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 


Model Portfolios, updated

January 23, 2019

Portfolio Visualizer is a highly rated online tool for designing investments (ref. 1). I used it to backtest the model portfolios listed in the following chart:

models

Legend: The top row shows the trading symbols of six index funds selected to build the model portfolios in rows 2-5.  The portfolios were backtested from December 2018 to January 2010.  $1.00 was initially invested in each portfolio and allowed to grow in value to the final balances shown in the righthand column.  The performance benchmark is Standard&Poors 500 TR Index in row 6.

Four-sector models in rows 2-4 represented diversified investments in stocks (VT, VTI), real estate investment trusts (VNQ), investment grade U.S. bonds (AGG), and gold bullion (GLD).  Several observations:

  • Four-sector models outperformed the bond market as determined by comparing their balances to the $1.32 that would result from investing only in AGG.
  • Portfolio performance was affected by the percentages of the index funds. The final balance of  four-sector models increased with the total percentage of stocks (VT, VTI) and real estate (VNQ) investments. 
  • Four-sector models underperformed the benchmark.

The one-sector model in row 5 held diversified investments in U.S. stocks. SCHX is a proxy for U.S. large-cap stocks and VTI is a proxy for all U.S. stocks. Among models, only the final balance of this model surpassed that of the benchmark in row 6.

Applications

Four-sector models are ideal portfolios for making short term investments of 1-5 year time periods. The goal of four-sector models is to improve safety by reducing the downside risk of investing in one sector.

The one-sector model of diversified U.S. stocks is ideal for making long term investments of 10 or more years.

Plan

Last year’s SmallTrades Portfolio, in 2018, was a four-sector portfolio that underperformed the benchmark.  In 2019, the new SmallTrades Portfolio will hold a group of actively managed stocks plus the passively managed Schwab U.S. Large-Cap ETF (SCHX). The initial allocation will be 20% stocks and 80% SCHX.

Thesis: SCHX is designed and tested to match the performance of the benchmark. Successful management of the stocks will raise the portfolio’s total performance above that of the benchmark.

References

  1. Vikram Chandrasekhar, 2016.  What is the best tool to backtest a portfolio online?

Math

The total return of a portfolio is estimated by the following formula:

RT = aRA + bRB+ cRC + dRD

For example, what is the estimated total return for the following portfolio?;  

25% VT + 25% VNQ + 25% AGG + 25% GLD

  • a, b, c, and d = 0.25.
  • RA = 7.19%, RB = 10.21%, RC = 3.13%, and RD = 1.37%.
  • RT = 0.25*7.19% + 0.25*10.21%+ 0.25*3.13% + 0.25*1.37% = 1.80% + 2.55% + 0.78% + 0.34% = 5.47%

By comparison, the Portfolio Visualizer  reported RT = 5.93% with a final balance of $1.68.  

Copyright © 2019 Douglas R. Knight 


2018

January 19, 2019
Once again, the SmallTrades Portfolio failed to outperform 
the Standards & Poor 500 TR Index ('benchmark'). In 2019, I
will replace five exchange-traded funds (ETFs) with a single ETF.

The SmallTrades Portfolio is actively managed within a tax-protected Roth IRA.  No cash has been added or removed from the account since the time of inception in 2007.  Figure 1 describes the portfolio and its investment strategy:

portfolio 2018 v3

Fig. 1. The holdings as of 12/31/2018.

The following strategies are used to earn capital gains:

  • The passive strategy is to collect dividends and capital gains from exchange-traded index funds (ETFs).  Each ETF is ‘passively’ managed to match the performance of a market index rather than ‘actively’ managed to outperform or underperform a market index.
  • The swing strategy is to buy the stock at a low price (‘bargain’) and sell it at a high price, however long the price-swing happens to occur.
  • The growth strategy is to purchase a reasonably priced stock and hold it until the company stops growing over several-to-many years.  The stock price should increase with the company’s profit.
  • The drip strategy is to buy a reasonably priced stock to collect dividends and reinvest them in additional shares of stock.  The beneficial effect of ‘drip’ increases as the stock survives several market cycles.

2018 Performance

Figure 2 shows the changes in value for every $1 invested in the Portfolio (solid blue line) and Benchmark (dashed blue line) after 12/31/2007.  The market value of the benchmark was consistently higher than that of the portfolio.

invested $ portfolio

Fig. 2.

 

In 2013, I replaced the Portfolio‘s mutual funds with ETFs that match the performance of 4 market sectors based on a model portfolio of global stocks, U.S. real estate investment trusts (REITs), U.S. bonds, and gold bullion.  I rebalanced the ETFs as needed and continued to actively manage a group of stocks.  Figure 3 shows annual fluctuations of the stock values (solid red line) and ETF values (dashed red line) as if $1 were invested in each group on 12/31/2013.

invested $ stocks

Fig. 3.

The benchmark (solid blue line) underperformed the stocks and outperformed the ETFs until 2018, when the benchmark surpassed both groups of investments (Fig. 3).

Why?

Several events in 2018 worked against the portfolio.

  • The U.S. stock market lost its collective annual earnings in the last quarter of 2018.  Most stocks declined in value.
  • Stop-loss trading orders triggered steep losses from 5 stocks in the portfolio.  Four were high-risk investments in small companies that failed to generate returns.  One investment was a large company with steadily declining earnings.
  • The 4-sector model portfolio predicted that the portfolio’s ETFs would collectively grow by nearly 9% every year, but instead they grew at half that rate, 4.4% annually.  The databases for the model portfolio were outdated (limited to the time period of 1997-2011) and have not been updated.

Plan

The new SmallTrades Portfolio will hold one index fund, the Schwab U.S. Large-Cap ETF (i.e., SCHX), and a group of stocks.  The SCHX is designed and tested to match the performance of the benchmark (more information in Model Portfolios, updated). The stocks will initially comprise 20% of the portfolio’s market value and they will be actively managed to outperform the SCHX.  Consequently, the portfolio’s growth should outperform the benchmark’s growth.

Copyright © 2019 Douglas R. Knight


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.


Investing is a life skill

January 1, 2014

Investing is a life skill that improves with experience.


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