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STOCK MARKET 101 - Through My Eyes

"Unless you can watch your stock holding decline by 50% without becoming panic-stricken, you should not be in the stock market." -- Warren Buffett.

Stock, also known as ''share'' or "equity," is a financial instrument that signifies ownership in a corporation and represents a claim of the holder on the corporation's assets and earnings. Even though the two terms “share” and “stock” are often interchangeably used, the subtle difference between the two must be noted. While “share” represents fractional ownership of a corporation in proportion to the total number of shares, stock is all of the shares into which the ownership of the corporation is divided. In short, stock is the total shares, and a shareholder is a part owner of it. 

 
The ownership stake of any shareholder in a company is proportionate. It is determined by the number of shares a person owns relative to the amount of the outstanding shares. Take as an example, if a company has a thousand shares of stock outstanding and one person owns a hundred shares, that person would own and have a claim to 10% of the company's assets. If the number of outstanding shares of a corporation is a million, and a person has a thousand, the person thus has a claim to a 10% stake in the company's earnings and assets.
 
Two types of stock based on two significant differences are identified: common stock and preferred stock. The first difference is in the area of dividends while the second difference has to do with voting rights. A dividend is an amount of money a corporation pays to its shareholders out of its profits or retained earnings (think of this as a monetary reserve!). Voting rights, as the name itself implies, refers to the right of a shareholder to vote on core corporate issues such as the membership of the board of directors of the corporation, the establishment of its policies, and others.
Common stock entitles the owner to voting rights and dividends. However, depending on the decisions of the board of directors, common stockholders may or may not receive dividend. Preferred stocks, on the other hand, do not convey voting rights on their owners but do convey higher claims on assets and earnings on their holders. As a result, when a corporation can no longer meet its debt obligations to lenders and has to liquidate and pay its creditors, common stockholders will not be paid until preferred stockholders are first paid. Because common stocks are more abundant in magnitude than preferred stocks, the terms "equity" and "shares" are often taken as synonymous to common shares.

Based on the difference in voting rights, common stock has been sub-classified into further categories such as Class A shares and Class B shares. It works like this: those shares both carry voting rights, but different voting rights are attached to each class. Shares in Class A, for instance, may have ten voting rights per share while those in Class B may have only one voting right per share. The significance of this is to concentrate voting power within a specific group of people.

In addition to the difference in voting rights and dividend, stocks can also be classified based on other criteria. Two other bases used for the classification of stock are market capitalisation and sector. Market capitalisation is a term used to denote the size of a particular corporation; it is the total market value of its outstanding shares, the totality of its shares currently held by all its shareholders. It is easily calculated by multiplying a company’s outstanding shares by the current market price of a share. Thus, if Company A has 10 million outstanding shares and the current market price of a share is $150, Company A would have a market capitalisation of $1.5 billion.

Market capitalisation can be a fundamental metric to consider for making investment decisions and for the diversification of portfolio. Large-cap companies are large, well-established companies with a market capitalisation of $10 billion or more. Mid-cap companies are also established (but not as established as the large-cap firms) companies with a capitalisation between $2 billion and $10 billion, and with massive potential for growth. Small-cap companies, small, young, and newly-emerging companies, have a market capitalisation of between $300 million to $2 billion. Because of their age, small-cap companies generally carry the highest risk. 

In classifying stocks by sectors, companies in similar industries are grouped for ease of analysis. Stocks within the same industry can be easily compared and sorted.

According to the Global Industry Classification Standard (GICS), there are eleven sectors, and they are:
• Financial Services
• Communication Services
• Information Technology
• Health Care
• Energy
• Materials
• Industrial
• Utilities
• Real Estate
• Consumer Discretionary
• Consumer Staples

The primary importance of classification by sector is its simplification of investment choices for investors. In the book, The Intelligent Investor, Benjamin Graham wrote about the defensive and aggressive investors. Aggressive investors generally have a high-risk tolerance level and gravitate toward highly volatile sectors such as information technology, communication services, and financial. Defensive investors, on the other hand, go for stable sectors such as health care and consumer staples which usually offer some stable returns.

