No one likes to lose money. Moreover, the pain threshold of some is greater than it is with others. If you're considering an investment in the stock market and the thought of a loss upsets you, you probably shouldn't invest. However, when you invest there are several things you should know to increase your chances of winning. That's the subject of this article. Although there are numerous details and caveats, this article will help you understand the basics of how the stock market works and why stocks react as they do. We’ll also discuss five things that every investor should know. Let's dispense with the mystery and take a look behind the veil.
What is a Stock Market?
The stock market is a complex system where shares of publicly-traded companies are issued, bought and sold. To some it is a nebulous, dark chasm where people gamble. Actually, it is not gambling at all. Why? Let’s say you put $100 on one roll of the dice. If you win, you win $X. If you lose, you lose the entire $100. When you invest in stocks, you will win $X or lose $Y. It's rare to lose it all, unless of course you invest in a company that goes bust. You could say that the stock market is a group of people pitting their expertise against one another. We'll touch on that in the next section.
The Stock Market is an Adversarial System of Trading
The stock market is a collection of millions of investors with diametrically opposing views. This is because when one investor sells a particular security, someone else must be willing to buy it. Since both investors cannot be correct, it is an adversarial system. In short, one investor will profit and the other will suffer loss. Therefore, it's important to become well versed on the investment you are considering.
What Makes Stock Prices Go Up and Down?
There are many factors that determine whether stock prices rise or fall. These include the media, the opinions of well-known investors, natural disasters, political and social unrest, risk, supply and demand, and the lack of or abundance of suitable alternatives. The compilation of these factors, plus all relevant information that has been disseminated, creates a certain type of sentiment (i.e. bullish and bearish) and a corresponding number of buyers and sellers. If there are more sellers than buyers, stock prices will tend to fall. Conversely, when there are more buyers than sellers, stock prices tend to rise.
Why is the Stock Market so Difficult to Predict?
Let's assume stock prices have been rising for several years. Investors realize that a correction will come and stock prices will tumble. What we don't understand is what will trigger the selloff or exactly when it will occur. Therefore, some investors will sit on the sidelines holding cash, waiting for the opportune time to get in. Those who are willing to assume the risk may jump in because the return on cash is so low and it hurts to earn zero while watching stocks move higher. This begs a couple of key questions. If you’re on the sidelines, how will you know when to get in? If you're already in, how will you know when it's time to get out? If the stock market was predictable, these questions could easily be answered. However, it is not. There are actually three issues an investor should consider. The first is understanding the point at which stock prices are fairly valued. The second issue is the event that will cause a downturn. The final issue is understanding the human decision-making process. Let’s briefly look at these.
The actual price of a stock is determined by market activity. When making the decision to buy or sell, the investor will often compare a stock's actual price to its fair value. For example, if a stock is trading at $30 per share and its fair value is $35, it may be worth purchasing. Conversely, if it trades at $30 but its fair value is $25, the stock would be considered overvalued and the investor would be wise to avoid it. What is a stock’s fair value and how do you calculate it? Ideally, it would be based on some standardized formula. However, there are many ways to derive this figure. One method is to combine the value of a company’s assets on its balance sheet, minus depreciation and liabilities. Another is to determine its intrinsic value, which is the net present value of a company's future earnings. We have briefly discussed two methods. There are a number of others. Because the methods yield a slightly different result, it's sometimes difficult to know if a stock is overvalued, undervalued, or fairly valued. And even if it is overvalued, that doesn't mean investors will suddenly sell and the price will fall. Actually, a stock can remain overvalued for quite some time. This is also why it can be problematic to make buy/sell decisions based on where the price of the stock is in relation to some moving average.
Knowing which event will cause a trend reversal is analogous to seeing around the corner of a solid brick building. Need I say more?
The Human Decision Process
This is the most interesting of the three. Inside every individual there is a logical and an emotional component. We may analyze a situation using our logical side but when it's time to act, we refer to our emotions. For example, when purchasing a car, we might research the engine, fuel efficiency, amenities, or other items. But when it's time to decide, we often ask other types of questions. Such as, how do I look in the driver's seat? Does the car match my image? When making investment decisions, since there is an investor on the other side ready to buy what you're selling or selling what you want to buy, you must be able to process the relevant data and make a good decision. However, it's impossible to know everything you would need to know and process it without any bias. For these and other reasons, we will make a sub-par decision at times. This will occur even with the most analytical individuals.
When is the Best Time to Buy and Sell?
The two most important decisions an investor will make are when to buy and when to sell. The best time to buy is when others are pessimistic. The best time to sell is when others are actively optimistic. When buying, remember that the prospect of a high return is greater if you buy after its price has fallen rather than after it has risen. But caution should be exercised. For example, after the stock of fictitious Company X declined by 30%, 40% or more, the first question to ask is why. Why did the stock fall as it did? Did other stocks in the same industry experience a decline? If so, was it as severe? Did the entire stock market fall? If the broader market or other stocks in the same industry/sector performed relatively well, there may be a problem specific to Company X. It's best to adopt a buy/sell discipline and adhere to it. Benjamin Graham, the father of value investing, once said, "The buyer of common stocks must assure himself that he is not making his purchase at a time when the general market level is a definitely high one, as judged by established standards of common-stock values." His reference was to what we discussed as fair value under the section Stock Valuation above.
The stock market is a complicated place for which the novice investor is not particularly well suited. Avoid the "hot tip" talk around the water cooler or in the lunchroom. Stock prices rise and fall for reasons which can be complex. Since the only sure bottom is zero, when you invest, consider adding protection (i.e. stop orders, options, etc.). To avoid another WorldCom, Enron, or even a 2008 type of disaster, be sure the company you're buying is worth owning. Unless you love risk, you may wish to avoid putting too much of your money in one stock.
It takes years to become well versed on the financial markets and on stocks in general. You may want to find someone you trust and seek their guidance. It may seem like an unnecessary expense but heading into unfamiliar territory alone can often cost us more than we expect.