Stock basics

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Imbox notice.png The tutorial referenced below is suggested for those wishing a "very basic" introduction to stocks.

A stock share (also known as an equity share) represents ownership in a corporation.

The two familiar types of stock shares are "common stock" and "preferred stock." Owners of common stock typically have voting rights to elect board members of the corporation. In some cases, such as Ford Motors, there are two (or more) types of common stock. One class has the right to vote and the other does not. The Ford family created this dual-share class in such a way that they were able to maintain control of the company without being fully exposed to its risk as an actual majority shareholder. Preferred stock typically has no voting rights but is legally entitled to dividends before other shareholders. Holding common stock in a corporation allows a shareholder the right to receive dividends from the company, and gives the shareholder a right to the company's assets during bankruptcy liquidation, though not before all creditors have been paid first. Holding stock may result in capital appreciation, as the demand for the stock goes up as the company grows its profits.

Buying and selling

Purchasing individual stock may be done through either direct investment with the company (through a dividend reinvestment plan, for example), or through a brokerage account. Buying and selling through a brokerage account usually involves a commission paid to the broker. Many discount brokerages offer commissions under $20, and some even offer free commissions for certain situations. Full service brokerages can charge anywhere from $50 to $200 a trade depending on their rates, the number of shares purchased, and how often the stock is traded.

When you place an order to buy or sell stock, you might not think about where or how your broker will execute the trade. But where and how your order is executed can impact the overall costs of the transaction, including the price you pay for the stock.[1]

While trade execution is usually seamless and quick, it does take time. And prices can change quickly, especially in fast-moving markets. Because price quotes are only for a specific number of shares, investors may not always receive the quoted price. By the time your order reaches the market, the price of the stock could be slightly – or very – different. No SEC regulations require a trade to be executed within a set period of time.

Just as you have a choice of brokers, your broker generally has a choice of markets to execute your trade such as: a specific stock exchange, a regional exchange, or a market maker.[2] In deciding how to execute orders, your broker has a duty to seek the best execution that is reasonably available for its customers' orders.

Classification of common stocks

Country

One classification of stocks is the country where the corporation is headquartered. Noting where a stock trades is important because international investments can provide a diversification benefit to a portfolio invested solely in the domestic market. All else being equal, a domestic investor should realize a diversification benefit from investing internationally because the equity markets in other economies are less-than-perfectly correlated with the domestic equity market. However, investments in foreign markets are also exposed to fluctuations in foreign exchange rates. In the long term, currency movements should have no impact on the returns of a foreign portfolio, but in the short term these fluctuations can significantly impact both portfolio volatility and returns.

Stocks are traded on stock exchanges all over the world, and generally speaking, buying stock on an exchange in a different country from your own will likely result in higher costs to buy and sell. This expense is greater if the company is located in a smaller or more underdeveloped country where the stock may not get traded frequently, resulting in even higher transaction costs. In the U.S., an American Depository Receipt (more commonly known as ADR) is a type of stock traded on U.S. exchanges that represents ownership of a non U.S. corporation. ADRs allow U.S. investors the ability to more easily and cheaply buy stock in corporations from many countries.

A representative global index such as the S&P Global Broad Market Index illustrates the breakdown of the global equity market by country.

Sector

Stocks may also be classified by the sector of business or industry where the corporation makes its revenue and profits. MSCI and S&P have created the widely used GICS global system of business sectors, which divides companies into four levels: 10 sectors, 24 industry groups, 64 industries, and 139 sub-industries. The ten sectors are listed below:


Global Industry Classification Standard
Consumer Discretionary
Consumer Staples
Energy
Financials
Health Care
Industrials
Information Technology
Materials
Telecommunication Services
Utilities


A detailed description of the GICS sectors is available at Sector Descriptions.

Size

Stocks may classified by the size of the corporation. This is most commonly done looking at the market capitalization. Market capitalization is simply a measurement found by taking a stock's current share price and multiplying it by the number of stock shares outstanding.

Exact market cap ranges will vary among different financial and rating institutions, but there are three different terms commonly used to describe stocks by their general size.

  • Large capitalization stocks:
    Large cap stocks have a market cap over $10 billion dollars.
  • Mid capitalization stocks:
    Mid cap stocks have a market cap between $2 billion and $10 billion dollars.
  • Small capitalization stocks:
    Small cap stocks have a market cap between $300 million and $2 billion dollars.


While these are the most common market cap references, there are also some less commonly used: mega cap, micro cap, and nano cap. Market cap terms are relative and are constantly changing as companies get bigger and smaller.

