2. HOW STOCK INVESTING WORKS¶
2.1. What Owning a Stock Actually Means¶
Most people realize that owning a stock means buying a percentage of ownership in the company, but many new investors have misconceptions about the benefits and responsibilities of being a shareholder. Many of these misconceptions stem from a lack of understanding of the amount of ownership that each stock represents. For large companies, such as Apple (AAPL) and Exxon Mobil (XOM), one share is merely a drop in the pond. Even if you owned $1 million worth of shares, you’d still be a small potato with very little equity in the company.
So what does this mean? Let’s take a look at three of the biggest misconceptions about being a shareholder.
KEY TAKEAWAYS
- Stockholders own shares of a company, but the level of ownership may not present the benefits and responsibilities sought after.
- Most shareholders have no direct control over a company’s operations, although some have voting rights affording some authority, such as voting for the board of directors members.
- Being a shareholder does not mean that you are entitled to discounts or can seize assets and property at will.
2.1.1. Misconception No. 1: I am the boss.¶
First of all, you’re better off not thinking that you can bring your share certificates into the corporate headquarters to boss people around and demand a corner office. As the owner of the stock, you’ve placed your faith in the company’s management and how it handles different situations. If you are not happy with the management, you can always sell your stock, but if you are happy, you should hold onto the stock and hope for a good return.
Furthermore, next time you are pondering whether you’re the only person worried about a company’s stock price, you should remember that many of the senior company executives (insiders) probably own as many, if not more, shares than you do.
This isn’t a guarantee that the company’s stock will do well, but it is a way for companies to give their executives an incentive to maintain or increase the stock’s price. Insider ownership is a double-edged sword, though, because executives may get involved in some funny business to artificially increase the stock’s price and then quickly sell out their personal holdings for a profit.
Even though you can’t directly manage the company with your stocks, vote for the directors who can if your stock has voting rights. These are the people who typically hire upper management, which hires lower management, which hires subordinate employees. Thus, as an owner of common stock, you do get a bit of a say in controlling the shape and direction of the company, even though this say doesn’t represent direct control.
FAST FACT
More than half of Americans own stock according to a 2016 Gallup Poll.
2.1.2. Misconception No. 2: I get a discount on goods and services.¶
Another misconception is that ownership in a company translates into discounts. Now, there are definitely some exceptions to the rule. Berkshire Hathaway (BRK.A), for example, has an annual gathering for its shareholders where they can buy goods at a discount from Berkshire Hathaway’s held companies. Typically, however, the only thing you get with the ownership rights of a stock is the ability to participate in the company’s profitability.
Why would it hurt for you to get a discount? Well, this answer can get a little complicated. After some thought, you probably would not want that discount. Let’s look at an example of Ben’s Chicken Restaurant (owned by Ben and a couple of his friends) and Cory’s Brewing Company (owned by millions of different shareholders). Because only a few people own Ben’s Chicken Restaurant, the discount would only be a small portion of the restaurant’s income and revenue, which the owners would bear.
For Cory’s Brewing Company, the loss in income and revenue would also be borne by the owners (the millions of shareholders). Since revenue is the main driver of stock price and the loss from a discount would mean a drop in stock price, the negative impact of a discount would be more substantial for Cory’s Brewing. So, even though an owner of stock may have saved on a purchase of the company’s goods, he or she would lose on the investment in the company’s stock. Thus, the discount isn’t nearly as good as it initially sounds. Misconception No. 3: I own the chair, the desk, the pens, the property, etc.
As an investor in a company, you own a portion of the company (no matter how small that portion is); however, this doesn’t mean that you own property of the company. Let’s go back to Ben’s Chicken Restaurant and Cory’s Brewing Company.
Quite often, companies will have loans to pay for property, equipment, inventories, and other things needed for operations. Let’s assume Ben’s Chicken Restaurant received a loan from a local bank under certain conditions whereby the equipment and property are used as collateral. For a large company like Cory’s Brewing Company, the loans come in many different forms, such as through a bank or from investors by means of different bond issues. In either case, the owners must pay back the debtors before getting any money back.
For both companies, the debtors—in the case of Cory’s Brewing Company, this is the bank and the bondholders—have the initial rights to the property, but they typically won’t ask for their money back while the companies are profitable and show the capacity to repay the money. However, if either of the companies becomes insolvent, the debtors are first in line for the company’s assets. Only the money left over from the sale of the company assets is distributed to the stockholders.
