Stocks represent ownership in a company, offering opportunities for profit through capital appreciation or dividends. This post will explain key concepts for beginners, covering the basics of what stocks are, the different types available, how to pick the right stocks, how to buy and when to sell them. Furthermore, it highlights essential risk management techniques, while addressing the benefits and risks associated with stock investing.

What is Stock?

When you buy a share of stock, you’re purchasing a partial ownership stake in a company. There are two common ways to make money by investing in stocks:

• Capital Appreciation: profit when the stock price rises

• Dividend Payments: profit when the company distributes some its earnings to stockholders

Because these ownership stakes represent slices of “equity” (i.e., value or financial interest) in the company, stocks are usually referred to as “equities.” 

Size of Share

The size of your ownership stake depends on the size of the company and the total number of shares it has issued. For example, suppose a company has 10,000 shares outstanding and you buy 100 shares. In this case, you own 1% of the company.

The large companies have hundreds of millions or even billions of outstanding shares, so an individual investor like us would typically hold only a tiny fraction of the overall shares. For instance, there are 2.4 billion shares of Nvidia (NVDA), and Apple (AAPL) has issued more than 16 billion shares.

IPO and Stock Exchanges

Stocks are bought and sold electronically through stock exchanges, the two primary ones in the United States being National Association of Securities Dealers (NASDAQ) or the New York Stock Exchange (NYSE). The buyers and sellers range from large institutional investors, such as insurance companies and Wall Street banks, to smaller firms and individuals.

Exchanges are what’s called a “secondary” market. Before a stock becomes available for trading on an exchange, the company typically holds an initial public offering (IPO), where shares are first sold to outside investors. This is known as going public. The primary function of going public for private companies is to raise capital to invest back in the business.

Stock Price and Value

EPS

Publicly traded companies report earnings a few weeks after the end of each quarter. For example, a company may report its results for the January–March quarter in mid-to-late April. Earnings per share (EPS), both actual and expected, are a key performance indicator for most companies and a critical driver of a stock’s price. So, investors should watch EPS numbers closely.

Analysts who follow a company typically release EPS forecasts that collectively shape the market’s expectations for the company. Suppose a company is expected to earn $1 per share in its current quarter, but it actually reports earnings of $1.10 per share–an earnings “beat.” Such a positive surprise could send the stock price higher. Conversely, if the company misses expectations and reports earnings of only $0.9 per share, the stock price may drop sharply.

P/E Ratio

Stock prices and earnings are also key inputs for other important fundamental indicators, including the price-earnings (P/E) ratio. The P/E ratio is most widely used to assess the value of a stock. The numerator, P, is the current market price of a stock. The denominator, E, is the company’s earnings per share, which is calculated by dividing after-tax profits by the average number of outstanding shares of common stock. 

For example, a company that earns $300 million in a year and has 100 million shares outstanding has earnings of $3 per share. If its stock sells for $30, the P/E ratio is 10 ($30 is divided by $3).

The P/E ratio tells you how much investors are willing to pay for each dollar a company earns. You can use the ratio to spot value. A company with a low P/E compared to others in its industry may be considered cheap, or undervalued. Conversely, a high P/E may signal that the stock price is overvalued and potentially more risky to hold.

However, a high P/E could also indicate high growth expectations. Tech companies frequently begin life with ultra-high P/Es, but as the technology is adopted, products are sold, and profits begin flowing, the P/E tends to fall in line with the general market. For example, electric carmaker Tesla saw its P/E fall  as its vehicle production rose. 

Types of Stocks

There are two main types of stocks, common stock and preferred stock.

Preferred Stock

1. Dividend and Growth

Like bonds, preferred stocks provide investors with a predictable flow of income, since their dividends are determined when the stock is issued. They have a par value which is affected by interest rates. When interest rates rise, the value of preferred stock declines, and vice versa. In addition the price of preferred stock is normally less volatile because the interest rates are relatively stable.

A callable provision typically comes with the issuance of a preferred stock. This gives the company the right to redeem the preferred stocks at a set call price, which is often slightly higher than the stock’s par value. 

2. Payment Priority

Preferred stockholders are paid their dividends before common stockholders. In case of a bankruptcy or liquidation, preferred stockholders have a priority claim on a company’s assets and earnings. This is also true during the company’s good times, when the company has excess cash and decides to distribute money to investors through dividends.

Common Stock

Common stock represents shares of ownership in a corporation and a claim on profits. It is the type of stock in which most people invest. When people talk about stocks, they are usually referring to common stock. In fact, the great majority of stock is issued in this form. Common stock value fluctuates, depending on the company’s earnings, as well as their supply and demand.

