Investing in the stock market is both a rewarding as well as risky proposition. Many investors are quite comfortable knowing their mutual funds are professionally managed, and the diversification of those portfolios has kept risk to a minimum. For other investors, selecting individual stocks provides both a sense of control and satisfaction.
In this article, we are going to cover some of the keys to successful stock market investing. That discussion will include how to go about researching companies, as well as a primer on stock trading terms and financial ratios. We're also going to explain how risk and reward are determined by market forces, and the effect price volatility can have on some investors. Finally, we'll talk about setting goals and how they can be used to figure out if it is the right time to sell stocks.
Buying Stocks
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The approach to buying stock in a company should be the same as that used for any other purchase of this magnitude. Most consumers wouldn't think of spending $5,000 without thoroughly researching the product or service they're thinking about buying. The same thought process should apply to common stocks.
Researching Companies
We've written extensively on the topic of researching stocks elsewhere in this publication. In this article, we're going to cover the basics. Whenever someone buys common stock in a company, they're becoming a part owner of the business. For that reason, investors need to think like a business owner when evaluating each company.
Thinking like a business owner entails finding companies that are considered leaders in their industry, demonstrate superior brand loyalty, or have some other competitive edge. Strong brand names such as Coca Cola or Starbucks can usually demand a premium price for their products, and that translates into higher profit margins.
Understanding Financial Ratios
One of the fundamental ways to gain a better understanding of the financial well-being of a company is by examining their financial ratios. Here there is almost an endless list of possible measures from which to choose and we provide more guidance on this topic in our article: Understanding Financial Ratios.
Here we're going to limit the discussion to four principal areas: price, profitability, financial condition, and investment return. Explanations for each of these critical ratios appear below:
Price / Earnings Ratio: Also referred to as the P/E ratio, this measure is calculated by taking the stock's price and dividing it by the latest 12 months of earnings per share. The P/E ratio is an indicator of the premium paid for a stock, and is an indicator of the market's view of future growth potential. Higher ratios indicating higher premiums.
Net Profit Margin (%): This is the ratio of net profits to sales. This is arguably the best indicator of the company's efficiency because net profit takes into consideration all expenses of the company. The net profit margin of stocks being considered should be high relative to their competitors or industry.
Debt / Equity Ratio: This is a measure of long-term debt divided by common stock equity. This financial ratio is a measure of leverage. The lower the debt to equity ratio, the less likely a company will be affected by a downturn in the economy.
Interest Coverage: This measure is calculated by taking a company's latest 12 months' earnings before interest and taxes (EBIT) and dividing it by the latest 12 months' interest expense. Interest coverage tells the analyst how easily a company can handle its debt service. The higher the interest coverage value, the easier it is for the company to pay back its debt.
Return on Equity: Also referred to as ROE, this ratio is calculated by taking the latest 12 months' net income and dividing it by common stock equity. The return on equity ratio is perhaps the most widely used, and most valuable, measure of how well a company is performing for its shareholders. The higher a company's return on equity, the better the company is performing.
Common Stock Trading Terms
While buying and selling shares of stock is a relatively simple process, the industry is full of unfamiliar sounding jargon. Before thinking about trading stocks for the first time, it's important to understand the fundamentals. Listed below are the most common trading terms used today:
Market Order
A market order is used to buy or sell a stock as quickly as possible at the prevailing price when the buy order reaches the marketplace. A market order guarantees a transaction will occur, but does not guarantee the price paid, or received, for the securities.
Limit Order
A limit order is used to buy or sell a stock only at a price specified (also known as the limit) or at a better price. With a limit order, there is no guarantee that a transaction will occur. But if it does, then the price will be better than the one set by the trader.
Stop Order or Stop Loss Order
A stop loss order is used to sell a stock once the market price has reached a stop price, which is set below the current market price. Stop orders are used to protect a gain, or prevent further loss on an investment.
Stop Limit Orders
A stop limit order is used to sell a security at a specified price, or better, after a stop price has been reached. A stop limit order identifies the minimum price an investor is willing to accept for the stock they own. There are two parts to a stop limit order: the stop price and the limit price.
Once a stock's price moves through the stop price, the trade then becomes a limit order. For this reason, there is no guarantee that a stop limit order will be filled, since the stock can trade through the limit price before the order is executed.
Market Risks and Rewards
Risk and reward often go hand-in-hand. It's possible to eliminate all the risk of losing money (preserve capital) by placing money in a steel safe. But even under these circumstances, inflation will erode the buying power of that money over time. While buying stocks entails greater risk, the potential rewards are greater too.
Smart investors want to maximize the returns they're achieving at any given level of risk. Thankfully, there are several ways to minimize the risks associated with owning stocks. Earlier we talked about researching companies before buying, and that's a great way to help minimize risk
Diversifying a portfolio is a second way to minimize risk. By holding a portfolio of stocks, it's possible to eliminate the risk associated with any single company underperforming versus market expectations. While the entire market is still at the mercy of macroeconomic factors, diversification allows investors to eliminate the risk associated with holding stock in just one company. Most experts agree an investor needs shares of six to ten companies to create a diverse portfolio.
Price Volatility
Some stock prices are more volatile than others. By this we mean the stock of some companies will experience price swings, both up and down, that are extreme when compared to the overall market. The most common measure of relative price volatility is a stock beta. This value is commonly published along with the ratios mentioned earlier. When evaluating relative volatility, there are only two rules to remember:
If the stock's price experiences movements that are more volatile than the stock market, then the beta value will be greater than 1. If a stock's price swings are less than those of the market, then the beta value will be less than 1.
Investors react to price swings differently. What's important to avoid is buying a stock then selling it because a drop in price is worrisome. Our risk tolerance calculator helps individuals understand their ability to avoid panic-selling when these price swings occur.
Knowing When to Sell Stocks
Whenever anyone buys a stock, they should also be thinking about the best time to sell. This is oftentimes referred to as an exit strategy. For some investors, knowing when to sell a stock is a twofold decision that involves targets:
Price Increases: setting a target price at which point they're willing to lock-in their profits and sell the stock.
Price Decreases: if the stock starts to falter, the investor should have a price point in mind to limit their losses and sell the stock.
Another approach is to ignore the target price theory altogether and simply hold onto a stock as long as it's performing as expected. When a stock's price appreciation is no longer meeting expectations, then it's time to sell that stock and lock in a gain.
Selling Stocks and Income Taxes
Finally, everyone should understand the income taxconsequences of investing in the stock market in terms of capital gains. The American Taxpayer Relief Act of 2012 made several important changes to the treatment of long-term capital gains. Individuals in the 10% and 15% federal income tax brackets pay 0%, while those in the 39.6% bracket pay 20%; all other taxpayers owe 15%. Short-term capital gains are taxed at an individual's "normal" incremental tax rate.
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