The Bottom Line
Hopefully, we’ve been able to dispel any misconceptions that some stockholders have about the powers of ownership. Next time you think about taking your stock certificate into the nearest McDonald’s (MCD) to get a discount on a Happy Meal, attempt to fire the employee after refusing to give it to you, and then finally walk out in disgust with a McFlurry machine, you should remind yourself of the common misconceptions about ownership powers.
2.2. The Basics of Trading a Stock: Know Your Orders¶
With the growing importance of digital technology and the internet, many investors are opting to buy and sell stocks for themselves rather than pay advisors large commissions to execute trades. However, before you can start buying and selling stocks, you must know the different types of orders and when they are appropriate.
In this article, we’ll cover the basic types of stock orders and how they complement your investing style.
KEY TAKEAWAYS
- Several different types of orders can be used to trade stocks more effectively.
- A market order simply buys or sells shares at the prevailing market prices until the order is filled.
- A limit order specifies a certain price at which the order must be filled, although there is no guarantee that some or all of the order will trade if the limit is set too high or low.
- Commissions are usually lowered on market orders.
- Stop orders, a type of limit order, are triggered when a stock moves above or below a certain level and are often used as a way to insure against larger losses or to lock in profits.
2.2.1. Market Order vs. Limit Order¶
The two major types of orders that every investor should know are the market order and the limit order.
Market Orders
A market order is the most basic type of trade. It is an order to buy or sell immediately at the current price. Typically, if you are going to buy a stock, then you will pay a price at or near the posted ask. If you are going to sell a stock, you will receive a price at or near the posted bid.
One important thing to remember is that the last-traded price is not necessarily the price at which the market order will be executed. In fast-moving and volatile markets, the price at which you actually execute (or fill) the trade can deviate from the last-traded price. The price will remain the same only when the bid and ask prices are exactly at the last-traded price.
Important
Market orders do not guarantee a price, but they do guarantee the order’s immediate execution.
Market orders are popular among individual investors who want to buy or sell a stock without delay. The advantage of using market orders is you are guaranteed to get the trade filled; in fact, it will be executed ASAP. Although the investor doesn’t know the exact price at which the stock will be bought or sold, market orders on stocks that trade over tens of thousands of shares per day will likely be executed close to the bid and ask prices.
Limit Orders
A limit order, sometimes referred to as a pending order, allows investors to buy and sell securities at a certain price in the future. This type of order is used to execute a trade if the price reaches the pre-defined level; the order will not be filled if price does not reach this level. In effect, a limit order sets the maximum or minimum price at which you are willing to buy or sell.
For example, if you wanted to buy a stock at $10, you could enter a limit order for this amount. This means that you would not pay a penny over $10 for that particular stock. However, it is still possible that you buy it for less than the $10 per share specified in the order.
There are four types of limit orders:
- Buy Limit: an order to purchase a security at or below a specified price. Limit orders must be placed on the correct side of the market to ensure they will accomplish the task of improving price. For a buy limit order, this means placing the order at or below the current market bid.
- Sell Limit: an order to sell a security at or above a specified price. To ensure improved price, the order must be placed at or above the current market ask.
- Buy Stop: an order to buy a security at a price above the current market bid. A stop order to buy becomes active only after a specified price level has been reached (known as the stop level). Buy stop are orders placed above the market and sell stop orders placed below the market (the opposite of buy and sell limit orders, respectively). Once a stop level has been reached, the order will be immediately converted into a market or limit order.
- Sell Stop: an order to sell a security at a price below the current market ask. Like the buy stop, A stop order to sell becomes active only after a specified price level has been reached.
Market and Limit Order Costs
When deciding between a market or limit order, investors should be aware of the added costs. Typically, the commissions are cheaper for market orders than for limit orders. The difference in commission can be anywhere from a couple of dollars to more than $10. For example, a $10 commission on a market order can be boosted up to $15 when you place a limit restriction on it. When you place a limit order, make sure it’s worthwhile.
Let’s say your broker charges $7 for a market order and $12 for a limit order. Stock XYZ is presently trading at $50 per share and you want to buy it at $49.90. By placing a market order to buy 10 shares, you pay $500 (10 shares x $50 per share) + $7 commission, which is a total of $507. By placing a limit order for 10 shares at $49.90 you pay $499 + $12 commissions, which is a total of $511.
Even though you save a little from buying the stock at a lower price (10 shares x $0.10 = $1), you will lose it in the added costs for the order ($5), a difference of $4. Furthermore, in the case of the limit order, it is possible that the stock doesn’t fall to $49.90 or less. Thus, if it continues to rise, you may lose the opportunity to buy.
