Language of the Stock Market

February 29, 2020

Summary: New investors might find it helpful to understand the basic language of the Stock Market.  In this article I discuss the basic vocabulary as it relates to practical ideas for personal investing.  Links are provided for further reading about a particular topic.

Investment returns

An investment is the payment of capital to earn a return.  The return is a gain (or loss) of value in the investment.  Taxes on returns are regulated by the Internal Revenue Service (I.R.S.) and local governments.   

  • Principal: the amount of money invested.
  • Capital: the cash or goods used to generate income.
  • Capital gain (or loss): the increase (or decrease) in cash value of an asset.
  • Dividend: a company’s cash payment to its stockowners.   
  • Interest: the borrower’s cash payment to the lender that is added to the principal of the  loan.

Investment portfolio

Financial assets are potential sources of income for investors.  Asset classes are groupings of assets that earn income in uniquely different ways.  The most popular asset classes are Equities and Fixed Income Securities.  Equities earn income by the sale of a security (e.g., shares of a Stock).  Fixed Income Securities earn guaranteed interest (e.g., bonds) or guaranteed dividends (e.g., preferred stocks).  Securities and investors are regulated by the Securities & Exchange Commission (S.E.C.). 

  • Securities: contracts that require an investment of money to generate profits from the efforts of other people. 
  • Stock: a security that represents part ownership of a company.  
  • Common stock: a security that entitles its owner to vote on important issues, collect dividends, and earn capital gains from the stock market.   
  • Preferred stock: a security that entitles its owner to receive dividends before dividends are paid to owners of the company’s common stock.  Preferred stockowners have no voting rights.    
  • Bond: the debt that requires a company to return an investor’s principal, plus interest, by the date of maturity.    

A Portfolio is the investor’s collection of financial assets called holdings.  By comparison, an Investment Fund is a portfolio of financial securities which are professionally managed on behalf of the fund’s investors.  Famous examples are mutual funds and exchange-traded funds (ETFs).  An actively managed portfolio generally seeks to earn higher returns than one which is passively managed.  The passively managed portfolio seeks to duplicate the returns of a market index.  

Glossary:

  • Market index: a hypothetical portfolio designed to measure the value of a market or market segment. 
  • ETF: an Investment Fund that sells shares of the fund in the stock market.  Index ETFs are passively managed. 

Stock market

A new stock is issued in its primary market.  The primary market is a private assembly of the company’s founders, venture capitalists, and third parties such as banks and advisors.  The stock may later be sold by public auction in the secondary market.  The secondary market is the familiar stock market where millions of investors, —like us!—,  trade cash for stocks and other exchange-traded securities (e.g., ETFs). 

Trading orders

The stock market participants include Investors who make offers, Brokers who generate orders, and Traders who finalize orders.  The broker’s trading platform is a computer program that assists investors with placing trading orders.  The platform provides a market “quote” comprised of the current purchasing price (the “bid”), sales price (the “ask”), last-traded price, and latest number of traded shares (the “volume”).   On any day there may be millions of orders to buy and sell in the stock market.  Orders are filled at the market price determined by an auction of shares conducted by the broker’s trader.  Brokers and traders often charge a fee for their services.  Custodians are hired by brokers to store traded securities in electronic accounts on behalf of investors.   

The simplest trading order, a MARKET ORDER, specifies the number of shares to be traded.  Market orders are filled immediately provided the shares are available; otherwise, the order remains open until shares are available.  Conditional limit- and stop orders are stored in computers until activated or expired at the end of a period called the time-in-force.  The LIMIT ORDER requires an investor to specify a preferred price for the trade.  Limit orders are activated when the market price reaches the preferred price and then filled at the preferred price or a better price. Please be aware that a sudden market event could displace the market price outside the limit range of an activated order, in which case the limit order is cancelled unfilled. The STOP ORDER is activated at a specified price after which it is converted to a market order to be filled immediately regardless of the next available price. 

Stock market index

Analysts like to follow the price trend of stocks by graphing a representative number called the stock market index.  The index rises and falls at any moment according to fluctuations in share prices during stock market transactions.  An influential sales surge moves prices downward and a buying surge generally sends prices upward.

Daily index values are strung together to form an observable trend called the market cycle.  The long market cycle is comprised of a “bull” market followed by a “bear” market.  The short market cycle is either a rally or a correction. Spikes and crashes are brief events caused by a sudden, large change of the index (chart 1).  

