle will take place. Investing in cyclicals is thus a
risky strategy because of how unpredictable the economy can be.
On account of the information they have access to, Wall Street
professionals are usually better at predicting changes in the
economy and business cycle than individual investors. Still, buying
cyclical stocks can be very profitable for anyone confident about
what will happen to the economy in the future.
Growth v. Value Stocks
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
As an investor, you want to buy low and sell high. But you
can also buy high and sell even higher to make a profitable
investment. How is this possible? The usual buy low, sell
high takes place with value stocks, but a type of stock
called "growth stocks" enables you to buy stocks at an
expensive price and sell at an even higher price. Now, the
real question is how you can determine if a stock is cheap
or expensive. Its value is not how much it's selling for?that
is its share price?but rather its price-to-earnings ratio (P/E)
in relationship to the benchmarks for the U.S. stock market
(such as the Standard and Poor's 500 Index, known simply
as the S&P 500). For example, if the P/E for the S&P 500 is
25, a 150 P/E for a particular company is considered
expensive.
P/E is the price-to-earnings ratio. The P/E is found by
taking the share price of a company and dividing it by the
company's earnings per share (EPS). If the P/E is used
correctly, it is a good indicator of whether you are paying
too low or too high a price for a given stock.
Growth v. Value Stocks


Growth stocks tend to grow faster than the S&P and have a
higher P/E than that of the S&P. Unlike value investors,
growth investors look for stocks with high growth potential.
They often buy stocks with high P/E ratios or even negative
earnings. The most profitable situation would be if a
generally fast-growing company has a dip on account of a
temporary setback. It is then possible to buy the stock at
the low price and make a profit when the company resumes
its usual, fast growth.
Growth and value stocks are two types of stocks from
which you can make a respectable profit. Value stocks will
be selling at a lower P/E than usual and can sometimes
stay at lower prices for a long time. Investors may have to
wait patiently for the stock market to realize the intrinsic
value of the company. Growth stocks can sell at very high
P/Es but still have plenty of room for growth.
Income Stocks


Wouldn't it be nice to earn income in addition to the capital appreciation
on your investment? Income stocks appreciate like other stocks, but they
also pay a relatively large dividend. It is helpful to compare an income
stock investment with a conservative investment in Treasury bonds or a
savings account where capital appreciation is impossible but income is
guaranteed. For example, if you put $1,000 in the bank at 4% interest,
you will get $40 interest annually, but the original $1,000 is unchanged.
Income stocks might pay similar dividends but potentially provide capital
gain on top of the dividends if the share price rises. As with all stock
investments, however, income or gains are not guaranteed.
An important term when investing in income stocks is "yield", which is the
percentage of the share price that a company pays in dividends annually.
To calculate the yield, take the dividend amount you will receive for the
year divided by the share price of the company. For example, if Disney
pays a $0.25 dividend quarterly, you will receive $1 in dividend annually.
If Disney is trading at $40, the yield would be 1/40, or 2.5%. If the share
price drops to $20, the yield would be 1/20, or 5%. In other words, if the
annual dividend remains constant and the share price decreases, the yield
will increase.
Income Stocks


High income stocks, or those paying high dividends, are
usually the utility stocks or Real Estate Investment Trust
(REIT). Traditionally, REITs have high cash flow from real
estate rental, which they distribute to shareholders
quarterly as dividends. Utilities and REITs usually have
yields between 5% and 10%. When buying income stocks,
shareholders could make money from the quarterly
dividends as well from as an increase in share price. But if
the company loses money, it could stop paying dividends.
One strategy for buying income stocks is investing in largecap, high-yielding stocks. An easy way to pick these stocks
is using a method called Dogs of the Dow. It involves
buying the ten Dow stocks with high yields and good
dividends because the share price is having a temporary
setback. If the company resumes upward growth, investors
will profit. By looking at the historical data and investing in
Dogs of the Dow, investors can get a better return and
higher yield on their investment.
Tech Stocks


Technology stocks are very volatile and, although they can
sometimes experience explosive growth, they may also
depreciate very rapidly. The world of technology stocks can
be very profitable compared to putting money in the bank,
but the risk associated with investing in tech stocks should
be taken very seriously.
Share prices of technology stocks can skyrocket because of
the rapid growth experienced by internet and information
technology companies. The tech sector is comprised of
many new markets, including e-commerce, content
providers, business to business, fiber optics,
telecommunications, Web site providers, as well as "dot
coms" (individual web companies). All of these markets are
constantly producing innovative products, and the stocks
can see tremendous profits.
Tech Stocks