2.2.2. Additional Stock Order Types¶
Now that we’ve explained the two main orders, here’s a list of some added restrictions and special instructions that many different brokerages allow on their orders:
- Stop-Loss Order: Also referred to as a stopped market, on-stop buy, or on-stop sell, this is one of the most useful orders. This order is different because, unlike the limit and market orders, which are active as soon as they are entered, this order remains dormant until a certain price is passed, at which time it is activated as a market order. For instance, if a stop-loss sell order were placed on the XYZ shares at $45 per share, the order would be inactive until the price reached or dropped below $45. The order would then be transformed into a market order, and the shares would be sold at the best available price. You should consider using this type of order if you don’t have time to watch the market continually but need protection from a large downside move. A good time to use a stop order is before you leave on vacation.
- Stop-limit Order: These are similar to stop-loss orders, but as their name states, there is a limit on the price at which they will execute. There are two prices specified in a stop-limit order: the stop price, which will convert t he order to a sell order, and the limit price. Instead of the order becoming a market order to sell, the sell order becomes a limit order that will only execute at the limit price or better. This can mitigate a potential problem with stop-loss orders, which can be triggered during a flash crash when prices plummet but subsequently recover.
- All or None (AON): This type of order is especially important for those who buy penny stocks. An all-or-none order ensures that you get either the entire quantity of stock you requested or none at all. This is typically problematic when a stock is very illiquid or a limit is placed on the order. For example, if you put in an order to buy 2,000 shares of XYZ but only 1,000 are being sold, an all-or-none restriction means your order will not be filled until there are at least 2,000 shares available at your preferred price. If you don’t place an all-or-none restriction, your 2,000 share order would be partially filled for 1,000 shares.
- Immediate or Cancel (IOC): An IOC order mandates that whatever amount of an order that can be executed in the market (or at a limit) in a very short time span, often just a few seconds or less, be filled and then the rest of the order canceled. If no shares are traded in that “immediate” interval, then the order is canceled completely.
- Fill or Kill (FOK): This type of order combines an AON order with an IOC specification; in other words, it mandates that the entire order size be traded and in a very short time period, often a few seconds or less. If neither condition is met, the order is canceled.
- Good ‘Til Canceled (GTC): This is a time restriction that you can place on different orders. A good-til-canceled order will remain active until you decide to cancel it. Brokerages will typically limit the maximum time you can keep an order open (active) to 90 days.
- Day: If you don’t specify a time frame of expiry through the GTC instruction, then the order will typically be set as a day order. This means that after the end of the trading day, the order will expire. If it isn’t transacted (filled) then you will have to re-enter it the following trading day.
- Take Profit: A take profit order (sometimes called a profit target) is intended to close out the trade at a profit once it has reached a certain level. Execution of a Take Profit order closes the position. This type of order is always connected to an open position of a pending order.
Important
Not all brokerages or online trading platforms allow for all of these types of orders. Check with your broker if you do not have access to a particular order type that you wish to use.
The Bottom Line
Knowing the difference between a limit and a market order is fundamental to individual investing. There are times where one or the other will be more appropriate, and the order type is also influenced by your investment approach. A long-term investor is more likely to go with a market order because it is cheaper and the investment decision is based on fundamentals that will play out over months and years, so the current market price is less of an issue. A trader, however, is looking to act on a shorter term trend in the charts and, therefore, is much more conscious of the market price paid; in which case, a limit order to buy in with a stop-loss order to sell is usually the bare minimum for setting up a trade.
By knowing what each order does and how each one might affect your trading, you can identify which order suits your investment needs, saves you time, reduces your risk, and, most importantly, saves you money.
2.3. Optimal Position Size Reduces Risk¶
Determining how much of a currency, stock or commodity to accumulate on a trade is an often-overlooked aspect of trading. Traders frequently take a random position size. They may take more if they feel “really sure” about a trade, or they may take less if they feel a little leery. These are not valid ways to determine position size.
A trader should also not take a set position size for all circumstances, regardless of how the trade sets up, and this style of trading will likely lead to underperformance over the long run. Let’s look at how position size should actually be determined.
2.3.1. What Affects Position Size¶
The first thing we need to know before we can actually determine our position size is the stop level for the trade. Stops should not be set at random levels. A stop needs to be placed at a logical level, where it will tell the trader they were wrong about the direction of the trade. We do not want to place a stop where it could easily be triggered by normal movements in the market.