  • Bull market: a 20% rise of the market index over 2 months or more.
  • Bear market: a 20% fall of the market index over 2 months or more.  
  • Rally: a rise of the market index due to a burst of buying that subsides after the money is spent.
  • Correction: a 10% decline of the market index over 2-10 days.
  • Spike: a sudden large upward or downward price movement.
  • Crash: a sudden correction that lasts 1-2 days.
  • Circuit breakers: programmed halts of trading designed to offset a downward plunge of stock prices.  

Chart 1. Long and short cycles of the Dow Jones Industrial Average (“DOW”).

market cycles, DJIA

In chart 1, the vertical scale shows values of the DOW Index during a 20 year time period shown by the horizontal scale.  The jagged line represents daily fluctuations of market prices. Green, red, and black symbols illustrate the timing of various market cycles and events.  The horizontal line of green and red segments portrays 4 long cycles of the DOW Index.  After the partial 1st cycle (Jan 2000-Jul. 2001), the complete 2nd (Oct. 2001-Aug. 2002) and 3rd cycles (Sep. 2002-Mar. 2009) show orderly sequences of bull and bear markets.  The nearly complete 4th cycle began with a very long bull market of eleven years (Mar. 2009- Jan. 2020) that recently reverted to a bear market at the time of this writing.  Chart 1 also shows short cycles of rallies (green triangles) and corrections (red triangles).  A few market crashes (black triangles) in Nov. 2008 and Mar. 2020 represent 1-2 day periods of a 10% drop in the Index.  Rapid declines of the Index by 7% in one day triggered temporary halts of trading (black circles) known as “circuit breakers”.

Diversification

Stocks are high risk investments with respect to potential capital gains (upside risk) and losses (downside risk).  Capital loss occurs when the company declares bankruptcy or its share prices decline.  Stock diversification, dollar cost averaging, and dividend reinvestment plans (DRIPs) are effective strategies for managing the common risks of stocks.  Monthly purchases of a Stock-index Fund accomplish these strategies.  Chart 2 illustrates the potential capital gains from investing in a Stock-index Fund that duplicates a broad market index such as the S&P 500.

Chart 2.  Historical prices of the S&P 500 Index.

dividend reinvestment

Assuming that the Fund matches the performance of the S&P 500 Indexthe difference between holding the original investment in the Fund without further action (red graph) and augmenting the holding with reinvested shares (blue graph) illustrates the potential benefit of a dividend reinvestment plan.  In this example, the benefit became ‘significant’ after 6 years.       

Postscript

Stock investing is a time-consuming process that might not interest many people who wish to put their money in the market.  They can save time (and money) by investing in a Stock-index Fund that provides an instant portfolio of diversified stocks for long term investment.

Stocks are one of several investable asset classes.  People with short term goals should consider diversifying their portfolio with different asset classes.

Copyright © 2020 Douglas R. Knight 


#conversation: the young should invest for retirement.

May 30, 2014

American youth should be investing for retirement regardless of their socioeconomic status. First comes money management, then investing. There are practical barriers to this model that can be managed with the help of educators and nonprofit organizations. My daughter recently asked what would happen to the markets if everyone suddenly began investing in index funds.


Hey Kids, money is important

April 16, 2014

Three reasons for liking money: The best is that it buys things you want at today’s prices. Another reason is that it will buy things in the future. And the third reason is that it represents the trading value of goods and services (1).

Risk

Most people aren’t given a lot of money. They have to earn it and invest it to get rich. They also have to protect it against ‘risk’. Think of risk as your chances of losing money. Here are some easy ways of losing money:

  1. Theft. People may steal your money unless you put it in the bank and keep your bank account’s password a secret.
  2. Overspending. Save money for things that you will need in the future. Otherwise, you are spending too much money. Another way of overspending is to borrow money to buy things that you don’t really need. The best way to avoid overspending is to plan a budget.
  3. Debt. Using a credit card or taking a loan are two different ways of borrowing money from somebody called a lender. Before borrowing the money, you must sign a contract that requires you to repay the lender on time with an extra amount of money called interest. All of the money that you owe is called debt and refusal to repay the lender may eventually prevent you from buying things. Don’t borrow money unless you need it for an important reason (such as education) and use a budget to manage your debt.
  4. Unemployment. Unemployment occurs when people can’t work for money. Avoid unemployment by getting a good education and learning good skills. Don’t drop out of high school before graduation.
  5. Disasters. Accidents, illnesses, wars, and severe weather conditions are disasters that require a lot of money to survive the damage. Adults can buy insurance that will help pay for illness, injuries, and property damage.
  6. Inflation reduces the purchasing power of money.
  7. Citizens are required to pay taxes on the money they earn.