Style

Stocks may also be classified by "style," either value, blend, or growth. Growth stocks are companies that are growing their profits at a very fast rate and are expected to continue to grow at an increasing rate. Value stocks are stocks that tend to trade at deep discount relative to their intrinsic value (as defined by profits, book value etc.). Common investor perceptions tend to perceive growth stocks as "high flying companies" and value stocks as "distressed companies."

Dividends

Dividends are payments made by a corporation to its shareholder members. It is the portion of corporate profits paid out to stockholders. When a corporation earns a profit or surplus, that money can be put to two uses: it can either be re-invested in the business (called retained earnings), or it can be paid to the shareholders as a dividend. Many corporations retain a portion of their earnings and pay the remainder as a dividend.[3] In other words, payment of a dividend is based on many factors and can only be decided by the corporation issuing the stock.

Risks

Figure 1. Risk vs. Return[4]

Stocks are subject to the following risks:

  • Business risk--the measure of risk associated with a particular security. It is also known as unsystematic risk and refers to the risk associated with a specific issuer of a security. A common way to avoid unsystematic risk is to diversify - that is, to buy mutual funds, which hold the securities of many different companies.
  • Financial risk--the risk due to the capital structure of a firm. Corporate debt magnifies financial risk.
  • Liquidity risk--the risk that an asset cannot be sold when desired due to a thin market.
  • Market risk--the systematic risk faced by all equity investors due to market volatility. This risk can not be diversified away. This is the type of risk most people are referring to when they casually use the term "risk" with respect to investments, without qualification.
  • Political risk--the risk to an investment due to changes in the law or political regime. Potential changes in tax law or changes in a country's structure of governance are sources of political risk.

In addition to these risks, International stocks are subject to currency risk.

As Figure 1. illustrates, these risks result in considerable volatility of returns.


Role in a portfolio

An investment in stocks provides an investor with an ownership stake in the profitability of corporate business enterprise. By receiving the dividends and potential long term appreciation of equity value, an investor can participate in the growth potential of capitalism. A diversified portfolio of stocks, invested for the long term, can provide a portfolio with an asset that has the potential to grow over time. Figure 2. shows the long term global equity market returns over the past 100+ years. Over this period, equities have provided investors with returns that exceeded returns from bonds and cash. However, equity returns are subject to large variation, and can trail bond and cash returns for extended periods (see Figure 3.) [5]


Style boxes

Based on the Fama and French three-factor model, “style boxes” are 3 x 3 grids used to categorize securities. Different investment styles have various levels of risk which leads to differences in returns. This visualization allows investors to perform informed comparisons using an easy-to-understand standardized format.

For equities (stocks and stock funds), securities are classified by market capitalization (“market cap”) on the vertical axis, and value and growth factors on the horizontal axis.


Stock and Stock Fund Style Box
Investment Style Market Capitalization
Value Blend Growth
      Large
      Mid
      Small


The Morningstar Style Box(tm) was introduced in 1992 to help investors determine the investment style of a fund.[7] Other fund providers, such as Vanguard, utilize style boxes.[8]

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Equity style boxes (stock funds) and fixed income style boxes (bond funds) represent two-dimensional (horizontal and vertical axis) views of risk versus return. However, the background behind these boxes is based on very different concepts. Only compare stocks-to-stocks and bonds-to-bonds.

Both equity and fixed income style boxes are a way to visualize how diversified your portfolio is with respect to the main characteristic of each asset class - size and value for equities; credit risk and term risk for fixed income.[9]

For example, an investor is interested in Vanguard's balanced funds, which contain both stock and bond funds. The style boxes provide the investor with a simple collection of colored boxes, facilitating asset allocation decisions with a minimum of effort.

See also

References

  1. Trade Execution from the SEC
  2. A "market maker" is a firm that stands ready to buy and sell a particular stock on a regular and continuous basis at a publicly quoted price. Market Maker, from the SEC.
  3. Dividend, on Wikipedia
  4. WWWFinance Historical Behavior of Asset Returns, Duke University
  5. Larry Swedroe, Embrace risk, but only over the long haul, CBS Market Watch, February 21, 2012 7:00 AM
  6. Damodaran, Aswath, Equity Risk Premiums (ERP): Determinants, Estimation and Implications – The 2011 Edition (February 23, 2011). Available at SSRN: http://ssrn.com/abstract=1769064 or http://dx.doi.org/10.2139/ssrn.1769064
  7. Categorization methodologies can be found in the Morningstar fact sheet. Morningstar Style Box Fact Sheet
  8. Vanguard Funds by Style Box
  9. Style boxes - Why the differences? Some questions, forum discussion

External links

Tutorial

Easy to understand, fundamental information about stocks. From Investopedia