Once we have a stop level, we now know the risk. For example, if we know our stop is 50 pips from our entry price for a forex trade (or assume 50 cents in a stock or commodity trade), we can now start to determine our position size. The next thing we need to look at is the size of our account. If you have a small account, you should risk a maximum of 1% to 3% of your account on a trade.
Assume a trader has a $5,000 trading account. If the trader risks 1% of that account on a trade, this means he or she can lose $50 on a trade, which means the trader can take one mini-lot. If the trader’s stop level is hit, then the trader will have lost 50 pips on one mini lot, or $50. If the trader uses a 3% risk level, then he or she can lose $150 (which is 3% of the account). This means that, with a 50-pip stop level, he or she can take three mini-lots. If the trader is stopped out, he or she will have lost 50 pips on three mini lots, or $150. (Learn more about implementing appropriate stops in: A Logical Method of Stop Placement.)
In the stock market, risking 1% of your account on the trade would mean that a trader could take 100 shares with a stop level of 50 cents. If the stop is hit, this would mean $50, or 1% of the total account, was lost on the trade. In this case, the risk for the trade has been contained to a small percentage of the account, and the position size has been optimized for that risk.
2.3.2. Alternative Position-Sizing Techniques¶
For larger accounts, there are some alternative methods that can be used to determine position size. A person trading a $500,000 or $1 million account may not always wish to risk $5,000 or more (1% of $500,000) on each and every trade. They may have many positions in the market, they may not actually employ all of their capital, or there may be liquidity concerns with large positions. In this case, a fixed-dollar stop can also be used.
Let’s assume a trader with an account of this size wants to risk only $1,000 on a trade. He or she can still use the method mentioned above. If the distance to the stop from the entry price is 50 pips, the trader can take 20 mini-lots, or 2 standard lots.
In the stock market, the trader could take 2,000 shares with the stop being 50 cents away from the entry price. If the stop is hit, the trader will have lost only the $1,000 that he or she was willing to risk before placing the trade. (For more, see: Calculating Risk and Reward.)
2.3.3. Daily Stop Levels¶
Another option for active or full-time day traders is to use a daily stop level. A daily stop allows traders who need to make split-second judgments and require flexibility in their position-sizing decisions. A daily stop means the trader sets a maximum amount of money he or she can lose in a day, week or month. If traders lose this predetermined amount of capital, or more, they will immediately exit all positions and cease trading for the rest of the day, week or month. A trader using this method must have a track record of positive performance.
For experienced traders, a daily stop loss can be roughly equal to their average daily profitability. For instance, if, on average, a trader makes $1,000 a day, then he or she should set a daily stop loss that is close to this number. This means that a losing day will not wipe out profits from more than one average trading day. This method can also be adapted to reflect several days, a week or a month of trading results.
For traders who have a have a history of profitable trading, or who are extremely active in trading throughout the day, the daily stop level allows them freedom to make decisions about position size on the fly throughout the day and yet still control their overall risk. Most traders using a daily stop will still limit risk to a very small percentage of their account on each trade by monitoring positions sizes and the exposure to risk a position is creating.
A novice trader with little trading history may also adapt a method of the daily stop loss in conjunction with using proper position sizing – determined by the risk of the trade and his or her overall account balance.
The Bottom Line
In order to achieve the correct position size, we must first know our stop level and the percentage or dollar amount of our account we are willing to risk on the trade. Once we have determined these, we can calculate our ideal position size.
2.5. When to Sell a Stock¶
There are a few good reasons and many bad ones to unload your shares.
Making money on stocks involves just two key decisions: Buying at the right time and selling at the right time. You’ve got to get both of those right to make a profit. There are only three good reasons to sell:
- Buying the stock was a mistake in the first place
- The stock price has risen dramatically
- The stock has reached a silly and unsustainable price
Read on for more on all three of these good reasons to sell. But first, consider a couple of common mistakes to avoid when you’re buying and selling.
2.5.1. Buying Right¶
The return on any investment is first determined by the purchase price. One could argue that a profit or loss is made at the moment it’s purchased. The buyer just doesn’t know it until it’s sold.
While buying at the right price may ultimately determine the profit gained, selling at the right price guarantees the profit, if any. If you don’t sell at the right time, the benefits of buying at the right time disappear.
2.5.2. Selling Stock Is Hard¶
Many of us have trouble selling a stock, and the reason is rooted in the innate human tendency toward greed.