Inflation

Money’s ability to pay for things is called purchasing power. It’s no secret that the purchasing power of money changes over time. Today the price of a Big Mac™ hamburger is nearly five dollars. But 50 years ago, the price of a Big Mac™ hamburger was only 45 cents. What happened over 50 years? The prices of most things went up, including the price of hamburgers. The increase in prices over time is called ‘inflation’.

You can be sure that today’s money will buy less in the future due to inflation. The best way to protect against the effects of inflation is to start investing money as soon as possible.

Investing money

Think of  ‘investing’ as a good way of using money to earn more money. The money that you earn is called a profit or a return. Investing is a lifetime skill worth learning now.

The risk of investing is that you will lose money. If you don’t want to risk losing money, invest in U.S. Government Bonds. The government always repays your money plus a type of return called interest.

Stocks are risky investments that often pay a higher return than U.S. Government Bonds. When you buy shares of a good stock, you must sell them at a higher price to earn the type of return called a capital gain. Try to avoid losing money by selling the shares at a lower price than you paid; that kind of loss is called a capital loss. The longer you wait to sell shares, the better your chance of selling them at a higher price. Some good stocks also pay small amounts of cash called dividends.

Investors who don’t have the time or interest in selecting a good stock can earn the average return from a large group of stocks by purchasing shares of a stock index fund. Investing in a good stock index fund is less risky than investing in a good stock.

Taxes

Investors must pay part of their returns to the Government by paying taxes. Employees are able to pay lower taxes on their returns by investing in tax-deferred and tax-free retirement accounts. If you earn wages as an employee, you may be able to invest in tax-deferred accounts known as the traditional individual retirement account [IRA] and the employer sponsored 401(k) account. Tax-deferred accounts protect you from paying taxes on returns until you start withdrawing money after retirement. You may also be able to invest in tax-free accounts known as the Roth IRA and the Roth 401(k). After you pay regular taxes on your wages, you never pay taxes on money that you withdraw after retirement. Employers, tax advisers, and librarians can provide information that you need to know before using these important retirement accounts.

Making the most of your money

Click into this money management website to get good advice on managing and growing your money.

Copyright © 2014 Douglas R. Knight

References

1. Free exchange. Money from nothing. The Economist, 3/15/2014.



#Investment-Returns-Calculator for Young Investors

April 9, 2013

3/13/2020 Update:    I am now recommending that you first click on each of the References at the end of this article to review several free online calculators.  They are reliable and well explained!

Original post:     Young people have limited resources for investing money.  But they can still invest if they make a realistic plan.  Simply click on this link, investment returns, to download a calculator that will help plan a retirement savings program.  The calculator predicts several possible outcomes from investing for 50 years.  Here are four examples of how the calculator works for different investment plans:

Jackpot Plan

Suppose you receive a $50,000 Jackpot.  After paying taxes you have $39,600 to invest in a stock index fund with the trading symbol YAY.  Assume that YAY’s annual rate of return is 8%, the stock broker charges a $10 trading fee, the fund manager charges an annual management fee of 1%, and the inflation rate is 2%.  Also assume that you don’t plan to make additional payments and don’t have a job that pays an annual salary.  You make the following entries in the calculator:

entrysingle

[COMMENTS ABOUT DATA ENTRY:  The calculator always assumes that you start investing at an early age and then plan to hold the investment for 50 years; otherwise, no results are displayed.  The white cells contain comments and suggested values; place your cursor over the cell to read the comment, then click on the cell to enter data.]

resultsingle

 The results are displayed next to the cells where you enter data.  In this example, the calculator uses the 8% annual rate of return to compound your investment returns from the stock market for the next 50 years resulting in an accumulated market value of $1,166,204.  The calculator assumes that you automatically reinvest all dividends and other cash payments earned from the market.  The “accumulated market value” will be your retirement savings.  You gave the Jackpot money ($39,600) to a stock broker and he took $10 of the money to pay the cost of trading.  That left a principal amount of $39,500 to invest in YAY.  The calculator subtracted the principal from the accumulated market value to determine the total return.  The total return is how much money you can expect to earn (or lose) from your investment.  In this case, you could earn a total return of $1,126,614 from YAYThe 2% inflation rate will reduce the purchasing power of your retirement savings [e.g., if your favorite book costs $10 today and $20 tomorrow, then tomorrow’s purchasing power = 100*(($10/$20)-1) = -50%; today’s dollar will only be worth 50 cents tomorrow].

