Stock Market Basics

We frequently hear people talking about the stock market. When the market was great in the late 1990s, everybody wanted to talk about the market and how well their investments were doing. People quit their jobs to become day traders, those steel-nerved folks who watch the market carefully, buying and selling stock in hopes of hitting it big and making tons of money. More people invested in the market than ever before, fueling the economy and keeping stockbrokers extremely busy.

In these days of market plunges, however, many investors aren't quite so anxious to talk about their stocks. Folks are still day trading, but many of them have given up the dream and gone back to “real” jobs. Stockbrokers are still busy, but these days a lot of that business entails reassuring clients.

So just what is this thing called the stock market, and how does it work? Why does it rise dramatically one day, only to take a plunge the next?

The stock market is a generic term that encompasses the trading of securities. The security can be a bond or a stock, and it's traded on an exchange. There are three major exchanges in the United States.

Formed in 1792, the New York Stock Exchange (NYSE) is the largest organized stock exchange in this country. Companies must meet certain requirements in order to be listed on the NYSE, so not all stocks are traded there.

If you want to buy a stock, your broker will relay your wish, either by telephone or the Internet, to a member of his firm who's on the floor of the NYSE. The order will then go to another broker on the floor who specializes in trading the particular stock you want to buy, and he'll make the trade for you. You can actually visit the NYSE and watch all the action.

The National Association of Securities Dealers Automated Quotation System, or NASDAQ, on the other hand, trades exclusively with computers. The trading is not conducted in a central location like the NYSE, but from different locations, via computers.

A third stock exchange, the American Stock Exchange, or AMEX, was known before 1951 as the American Curb Exchange. That's because trading was conducted on the curb of Wall and Broad streets in New York City. The AMEX does not have as stringent requirements as the NYSE, which makes it attractive to many smaller companies.

The overall performance of the stock market is evaluated in different ways. The Dow Jones Industrial Average is one measure of the market, and the one we most often hear about.

The Dow Jones Industrial Average is a composite, or group, of 30 selected stocks with a daily average. If the average price of the stocks goes up, the Dow Jones Industrial Average goes up for that day. If the average price of those 30 stocks goes down, we say the Dow Jones is down. Trading depends on many factors, and the stock market can have major fluctuations in its averages. The 30 stocks change infrequently, decided upon by a group of members of the New Stock Exchange. Mergers between large firms (like Mobil and Exxon becoming Mobil Exxon) require the addition of a new company onto the Industrial Average. Cisco was added in early 2000.

Knowing What and When to Buy

Stocks represent ownership, or equity, in a public corporation. When you buy the stock of a particular company, you're actually buying a tiny piece of the business. If the company prospers, you as a stockholder share in its profits (frequently in the form of dividends) and benefit from any rise in the market value of its stock. Conversely, if the company runs into problems, the value of your investment could decline.

Because their prices tend to fluctuate suddenly and sometimes sharply, stocks are considered more risky than bonds or cash investments. Over time, however, stocks have offered the highest returns of the three asset classes—as well as the best hedge against inflation.

So how do you know what stocks to buy, and when you should buy them?

Unless you're a real daredevil with lots of money to play around with, it's a good idea to invest your money in industries and companies that are stable, with good earning histories. Sure, you might be tempted to buy a few stocks in a sexy, new firm that's just starting up, or sink some of your money in a hot, new growth industry, and that's fine. The majority of your money, however, should go to buy stock that is tried and true.

There may be opportunity for increased profits in more risky stocks, but you should look for those that have reasonable price-to-earnings ratios. Price-to-earnings (P/E) ratios determine how the market is pricing a company's stock, and can help you to get an idea of the strength of a company.

Some investors target growth industries and only buy stock from companies within those industries. Some examples of growth industries at the present time include the following:

• Home healthcare services
• Computer and data processing services
• Residential care
• Water supply and sanitary services
• Management and public relations

While it's fine to invest some of your money in companies in these industries, it's not a good idea to rely only on growth industries.

There is risk involved whenever you buy stock, but some stock involves less risk than others. The risk of the stock you own going up and down in value because the entire stock market goes up and down is called systematic risk. Chances are, if the entire stock market drops by 10 percent, the stocks you own will decrease in value, as well. And the same is true if the overall market value increases. You can minimize the effects of systematic risk by investing in other forms of securities, such as bonds.