Here’s an all-too-common scenario: You buy shares of stock at $25 with the intention of selling it if it reaches $30. The stock hits $30 and you decide to hold out for a couple of more points. The stock reaches $32 and greed overcomes rationality. Suddenly, the stock price drops back to $29. You tell yourself to just wait until it hits $30 again. This never happens. You finally succumb to frustration and sell at a loss when it hits $23.
Greed and emotion have overcome rational judgment. You’ve treated the stock market like a slot machine and lost. The loss was $2 a share, but you actually might have made a profit of $7 when the stock hit its high.
These paper losses might be better ignored than agonized over, but it comes down to the investor’s reason for selling or not selling.
To remove human nature from the equation in the future, consider using a limit order, which will automatically sell the stock when it reaches your target price (excluding gap-down situations).
You won’t even have to watch that stock go up and down. You’ll get a notice when your sell order is placed.
2.5.3. Never Try to Time the Markets¶
Timely selling does not require precise market timing. Few investors ever buy at the absolute bottom and sell at the absolute top.
Warren Buffett couldn’t do it. He and other legendary stock pickers focus on buying at one price and selling at a higher price.
And that brings us to the three good reasons to sell a stock.
2.5.4. When Buying Was a Mistake¶
Presumably, you’ve put some research into that stock before you bought it. You may later conclude that you’ve made an analytical error. That error fundamentally affects the business as a suitable investment.
You should sell that stock, even if it means incurring a loss.
The key to successful investing is to rely on your data and analysis instead of Mr. Market’s emotional mood swings. If that analysis was flawed for any reason, sell the stock and move on.
The stock price might go up after you sell, causing you to second guess yourself. Or a 10% loss on that investment could turn out to be the smartest investment move you ever made.
Of course, not all analytical mistakes are equal. If a business fails to meet short term earnings forecasts and the stock price goes down, don’t overreact and sell if the soundness of the business remains intact. But if you see the company losing market share to competitors, it could be a sign of long-term weakness and a good reason to sell. When the Stock Rises Dramatically
It’s very possible that a stock you just bought will rise dramatically in a short period of time for one reason or another. The best investors are the most humble investors. Don’t take the fast rise as an affirmation that you are smarter than the overall market. Sell it.
A cheap stock can become an expensive stock very fast for a host of reasons, including speculation by others. Take your gains and move on. Even better, if that stock drops significantly, consider buying it again. If the shares continue to increase, take comfort in the old saying, “no one goes broke booking a profit.”
If you own a stock that has been sliding, consider selling on a so-called dead cat bounce. These upticks are temporary and usually based on unexpected news.
2.5.5. Sell for Valuation¶
This is a difficult decision, part art, and part science.
The value of any share of stock ultimately rests on the present value of the company’s future cash flows. The valuation will always carry a degree of imprecision because the future is uncertain. This is why value investors rely heavily on the margin of safety concept in investing.
A good rule of thumb is to consider selling if the company’s valuation becomes significantly higher than its peers. Of course, this is a rule with many exceptions. For example, if Procter & Gamble (PG) is trading for 15 times earnings while Kimberly-Clark (KMB) is trading for 13 times earnings, it’s no reason to sell PG when you consider the sizable market share of many of PG’s products.
Another more reasonable selling tool is to sell when a company’s P/E ratiosignificantly exceeds its average P/E ratio over the past five or 10 years. For instance, at the height of the internet boom, Walmart shares had a P/E of 60 times earnings. Despite Walmart’s quality, any owner of shares should have considered selling and potential buyers should have considered looking elsewhere.
When a company’s revenue declines, it’s usually a sign of reduced demand. First, look at the annual revenue numbers in order to see the big picture, but don’t rely solely on those numbers. Look at the quarterly numbers. The annual revenue numbers for a major oil and gas company might be impressive annually, but what if energy prices have fallen in recent months?
Also, when you see a company cutting costs, it often means that the company is not thriving. The biggest indicator is reducing headcount. The good news for you is that cost-cutting will be seen as a positive, initially, which will often lead to stock gains. This shouldn’t be seen as an opportunity to buy more shares, but rather as a chance to exit the position before any subsequent plunge in value.
2.5.6. Selling for Financial Needs¶
This might not count as a “good” reason from an analytical standpoint, but it’s a reason nonetheless. Stocks are an asset, and there are times when people need to cash in their assets.
Whether it is seed money for a new business, paying for college, or purchasing a home, the decision depends on an individual’s financial situation rather than the fundamentals of the stock.
The Bottom Line
Any sale that results in profit is a good sale, particularly if the reasoning behind it is sound. When a sale results in a loss with an understanding of why that loss occurred, it too may be considered a good sell. Selling is a poor decision only when it is dictated by emotion instead of data and analysis.