1. Growth and Dividends

Common stock tends to outperform preferred stocks and offers greater potential for long-term growth. If a company does well, the value of a common stock can go up. However, if the company does poorly, the stock’s value usually goes down.

Additionally, a company’s board of directors decide whether or not to pay out a dividend to common shareholders. They are not guaranteed. In fact, many companies do not pay common stock dividends at all.

2. Voting Rights

Common shares confer voting rights. Investors usually receive one vote per share owned. They vote to elect board members who oversee the major decisions made by management. Thus, stockholders have the ability to exercise control over corporate policy and management issues.

The below is a comparable table for the difference between preferred and common stocks:

Different Favors of Stocks

Common and preferred stocks may fall into one or more of the following categories:

• Growth stocks have earnings growing at a faster rate than the market average. They rarely pay dividends and investors buy them in the hope of capital appreciation. A start-up tech company is likely to be a growth stock. Note that even fast-growing companies are not necessarily good investments if their stocks are overvalued.

• Income stocks pay dividends consistently. Investors buy them for the income they generate. An established utility company is likely to be an income stock.

• Value stocks have a low P/E ratio, meaning they are cheaper to buy than stocks with a higher P/E. Value stocks may be growth or income stocks, and their low P/E ratio may reflect the fact that they have fallen out of favor with investors for some reason. People buy value stocks in the hope that the market has overreacted and that the stock’s price will rebound.

• Blue-chip stocks are shares in large, well-known companies with a solid history of growth. They generally pay dividends.

• Cyclical stocks are shares of companies whose earnings are highly sensitive to the ups and downs of the economy. When the economy is performing well, cyclical companies tend to shine. A contracting economy typically hammers their earnings and hurts their stocks. Cyclical industries include manufacturers of steel, automobiles and chemicals, airlines, as well as homebuilders.

How to Pick Stocks?

Understand your investment goals and strategy

Choosing the right stocks depends on your investment time horizon. Investment horizon refers to the length of time an investor is aiming to maintain their portfolio before selling their securities for a profit. Generally, a short investment horizon usually ranges from a few minutes to a few months, while a long investment horizon exceeds one year.

An investor’s investment horizon is affected primarily by their investment goal and idiosyncratic factors, such as risk tolerance, personality, and level of investment experience. For example, are you aiming to generate a quick profit or save for retirement? How much time can you dedicate to managing your investment each day?

In addition, short-term investments carry higher risks because you typically have limited knowledge about the company whose stocks you hold. Short-term strategies are more suitable for experienced investors. That said, you don’t have to choose exclusively between short-term and long-term investments. If you are a beginner in stock markets, it’s recommended to allocate more money on long-term investments, such as 90% of your portfolio. You can gradually increase your exposure to short-term opportunities when you gain more experience.

Fundamental Analysis for Long-Term Strategy

Top-down approach

You can begin with an analysis of the economy, markets and industries. Trends in the economy, such as employment and interest rates, substantially influence company earnings. Because many companies operate all over the world, the analysis must often be global in scope.

Stock tends to perform differently at various points in an economic cycle. For example, financial companies and homebuilders often perform well early in an economic recovery, or even in anticipation of a recovery. Commodities-related companies, such as chemical and aluminum manufacturers, often perform well in the late stages of an economic cycle, when inflation tends to heat up and they can command higher prices for their products.

Bottom-up analysis

There are numerous ways to pick individual stocks. In general, investors prefer companies that deliver solid earnings growth or those share prices are cheap relative to the perceived value of the company. Finding the best of both is a better formula for successful stock picking.

It is crucial to understand how stocks are valued. By itself, a stock’s price tells nothing about its value. A stock that trades for a nickel per share can be expensive, while a stock that trades for $500 per share can be cheap. What matters is how much the share price compares with a fundamental measure, such as a company’s profit or shares.

• Price-earnings ratio: The P/E ratio tells how much investors are willing to pay for each dollar a company earns. You can use this number in a variety of ways to spot value. For example, you might look for P/E ratios that are lower than the P/E ratio of the overall market. You might search for stocks of companies whose P/E ratios are lower than the average P/E of the industry in which they operate. Or you might be willing to accept a high P/E ratio if you think a company will grow rapidly in the future. You can find earnings estimates on many third-party service websites including yahoo and MSNMoney.

