Top ten things to know about stock investing:
Here is an overview of the most important points of this lesson. For more discussion.
1. The stock market may not always seem rational, but it’s usually right in the long haul.
Over the short term, the market moves based on enthusiasm, fear, rumor and news. Over the long term, though, it is mainly earnings that determine whether a stock’s price will go up, down or sideways.
2. Individual stocks are not the market.
A good stock may go up even when the market is going down, while a stinker can go down even when the market is booming.
3. Prices are set by where a company appears to be going, not where it’s been.
Investors buy stocks with the expectation that they’ll be able to sell them for higher prices at some time in the future. That means they expect that earnings will likewise grow. And if they don’t, the best past performance in the world isn’t going to help.
4. A stock’s underlying value is not always reflected in its price.
Because investors judge a stock based on its probable future profits, a $100 stock can be viewed as cheap if the company’s prospects are bright, while a $2 stock can be expensive if its prospects are dim.
5. A little homework can go a long way.
You can often get a sense of whether a stock is over- or undervalued by comparing its specific performance ratios, like price-to-earnings, debt-to-equity, price-to-sales and return on equity, to those of other companies in the same industry or to the market as a whole.
6. A quick way to judge whether a stock is expensive or cheap is to compare its P/E ratio to its projected growth rate.
The Wall Street analysts who track stocks specialize, among other things, in predicting how fast a company’s earnings will grow. By matching predicted five-year growth rates with price/earnings ratio (based on estimates for the year ahead), you can get an idea whether the stock is overvalued or undervalued: If the P/E is greater than the projected growth rate, the stock is pricey; if it's below it, the stock is cheap.
7. Don't ignore dividends.
During a bull market like the one of the mid-1990s, investors sometimes sniff at dividends -- the small share of profits that some companies distribute to their shareholders one or more times a year. But when the market slows, dividends carry more of the load. Case in point: Between 1926 and 1997, reinvested dividends produced nearly half of the market’s 10.9 percent average annual gain.
8. The Internet has become the best source of free information on stocks.
Thanks to a proliferation of financial data on the 'net, the average person today can tap into information that would have been available only to investment professionals 10 years ago -- and much of it is free.
9. Borrowing money to buy stocks can increase your reward -- or your loss.
Brokerages will typically lend up to 50 percent of the value of the stocks you already own free and clear towards the purchase of new shares, either in those or in other companies. This is known as "buying on margin." It can goose your returns if you bet right, and hurt you badly if you don't.
10. It's smarter to buy and hold good stocks than to engage in rapid-fire trading.
Retail investors pay commissions and fees that total an average of 6 percent for one round-trip trade -- that is, to buy and sell the same shares of stock. So if you trade frequently for small gains, the cost of those trades can erode -- or even erase -- your profit on the transactions.