2.6. Income, Value, and Growth Stocks¶
Investors who buy stocks typically do so for one of two reasons: They believe that the price will rise and allow them to sell the stock at a profit, or they intend to collect the dividends paid on the stock as investment income. Of course, some stocks can satisfy both objectives, at least to some extent, but most stocks can be classified into one of three categories: growth, income or value. Those who understand the characteristics of each type of stock can use this knowledge to grow their portfolios more efficiently.
2.6.1. Growth Stocks¶
As the name implies, growth companies by definition are those that have substantial potential for growth in the foreseeable future. Growth companies may currently be growing at a faster rate than the overall markets, and they often devote most of their current revenue toward further expansion. Every sector of the market has growth companies, but they are more prevalent in some areas such as technology, alternative energy, and biotechnology.
Most growth stocks tend to be newer companies with innovative products that are expected to make a big impact on the market in the future, but there are exceptions. Some growth companies are simply very well-run entities with good business models that have capitalized on the demand for their products. Growth stocks can provide substantial returns on capital, but many of them are smaller, less-stable companies that may also experience severe price declines.
An example of a growth company:
- Amazon.Com Inc (AMZN) – This Net juggernaut continues to add features, open new markets and take customers from other retail-oriented companies. The 2018 trailing P/E of 263 reflects this astounding growth potential, compared to the SP-500 trailing P/E of 24.6.
2.6.2. Value Stocks¶
Undervalued companies can often provide long-term profits for those who do their homework. A value stock trades at a price below where it appears it should be based on its financial status and technical trading indicators. It may have high dividend payout ratios or low financial ratios such as price-to-book or price-earnings ratios. The stock price may also have dropped due to public perception regarding factors that have little to do with the company’s current operations.
For example, the stock price of a well-run, financially sound company may drop substantially for a short time period if the company CEO becomes embroiled in a serious personal scandal. Smart investors know that this is a good time to buy the stock, as the public will soon forget about the incident and the price will most likely revert to its previous level.
Of course, the definition of what exactly is a good value for a given stock is somewhat subjective and varies according to the investor’s philosophy and point of view. Value stocks are typically considered to carry less risk than growth stocks because they are usually those of larger, more-established companies. However, their prices do not always return to their previous higher levels as expected.
An example of a good value stock:
- Cardinal Health Inc (CAH) –The stock looks undervalued because it’s trading at a 4 year low even though EPS has nearly doubled from $2.48 in 2014 to an estimated $4.95 in the fiscal year 2018. This is better than the broad market’s estimated 3.14% annual earnings growth in the next 7 to 10 years.
2.6.3. Income Stocks¶
Investors look to income stocks to bolster their fixed-income portfolios with dividend yields that typically exceed those of guaranteed instruments such as Treasury securities or CDs.
There are two main types of income stocks. Utility stocks are common stocksthat have historically remained fairly stable in price but usually pay competitive dividends. Preferred stocks are hybrid securities that behave more like bonds than stocks. They often have call or put features or other characteristics, but also pay competitive yields.
Although income stocks can be an attractive alternative for investors unwilling to risk their principal, their values can decline when interest rates rise.
One example of a good income stock:
- AT&T (T) – The company is financially sound, carries a reasonable amount of debt and currently pays an annual dividend yield of 6.2%.
2.6.4. How to Find Stocks in These Categories¶
There is no one right way to discover specific types of stocks. Those who want growth can peruse investing websites or bulletin boards for lists of growth companies, then do their own homework on them. Many analysts also publish blogs and newsletters that tout stocks in each of the three categories.
Investors looking for income can calculate the dividend yields on common and preferred offerings, and then evaluate the amount of risk in the security. There are also stock screening programs available that investors can use to search for stocks according to specific criteria, such as dividend yields or financial ratios.
The Bottom Line
Stocks can provide a return on capital from future growth, current undervaluation or dividend income. Many stocks (such as AT&T) offer some combination of these, and smart investors know that dividends can make a substantial difference in the total return they receive.
2.7. How can I prevent commissions and fees from eating up my trading profits?¶
First off, understand that there is no universal system regarding trading commissions charged by brokerage firms. Some charge rather steep fees for each trade, while others charge very little, depending on the level of service they provide. A discount brokerage firm might charge as little as $10 for a common stock trade or even less, while a full-service broker might easily charge $100 or more per trade.