Why do companies issue stock? The answer to this can be found in the history of stock. The history of stock is a long and interesting one and is worth studying by anyone interested in the stock market. During the Roman Republic, the state contracted out many of its services to private companies in a similar arrangement to the current model of modern corporations. They issued shares, and there is evidence that the price of stocks fluctuated then, too. The English (later British) East India Company was the earliest recognized joint-stock company in modern times.


Elizabeth 1, on December 31, 1600, granted an English Royal Charter to the company, with the intention of having privileges to trade in India. Soon afterward, the company issued the first shares that were made tradeable on the Amsterdam Stock Exchange, an arrangement to attract capital from investors. It is this access to substantial capital that the stock market provides that continues to account for its enduring relevance. To facilitate the execution of a startup idea, an entrepreneur requires a significant amount of capital which can be acquired through one of the two principal means, equity financing, and debt financing.


Debt financing, the act of taking on loans to implement an entrepreneurial venture, because of the burden it poses, is less preferred to equity financing. On the other hand, when capital is raised through the sales of shares, it is called equity financing. It is generally preferred because it is less burdensome, and because of the access to much more massive amounts of capital it can provide. A privately-held company first sells its shares to the public through an initial public offering (IPO), and the status of the company changes into a publicly traded firm. The company's shares then become listed on a stock exchange.

Before I proceed, an essential explanation has to be made. There are often two phases of equity financing, and the two occur in different markets called primary and secondary markets respectively. In the primary market where the initial issuance of equity in exchange for capital occurs, the major players are the corporations seeking to expand their businesses, institutions which are willing to invest in them, investment banks which link up the two, and public accounting firms which are responsible for the preparation and review of the financial statements.

While the initial issuance of equity in exchange for capital occurs on the primary market, the secondary market is where the more significant action is, as the previously issued shares are actively traded on an exchange. Here, the primary market participants are retail traders and investors, insurance companies, pension, and hedge funds, and investment banks which again come in to provide equity research, expedite buying and selling between traders, and also trade shares on behalf of their clients. Both the primary and secondary markets make up the capital markets. 


A stock exchange can be likened to a marketplace. Except that on it, it is not tangible commodities like groceries that are traded; it is financial instruments like shares and bonds that are bought and sold. The stockbroker is a regulated individual usually working with a brokerage firm who executes the buying and selling on the exchange on behalf of an investor or trader in exchange for a commission or fee. Today, there are sixty major stock exchanges in the world, and they differ in size, market capitalisation, and trading volume.

The ten largest stock exchanges in terms of market capitalization in the world are:
• New York Stock Exchange
• National Association of Securities Dealers Automated Quotation (NASDAQ) Stock Exchange
• Tokyo Stock Exchange
• Shanghai Stock Exchange
• Hong Kong Stock Exchange
• London Stock Exchange
• Euronext
• Shenzhen Stock Exchange
• Toronto Stock Exchange
• Deutsche Boerse

Traditionally, transactions had to be conducted at physical locations. Buyers and sellers were manually matched on the floor of an exchange using the open outcry method. In the open outcry method, traders would shout the bid and ask prices. The bid price is the price at which a potential buyer is willing to buy while the ask price is the price at which a potential seller is willing to sell. The manual trading system has been superseded by the electronic system which gives real-time quotes, matches buying and selling traders quickly, and has resulted in a considerable reduction in transaction costs.  Consequently, stocks are now traded at both physical exchanges and hybrid markets.

What drives stock prices? The answer is as intriguing as the question. The stock market, as highlighted earlier on, has millions of participants. There are institutional investors such as banks, mutual funds, hedge funds, pension funds, and retail investors and traders, and all of them, at different points during the trading days, may have differing opinions about the values of different stocks and correspondingly about their prices, too. The differing views become reflected in the constant fluctuations in the price of stocks during a trading day. The variation in the prices of stocks is of concern since it is the primary determinant of volatility in the market.

The law of demand and supply is another unbending rule that explains why and how stocks fluctuate in price. When buyers outnumber sellers, the price rises. When sellers outnumber buyers, the price falls. Buyers demand; sellers supply. Sometimes, certain events also can cause a dramatic increase or fall in the price of a stock. They could be the release of a business report, a change in key management positions, or even a natural disaster that could impact in some way on the operations of the company concerned. "Each price," Dr. Alexander Elder, the best-selling author wrote, "represents a momentary consensus of value between buyers, sellers, and undecided traders at the moment of transaction. There is a crowd of traders behind every pattern on the screen."