• Price-sales ratio: Price-sales ratio is useful in valuing a company whose earnings are negative or erratic. That’s because sales are more stable than earnings and because it’s more difficult for a company to use accounting techniques to manipulate revenues than it is to use them to manipulate earnings figures.

Technical Analysis for Short-Term Strategy

When you are choosing stocks for your short-term strategy, you are not waiting for price trends to emerge but rather to identify the trends that are about to happen. Thus, short-term stock investment primarily relies on technical analysis. Technical analysis focuses on security’s price and volume in the market. Price charts and technical indicators are the heart of technical analysis where lines and bars illustrate price movements over time to spot trends. Indicators used to gauge momentum, overbought/oversold conditions, and potential price volatility.

Technical analysis assumes that price reflects all realities of the stock. Price trends in three directions: uptrends (bull markets), downtrends (bear markets), and sideways (consolidations). History tends to repeat itself as emotions and behavior tend to be repetitive.

You can utilize a variety of indicators to identify trading opportunities. Here are a few popular ones:

• Moving Averages smooth out price fluctuations to reveal the underlying trend. They can also act as dynamic support and resistance levels, indicating areas where price may find buyers or sellers.

• Support and Resistance are price levels where the price tends to bounce or stall. Support represents areas where buying pressure is likely to halt a decline, while resistance indicates zones where selling pressure might cap a rise.

• Trendlines are lines drawn along highs or lows in a price chart to visualize the direction of the trend. Uptrends have rising trendlines, while downtrend have falling trendlines.

• Chart Patterns help identify specific price information on charts, such as spinning top, that may signal reversals or continuations.

• Volume refers to the number of shares traded in a given period. Rising volume alongside a price increase confirms the strength of an uptrend and vice versa for downtrends.

How to Buy?

The following are the most common ways to buy stocks:

• Some companies allow you to buy or sell shares directly through them without an exchange or a broker. Some companies limit direct stock to employees of the company or existing shareholders. Some require minimum amounts for purchase levels.

• Dividend reinvestment plans allow you to buy more shares of a stock you already own by reinvesting dividend payments into the company. You must sign an agreement with the company to have this done. Check with the company or your broker to see if you will be charged for this service.

• Discount or full-service brokers buy and sell shares for customers for a fee, known as a commission. Many brokers run websites where you can buy stocks.

• Stock funds are another way to buy stocks. These are a type of mutual fund that invests primarily in stocks. Stock funds are offered by investment companies and can be purchased directly from them or a broker.

Stock Market Trading Hours

If you trade stocks with an exchange, be aware of the trading hours. Trading hours concentrate market activity into a specific time frame, ensuring better liquidity and tighter bid-ask spreads. This makes it easier for trades to be executed efficiently at fair prices. In addition, extended trading hours can lead to heightened volatility due to lower trading volumes. Limited hours help stabilize market movements by reducing the impact of sporadic trades.

These hours for each stock exchange vary across regions and are influenced by local time zones and holidays. Here is an overview of trading hours for major stock exchanges worldwide, ranked by their daily trading volume:

When to Sell?

The decision of when to sell a stock is as important as deciding which stocks to buy in the first place. If you’re a long-term investor, you don’t want to cash in every time your stock moves up a few dollars. Commission and perhaps taxes would cut into your gain, and you would have to decide when to put the proceeds. By the same token, you don’t want to bail out in a panic in the aftermath of a steep market decline. Here are some clues that will tell you when it is the time to consider selling a stock:

The fundamentals change. 

Whether you own shares in a large Fortune 500 company or a company most people have never heard of, you need to follow the corporation’s prospect, its earnings progression, and its business success as reflected in such things as its products and services, market share and profit gains. Annual reports, new stories, research reports from brokerage firms and investment newsletters are fertile ground for such information. If a company’s basic, fundamental measurements start to weaken, it’s time to reconsider your investment. For example, a fast-expanding retail chain whose sales per store suddenly decline after rising for years. Or, if you bought a stock due to the high expectation of a new product but the product turns out to be a dud, sell.

The dividend is cut. 

The progression and security of the dividend are important to any stock’s prospects. A dividend cut signifies that the dividend is in trouble–meaning that the company cannot maintain its payout to shareholders–and can undermine the stock price. 

You reach your target price. 

Many investors set specific price targets, both up and down, when they buy a stock. When the stock reaches the target, they sell. A good target might be to look for a 50% gain within two years or to limit your patience with a stock to a loss of 20%. Such guidelines can prompt you to take your gains in a timely fashion and to dump losers before the damage gets too painful. Take the simple step of setting a “mental protective stop.” Keep track of the stock’s price and sell any stock that hits your mental stop point. Once you’ve reached your objective, take the money. If the goals you set are very conservative, you might miss some gains from time to time, but that’s better than holding on too long and losing all your money.