Unsystematic risk is that which affects only a particular business or industry. The good news is that diversifying your portfolio can minimize unsystematic risk. That means that you have a variety of investments in different types of companies and industries. If one sector of the stock market experiences a major downturn, you'll still have stocks in other areas to offset your losses.

So when you're looking for companies in which to invest, make sure you mix them up. Your portfolio should include a mixture of some of the many kinds of stock. Blue-chip stock, for instance, is that of the tried and true companies such as IBM and General Motors. Companies experiencing unusual growth issue growth stocks. Emerging market stocks are those in new markets, in the United States and around the world.

You can find out a lot about companies in whose stock you're interested by checking out their financial statements in their annual reports. You also should look at some of the company's ratios, including price to earnings (P/E), earnings per share (EPS), return on investment (ROI), and return on equity (ROE). Pay special attention to a company's profitability and how much debt it has.

Investors have been trying since investing began to time when they buy, trade, and sell stock. Even experienced investors, however, get hung up when they try to time the market. Ideally, you want to buy stock when the price is low, and sell it when the price is high.

Realistically, however, you should buy when you (and your financial advisor, if you have one) feel the time is right. Trying to time the market might be interesting, but it rarely pays off. The best time to buy stock is after you've explored your options, researched the companies, and decided that the stock is right for you.

Knowing When to Sell Stock

Anyone who's got money in the stock market these days has been through some trying times lately. After the longest period ever of sustained gains, the market is behaving as moodily as a teenaged girl with no date for the dance.

It's tempting, at times like these, to unload your stocks and put your money back into your savings account. You shouldn't, however, be in a hurry to sell stock that you feel is not performing as well as it should. Give it some time to see if it's going to bounce back. If the entire market is in a slump, chances are that your stocks will be slumping along with it.

The one piece of advice a financial advisor will give when the market dips is to not panic. In some ways, investors are like poker players. Even when the game isn't going the way they'd like it to, they've got to sit tight, stay cool, and hang on to their cards (or stocks).

That's not to say, however, that there is never a reason to sell stocks. If you have stocks that have increased in value, and you want or need money for a good reason, then selling the stock is a reasonable thing to do.

If the stock you own turns out to be a big loser, it also makes sense to get rid of it. Be sure, though, that the stock really is bad, not just stock that's not doing well at the moment. There are investor services that can tell you how your stocks are doing, and why, or you can check out a periodical such as Investors Business Daily. Two investor services you can access on the Internet are Moody's Investor Service at www.moodys.com, and the Value Line's Investment Survey at www.valueline.com.

If you think the price of your stock is as high as it's going to go, it's a good idea to sell it before the price begins to drop. Predicting if your stock has hit its peak requires that you conduct fundamental analysis. Fundamental analysis is a system that evaluates a company's overall condition, based on various criteria that measure the health of the company.

You shouldn't sell stock simply because you're bored and want something that's more exciting. Nor should you sell because you're nervous about the overall condition of the stock market. Unless you're only months away from retirement and are going to need the money you have invested, hang in there, and trust that better days are ahead.

If you do sell stock, you'll need to consider the capital gains or losses that you may incur. Naturally, we all hope to sell our stock for more than we paid for it. If you hold an investment for less than one year, however, you may pay big taxes on your profits. Gains or losses from an investment of less than one year are considered short term. Short-term gains and losses are netted against each other, and short-term gains are taxed at your regular tax rate. If you're in the 28-percent tax bracket, you'll have to pay 28 percent on your gains. As you can see, short-term gains are expensive.

If you hold an investment for more than a year, the gain or loss is considered long-term. Long-term gains and losses are netted against each other, too, but the tax on them isn't quite as hefty as with short-term gains. If you're in a 15 percent tax bracket, net long-term capital gains are taxed at 10 percent. If you're in the 28 percent or greater bracket, your capital gains are taxed at 20 percent. This tax advantage makes it desirable to hold assets for more than a year, particularly if you're in a higher tax bracket.

Excerpted from The Complete Idiot's Guide to Personal Finance in Your 40s and 50s © 2002 by Sarah Young Fisher and Susan Shelly. All rights reserved including the right of reproduction in whole or in part in any form. Used by arrangement with Alpha Books, a member of Penguin Group (USA) Inc.

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