In these cases, the answer to this question actually has more to do with the amount of money you invest in each trade than it does with how often you trade. If, for example, you only have $1,000 to invest in a trade and you’re using a discount broker that charges $20 per trade, 2% of the value of your trade is eaten away by the commission fee when you first enter your position. When you eventually decide to close out of your trade, you will likely pay another $20 commission fee, which means that the round-trip cost of the trade is $40, or 4% of your initial cash amount. That means that you will need to earn at least a 4% return on your trade before you break even and can begin to make a profit.
With this type of fee structure, which is quite common, it really does not matter how often you trade. All that matters is that your trades make enough of a percentage gain to cover the costs of your commission fees. However, there is one caveat to this - some brokerage firms give commission discounts to investors who make many trades. For example, a brokerage firm may charge $20 per trade for its regular customers, but for customers who make 50 trades or more per month, they may only charge $10 per trade.
In other cases, an investor and his or her broker may agree to a fixed annual percentage fee (e.g. an annual fee of 2% of assets under management). In this case, it really does not matter how often you trade because you’ll pay the same annual percentage fee.
To learn more about commission fees and their impact on your investment returns, check out Paying Your Investment Advisor - Fees Or Commissions?
ADVISOR INSIGHT
Minimizing commissions and fees can have a huge impact over the course of your entire investing career. Here are three ways to do so:
- Invest in exchange-traded funds (ETFs) rather than mutual funds. The expense ratios are almost always lower for an ETF versus a comparable mutual fund. It is now very easy to build a low cost, well-diversified portfolio using ETFs with an expense ratio of 0.25% or less per year.
- Avoid products with front-end loads, back-end loads or 12b-1 fees. These are typically found within mutual funds, but not ETFs.
- Seek out ETFs with no trading fees. A growing number of fund families are waiving trading fees on their ETFs.
If you do decide to invest in a fund with a trading fee, try to invest more than $1,000 per fund.
2.8. What Type of Brokerage Account Is Right for You?¶
A broker, also known as a brokerage, is a company that connects buyers and sellers of investment vehicles like stocks and bonds. A brokerage account is often where an investor keeps assets. Which type of brokerage to choose is a matter of the investor’s needs and preferences.
2.8.1. Quick History of Brokerages¶
Before the middle of the twentieth century, access to stock and bond markets was restricted to the affluent who had enough money to invest and who could afford the services a human broker to place trades and act as an investment advisor.
In the 1970s and 1980s, a range of so-called discount brokerage firms, such as Vanguard and Charles Schwab, sprang up. They were willing to take on a less affluent clientele because their business models sought to accumulate a large number of small clients.
The late 1990s saw the rise of the internet, and online brokerages such as E*TRADE and FOREX.com were founded to seize the opportunity new technology offered. They extended the discount brokerage model by reducing commissions and minimum balances. That’s because they had far less overhead in terms of physical space and human brokers placing trades, so they could pass these savings on to the consumer
2.8.2. The Rise of Self-directed Investing and Online Brokerage¶
With lower trading costs, the online brokerage account also brought with it the self-directed investor—the investor who conducts investment research on their own and then chooses which stocks and bonds to buy for their portfolio.
Today, there are a wide array of traditional, discount, and online self-directed brokerage platforms available, each with their own pros and cons.
In addition, a new development over the past few years has been the advent of the robo-advisor. These are automated software platforms, often available as mobile apps, that take care of nearly all of your investment decisions at a very low cost.
Arguably the first robo-advisor, Betterment launched in 2010 after the Great Recession. Since then, robo-advising has seen exponential growth in adoption and a flurry of both startups and existing brokerages adding a robo-advisor arm. With all of these choices, then, let’s look at which type of brokerage is best suited for what type of investor.
2.8.3. Human Brokers and Financial Advisors¶
Some people prefer to have a human handle their finances. If this is you, then a traditional human advisor may suit you better than a robo-advisor. Human brokers and financial advisors have been around since the beginning of modern stock markets, and they’ve carved out a space in today’s competitive landscape by catering to the more affluent investor (typically with $100,000 or more to invest) or those who prefer human interaction.
Effective financial advisors not only build and monitor investment portfolios, but they offer financial advice in all areas of their clients’ lives and provide auxiliary services such as insurance, estate planning, accounting services, and lines of credit, either themselves or via a referral network.
Customers of these brokers can expect to pay around 1% a year or more of assets under management to the advisor, or up to $50 per trade for individual transactions. Many advisors claim that these fees are well worth the extra value that they bring, whether it be their ability to pick stocks appropriate for their clients’ portfolios, their access to unique products and offerings, or a comprehensive financial plan.