Benefits 

Stocks of companies with good management and widely or increasingly used products and services can be solid long-term investments that generate stronger returns than bonds or saving accounts. For example, over the long run, U.S. stocks have beaten the performance of any other major asset class by a wide margin. Since 1926, stocks have returned nearly 10% per year, on average. Note that this includes the severe decline in the stock prices from late 2007 to early 2009, a period that overlaps what some call the Great Recession. Some companies may also pay investors a quarterly or yearly dividend, which is a proportion of the company’s funds distributed to shareholders.

Risk

Stock prices move down and up. There’s no guarantee that the company whose stock you hold will grow, so you can lose money when you invest in stocks.

If a company goes bankrupt and its assets are liquidated, common stockholders are the last in line to share in the proceeds. The company’s bondholders will be paid first, then holders of preferred stock. If you are a common stockholder, you get whatever is left, which may be nothing.

Even when a company is not in danger of bankruptcy, their stock price may fluctuate up and down. If you have to sell shares on a day when the stock price is below the price you paid for the shares, you will lose money on the sale. For example, if you bought 100 shares of stocks of a company at $50 for an initial investment of $5,000, and a year later the stock was trading at $40, you’d be down $1,000.

Even if a company is consistently profitable, that doesn’t mean its shares aren’t subject to the whims and emotions of the market or worldwide events beyond anyone’s control, such as recessions, pandemics, geopolitics, and weather. For example, if overall market sentiment turns negative, it can take any and all stocks down with it quickly.

Risk management

Diversification

Diversification means spreading your money among many investments to lessen risk. The idea is to avoid a situation where your investments are concentrated in so few holdings that big declines in the value of just one or two of them wreck your portfolio. If you buy individual stocks, you probably need a minimum of 20-30 companies from a variety of industries to provide sufficient diversification. 

For instance, you may strive for a mix of stocks that tend to fare well in different economic environments, such as strong, stagnant and inflationary economies. Perhaps you want to blend growth and income stocks in the portfolio and add a dash of small-company and emerging-market stocks. The appropriate balance of stocks depends on personal circumstances, including your time horizon (when you’ll need to spend the money) and your tolerance for risk and volatility (your ability to sleep at night when stock prices fall).

Mutual Funds

If you choose to invest in a diversified stock mutual fund, the fund will achieve this diversification for you.There are a number of benefits to investing in stocks through mutual funds. Instead of  researching individual stocks yourself, you are effectively hiring an investment professional to analyze companies and stocks. The manager will decide when is an opportune time to purchase and sell stocks.

Funds are convenient. While you may need to purchase 20 to 30 stocks for adequate diversification, a diversified mutual fund provides a one-stop approach to spreading risk. For example, researching small companies or foreign stocks can be especially daunting. You can find funds that address almost any investment strategy.

Stock mutual funds come in several varieties:

• Index funds are passively managed funds that seek to mimic a benchmark, such as S&P 500.

• Actively managed funds are funds run by a manager who selects stocks according to his own assessment of their attractiveness. Exchange-traded funds (ETFs) typically are a version of actively managed funds. ETFs trade like stocks on a stock exchange. And you can buy and sell them through a broker as would an individual stock. In all cases, it pays to be sensitive to fund fees, which subtract from your returns.

Mutual funds are amenable to a technique known as dollar-cost averaging. With this strategy, you invest a fixed amount of money on a regular basis. For example, if you have $8,000 to invest in a stock fund, instead of plunking it down all at once, you might choose to invest $2,000 now and $2,000 three, six, and nine months from the time of first purchase. Dollar-cost averaging offers psychological benefits. It prevents you from investing all of your money near what could be a market top, seeing the value of your investment drop, then having to sell at a loss.

Summary

Stock investment can be a powerful way to grow your wealth over time. However, it's essential to approach stock investing with a clear understanding of your financial goals, risk tolerance, and investment horizon. Whether you're drawn to the growth potential of common stocks or the steady income of preferred stocks, the stock market provides a wide array of options to suit different strategies.

By learning to evaluate stocks through both fundamental and technical analysis, diversifying your portfolio, and practicing disciplined risk management, you can navigate the complexities of the stock market more effectively. Remember, while stocks have historically delivered strong long-term returns, they come with inherent risks and uncertainties. Patience, research, and a well-thought-out investment strategy are key to achieving success in the dynamic world of stock trading.