SURPRISE!  You can expect to become a millionaire in 50 years, but that nasty inflation will reduce the purchasing power of your retirement savings by -61% to $453,994.

An additional chart is displayed on the graphs worksheet to show the expected growth of your Jackpot during 50 years of compounding the returns:

growthsingle

Dollar Cost Averaging Plan

A generous uncle wants to help you invest in YAY by contributing $2,500 every year until you can continue the additional payments.  A $10 trading fee is taken from each payment and YAY’s manager charges an annual 1% management fee.  You make the following entries in the calculator:

entryregular

[COMMENTS:  The calculator assumes that you, or your uncle, will pay the stock broker $2,500 at the beginning of every year for 50 years.   At this time, you do not plan to set up an allotment from your future salary.]

resultregular

The calculator automatically constructs three Regular Payment Plans depending on whether you pay $2,500 at the beginning of every year, every quarter (a quarter is 3 successive months), or every month.  Since your uncle offered to pay every year, we will focus on results from the yearly payments.   The total payment ($127,500) is the sum of the initial payment and 50 additional payments.  The total trading cost, which is the sum of 51 trading fees, reduces the total payment to a principal amount of $126,990.  You can expect the compounded returns to generate a retirement savings of $1,156,463 based on the sum of the $126,990 principal and $1,029,473 total return.

growthregular

SURPRISES!

  • Compared to the single payment plan of investing a Jackpot, the dollar cost averaging of yearly payments is expected to increase the purchasing power of your retirement savings; that’s a good deal!  [Inflation reduces the purchasing power of your retirement savings by -50% when making regular payments (better!) compared to -61% when only making one payment (worse!).]
  • Look at the fantastic growth of retirement savings by making the same payment on a monthly or quarterly basis!

Salary Allotment Plan

Not everyone hits the Jackpot or has a rich uncle.  But anybody who gets a good education can plan on getting a job at some time in their life.  Let’s assume that you save $100 a year from your allowance to invest in YAY.  Fifteen years later you start earning $65,000 per year and invest 10% of it.  You make the following entries in the calculator:

entrysalary

[COMMENT:  The calculator assumes that you make the first payment at an early age (e.g., age 10 years) and begin earning wages 15 years later (e.g., age 25 years).]

resultsalary

Your salary allotment plan predicts $1,061,559 of retirement savings.  Inflation reduces the purchasing power of the retirement savings by -37% (best!) when making salary allotments compared to -50% (second best!) when making regular payments and -61% (worst!) when making only the first payment.  Here’s what happens to salary allotments during 50 years of compounding returns:

growthsalary

Thrifty Investing Plan

Two ways of reducing the total cost of investment are to purchase a no-fee index fund that charges a low management fee.  Some discount brokerage firms don’t charge a trading fee for investing in their sponsored index funds.  Some index fund managers charge a very low 0.06%-0.08% annual fee for stock funds that invest in a broad-market index (e.g., Standard & Poor’s 500 Index).  Assume that you repeat the same money management plan that was previously used in the Yearly Salary Allotment Plan, but this time you reduce the costs of trading and management.  You make the following entries in the calculator:

entrythrifty

This thriftier investing plan should increase your retirement savings compared to the more expensive yearly salary allotment plan.  The reduced costs of investment predict a good improvement in total return without significantly changing the purchasing power (-38% in this example).

resultthrifty

NO SURPRISE!  Thrifty investing can increase your retirement savings [by $271,871 in this example].

Summary

Unless young investors have a lot of money, they will probably invest small amounts during their formative years until they get a job in adulthood.  They should still make small investments as early as possible if for no other reason than to start acquiring the skills of money management and investing.  Regularly scheduled investments throughout life are essential to maintaining the purchasing power of retirement savings.  This investment returns calculator helps young investors (and their parents) plan for retirement.

Copyright © 2013 Douglas R. Knight

Links to previously published calculators of compound returns

Previously published calculators predict the long-time return from an initial investment1, a series of annual investments2, a series of monthly investments3, or a mutual fund4.

1.           Dividend.com: http://www.dividend.com/tools/compounding-returns-calculator.php (calculates growth of initial investment)

2.           Moneychimp.com: http://www.moneychimp.com/calculator/compound_interest_calculator.htm (calculates growth of initial investment and annual additions)

3.           Math.com: http://www.math.com/students/calculators/source/compound.htm (calculates growth of initial investment and monthly additions)

4.           SEC mutual fund calculator: http://www.sec.gov/investor/tools/mfcc/get-started.htm (calculates growth of investment after deduction of various fees)


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