Many advisors are available by phone or email and quite responsive. They also usually make a point to meet their clients in person when appropriate.
When comparing this set of brokerages, pay attention to independence. Ask if your advisor is compelled to sell a particular product or service (for example the one offered by their particular company), or if they’re able to offer you the best products regardless of which fund family it came from.
Also, pay attention to fees. If they’re charging more than 1%, ask why and judge for yourself whether the extra cost is worth it. Professional certifications such as the CFP or CFA designation show that your broker has been trained and has passed a series of rigorous exams related to financial markets and planning.
Customers should use FINRA’s BrokerCheck tool to see if their broker has been subject to regulatory complaints or ethics violations.
2.8.4. Online Self-Directed Broker Accounts¶
Online self-directed platforms include the likes of E*TRADE, TD Ameritrade, and Robinhood, among many others. Today, most financial institutions and even many banks offer their customers a self-directed online brokerage account.
For example, Capital One, Citibank, or Wells Fargo all offer investing platforms. Almost twenty years into the 21st century, most of the discount brokerage space has consolidated into online investing.
For the most part, these platforms leave it up to you to figure out which investments are the best, but they typically offer a suite of research and analysis tools, as well as expert recommendations and insights, to help you make informed decisions. You are then on your own to execute the trades to build your portfolio through their website or mobile app.
These platforms charge a per-transaction commission, usually ranging from $4.95 to $9.95 per stock trade, and an extra $.50 to $1.00 per options contract. They let you trade on margin, create options strategies, and invest directly in mutual funds as well as individual stocks, foreign exchange (forex) and exchange-traded funds (ETFs).
Online brokerages are best for the self-directed investor who knows about the markets or knows how to conduct their own research to choose a portfolio best suited for their goals. If you’re only going to make a few trades a year, you may want to pay a little bit more per trade in order to get access to higher quality research and analysis. If you’re a day trader, you’ll probably want to consider a site that hands out free trades to their most active users.
Each online brokerage has its own strengths and weaknesses. Who you are and what you value will steer you to the one that’s best for you. For instance, some people may value the convenience of having all of their financial accounts under the same roof. Others may value interactive charting. Still, others may value access to IPOs.
2.8.5. Robo-advisors¶
Robo-advisors automate investing and use technology to manage your portfolio. Since Betterment launched in 2010, there has been a proliferation of both startups and existing financial companies offering this sort of algorithmic trading service.
Unlike the trading algorithms that power the high-frequency trading (HFT) desks at hedge funds and banks, robo-advisors are likely to put your money to work using low-cost, indexed ETFs. In fact, it is the convergence of ultra-low-fee ETFs with low-cost technology solutions available on mobile platforms that make robo-advising possible. You can now invest with as little as $1 on some platforms for as little as 0.15% per year in fees. Some platforms don’t charge an advisory fee at all, but they charge for optional add-on services.
Before robo-advisors, if you had only a few hundred dollars or even a few thousand dollars to invest, you’d have to go online to a self-directed platform. Now, you can put your $200 or $2,000 to work without having to conduct any investment research, pick any individual stocks, or worry about rebalancing your portfolio.
Algorithm-based robo-advisors aim to place you in an efficient and diversified passive portfolio. Many of these platforms will even tax-optimize your portfolios with tax-loss harvesting, a process by which an investor sells losing positions to offset the capital gains generated by winning positions. The algorithms themselves are a proprietary company secret of robo-advisors.
Robo-advisors are an ideal option for new or young investors who have little to invest. Minimum balances for robo-advisor accounts are quite low, and some will let you start with as little as $1. These platforms are also good for people who are fans of passive investment strategies since most often you’ll find your robo-advisor develops a portfolio of indexed ETFs on your behalf.
Robo-advisors also shine for those long-term investors who simply are too busy (or unmotivated) to do their own research on which ETF has the best risk/return characteristics combined with their associated fees, costs, and tax implications.
But robo-advisors are certainly not for everyone. If you’re an active trader, you may find them boring or unsophisticated. While robos are adapting to this by allowing for more customizability of portfolio choice (for example, most robos will now let you adjust your allocation weights away from their initial recommendation), it defeats the purpose of these products to start speculating on hot stocks or volatile companies within these platforms. Likewise, if you’re a sophisticated investor who needs margin, options trading and technical charts, a robo-advisor is probably not for you.
If you choose a robo-advisor, the factors to consider are primarily cost, reputation, and added services. Monitor the cost of extra services: some are free but others add an extra cost.