So how is stock market performance measured? Usually, market indices are used. Index, according to the lexicon of Financial Times, is defined as an indicator of trends in a market or economy, reflecting changes in various component data (often weighted to account for their relative importance). “An index is a portfolio of stocks, chosen according to simple, pre-defined rules, and designed to capture a particular investment style,” the same source continues. A market index, therefore, is a performance benchmark that indicates the financial health of a sector invested in.  The first equity index, the Dow Jones Industrial Average (DJIA), attributed to Charles Dow, was created in 1896.

Some other market indices include:
• Standard & Poor’s 500 (US)
• NASDAQ composite (US)
• Nikkei 225 (Japan)
• TSX composite (Toronto Stock Exchange, Canada)
• Dax index (Germany)
• Sensex (Bombay Stock Exchange, India)
• All Share Index (ASE, Nigerian Stock Exchange)

Throughout its long and rich history, many schools of stock market analysis have evolved. The majority of stock market analyses, however, can be grouped into the three: fundamental, technical, and sentiment analyses. Fundamental analysts attempt to determine a company's actual value using some factors such as its quarterly and annual revenues, profits, the history and leadership of its management, its ability to generate positive cash flow, and its strengths and weaknesses compared to its competitors. This approach, therefore, can be quantitative or qualitative. 


Technical analysis is the use of stock charts and indicators to determine trends without paying attention to the underlying fundamental details. Essentially, technical analysts rely on charts to make sense of the behavior of the market and the direction of the stock. Sentiment analysis, as the term itself implies, is the analysis of the sentiments of market participants. Sentiment analysts, working on the assumption that most investors have biased views of the market, tend to go against the flow. Thus, they are often contrarian.

Which approach is the best? There is no clear-cut answer. The strategy to adopt may depend on your personality, your situation, and your investment goals. There are also a lot of investors who combine those methods of analyzing the market. However, one thing is sure: investing in the stock market, irrespective of the strategy adopted, carries its risk, and the amount invested in it may end being more or less.


Despite the long history of stock, it would seem that everybody should have been exploring this time-tested financial vehicle. No, that is not the case. I guess it has been due to the knowledge-gap among people. Stock still seems like an esoteric thing available to only a few.  Yes, investing in the stock market is not without its risk but it continues to be a viable means of building up one's net-worth. Stocks often offer consistent investment gains in the long run, and they can also be used for collateral. You have worked hard for your money, and with stock, you give your money the chance to work harder for you. Apart from dividend yield, by taking advantage of value rise, you may also become a millionaire.



7 comments:

  1. The MOST complete and excellent article I have seen about introducing this topic. It's simple, honest and clear, love it. I have tried to explain many of these things to my family, and most of the times I ended up being too hard to understand, even for myself haha. Will send this to them, thank you for your contribution!

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    1. Thanks for taking the time to read the article Blair. Feel free to share with friends, and ask any questions you might have.

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  2. 5/5 to this article, this is a MUST read for someone who is interested in learning about this. I agree with all of your words, indeed the most common questions that I have seen is about the prices! Very good job!

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  3. Well, I agree with many of your words, this is something definitely seen as "esoteric thing available to only a few", so obviously not esoteric, but do you think this is something everybody could do? I think is the same about running your own business, not everybody is made or ready for that, it requires discipline, motivation, extra work, and such, sadly not everybody has those quality's! Is not something you born with either, but you need to put heart on it to succeed! Good day, keep the hard work!

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  4. Based on that first quote I don't think the stock market is a place for me. Eek. However, your post is so thorough and informative and helped me to see the basics of the stock market. How did you get interested in the stock market and were you wary at first?

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  5. This is a great article. I loved how you went into detail about all of the specifics of the stock market and the meaning behind some of these commonly used words such as Mid Cap and Large Cap. You would be surprised how many investors don't understand the difference.

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  6. Took me a while to process all this information, but it's exactly what I needed. Definitely not ready to start my journey as a trader, but I'm building that discipline that it requires!

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