While technology stocks can be very profitable, the fast-growing
industry has led to many new, unstable companies. Sometimes
new technology stocks have no real earnings, or the possibility of
securing future earnings can vary greatly. In the past, investors
have rushed to invest in new technology stocks because of the
popularity of the .com initial public offerings (IPOs). These new
companies may have a 200%-300% increase on the opening day
of the IPO but drop quickly afterwards. The companies have no
fundamentals or earnings, causing investors to lose patience, sell
the stock, and this causes the share price to drop. Investing in
tech stocks can thus result in high percentage losses if you choose
the wrong stocks.
On account of their volatility, tech stocks are an exciting place to
invest and may result in superior returns. If you make an
informed investment decision by researching companies to learn
about their fundamentals and earnings outlooks, it may be
possible to pick the winners that will lead to high returns. But by
picking losers you can ultimately lose your entire investment.
Industry Segmentation

One method for obtaining balance in a portfolio is
diversification across different industry sectors. Different
agencies use different sector lists to divide the market, but
most lists are very similar. Standard and Poor's uses ten
sector headings:
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

Consumer Discretionary
Consumer Staples
Energy
Financials
Health Care
Industrials
Information Technology
Materials
Telecommunication Services
Utilities
This is known as the Global Industry Classification Standard
(GICS).
Industry Segmentation





Dividing stocks in this way helps analysis of individual stock performance.
If the energy sector is generally up 10%, but your share is down 5% you
can measure its underperformance against its peer group. Then you must
decide whether there is good reason for that underperformance, or
whether this represents a buying opportunity. Long-term performance can
also be measured between companies in the same industry to determine
which are historically the best performers in that sector.
Secondly, the performance of whole sectors can be compared. At a macro
level there are sectors that tend to outperform the market when it is
falling and those that historically outperform in rising markets.
Utilities and Consumer Staples are considered "defensive" sectors for the
market and tend to outperform in falling markets. People still need to buy
food and pay their electric bills when times are hard, so sales in these
sectors are more stable. Conversely, they will not see the same gains in
rising markets as some others. Some analysts also include Health Care as
a defensive sector.
The other sectors are called "cyclical". The performance of these industries
depends more on market conditions and economic cycles. There is more
volatility inherent in these sectors.
There are no firm rules as to how sectors are classified; different analysts
will award different weightings to each sector.
EFTs


ETF's, or Exchange Traded Funds, came into being in the
USA in 1993 and in Europe in 1999. They are an
investment vehicle made up of a basket of individual stocks
and are traded on major stock exchanges. They have some
of the characteristics of a mutual fund, as the closing price
is calculated by the net asset value of its constituent
securities. Unlike mutual funds however, they can be freely
traded throughout the trading day. Demand factors will
sometimes move the price away from the net asset value,
creating possible arbitrage possibilities.
Until recently ETFs were all index funds, but in 2008 the
SEC began to allow actively managed ETFs to be traded.
You can now also buy commodity ETFs, sometimes known
as ETCs, and Currency ETFs. Since 2008, Leveraged ETFs
have also been issued.
EFTs


The advantages of ETF's for the investor are the
diversification and low expense costs they
provide, whilst enabling you to employ
techniques used in trading individual stocks, like
the ability to place limit orders or carry out short
selling. With over a thousand different funds
available by early 2009, there is plenty of choice
available.
Retail investors do not trade directly with the
fund manager running the ETF. He trades large
blocks of shares with major financial institutions.
Holders of these large blocks can trade them
throughout the day on the exchange. It is this
secondary market that other investors trade with.
Leverages ETFs


The first Leveraged ETFs were issued in June 2006. They use equity
swaps, derivatives and a daily rebalancing of the basket of stocks to
reduce a multiple of leveraging over the performance of an indexed ETF,
based on either the S&P 500 or the Dow Jones Industrial Average. The
most frequent leveraging is to double the return on the selected index.
These are known as 2X funds. However, 3X funds are now becoming more
common. It is important to note that the leverage works on the daily
returns of the index, not the annual return. This makes leveraged ETFs
more suitable for short-term investors than long term.
To illustrate why the leveraged returns are not accurate over the longer
term, take this example of a 3X fund based on the S&P 500






Assume both have a starting price of 100 and the underlying index rises
by 10% on day 1
The S&P price would now be 110 and the ETF price 130, reflecting the
leveraging.
The next day the index falls by 10%
The S&P now stands at 99, giving a fall of 1% over the two days
The ETF would stand at 91, because of the leverage, meaning a two day fall of
9%, or nine times as large as the underlying index.
Remember that leverage always increases risk, but gives the potential for
better rewards as well.
Leverages ETFs


Here are the main advantages and disadvantages
of Leveraged ETFs
Advantages:



A simple way of obtaining leverage, not requiring
derivatives or multiple trades
A good way of leveraging short-term market gains,
particularly intra day
Disadvantages:


The pricing mechanisms mean that longer-term
performance cannot be accurately predicted and may
under perform the expected leverage significantly.
Liquidity is, as yet, comparatively poor and trading
volumes low.
Some Definitions

Standard & Poor's (S&P) is a division of
McGraw-Hill that publishes financial
research and analysis on stocks and
bonds. It is well known for the stock
market indexes, the US-based S&P 500,
the Australian S&P/ASX 200, the Canadian
S&P/TSX, the Italian S&P/MIB and India's
S&P CNX Nifty.