Tuesday, September 14, 2010

5 Beginner Misconceptions About Stocks

There are a lot of misconceptions about what it means to own a stock and how the market works, so in this post I'm going to debunk 5 of the most common ones.

1) If you own a stock, you own part of the underlying company.



This is the biggest bubble we need to burst, so let's get to it right away. As someone who's just starting out, never forget that a stock is a piece of paper with an arbitrary value assigned to it. Furthermore, nowadays with electronic trading, you don't even get the piece of paper! To be fair, a stock gives you a piece of the action when/if everything goes well. This may come in the form of a higher dividend, a buyout that drives the price of the stock up, or simply a higher number of people wanting to buy it. When things go bad, however, the company goes bankrupt or is sold for dirt cheap, you own nothing, and you're entitled to nothing. Some people think that in this case the company owes them for owning its stock. In fact, it is much more likely that someone else will take whatever little belongs to you. Never forget that.

2) If a stock costs more, it is more expensive.



This falls under financial analysis and look for a dedicated post to explain it thoroughly, but for now think about this: the price of a stock is affected by how much the company earned over the last year, and how much people are expecting it to earn in the next (As you might have guessed, forecasting is a huge ordeal in the stock market). To buy into this kind of growth, people will pay a premium that varies with each company. Some stocks are just more attractive, more reliable, more promising, 'hotter', it's a mentality that's not too different from clothing, for example. Since the earnings and this premium vary for every single stock, Wall Street is the only place where a stock trading at $200 might actually be a better bargain than one trading at $80! This is not always true, but it happens more often that you might think. As I said, I will talk about this more specifically in the near future.

3) Tech is the best sector to invest in.



I guess you could replace Tech with any single sector, and I'm not exactly sure why it is Tech that gets most of the attention, but I've seen a lot of friends own nothing but Apple, Google, Oracle, Cisco, Intel, and maybe a VoIP company and think they're diversified. Everyone seems to want to make a killing in Tech, and let me tell you, it's not going to happen. Yes, you can hit the occasional home run if you end up owning everything across the board, but once things go bad in a specific sector (and they will, they always do), your only saving grace will be that none of the stocks you own can go below zero.

4) If business is good, the stock will go up.



This is partially true, but it is also the reason that companies like AMD have a stock that's pretty much trash in the face of decent action. Stocks are affected by much more than how well the company is doing. You have to remember that a company can do well, but if nobody is buying the stock, the price won't budge, or even worse it'll go down. At the same time, people might be willing to pay more for a certain stock, but if nobody is selling, the price won't move. This can come in handy when the general public is shying away from a perfectly fine stock, or one that you know is going to do well in the upcoming reports. It happens very rarely, but when it does it's a good way to make some cash on the side. For now, remember that the change in supply and demand is the main catalyst for a price move. It might happen *because* of some piece of news or unexpected event, but unless you see this change in buying and selling, no piece of news on its own will change the price of a stock.

5) Speculating is bad. Buy and hold is the way to go.



I would suggest the buy and hold strategy if you plan on buying some big conglomerates that pay dividend (General Electric, Altria, Dupont, Pfizer, etc.), as long as you plan to reinvest that dividend into the company. The compound effect of this process alone can get you pretty far. I also think, however, that everyone should set aside a little bit of money for the speculative plays, maybe 10-20% of their total working capital. Look at it as a calculated risk, where you can allow to lose some money, with a bit of downside (potential loss) but with a huge upside (potential gain). If you're really unsure about what to do, put this 20% in gold. It'll cushion your fall when things go bad.

25 comments:

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  3. This is a great blog with helpful information. Thanks!

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  4. Nice of you to post this, keep it up

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  5. nice post! i like it very much;)
    supportin you & follow you :)

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  6. Good stuff, Supportin! http://digg.com/news/offbeat/life_mysteries_blog_2

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  7. Good read, not too hard. Bookmarking this for future use

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  8. very useful, this is where the big money is at

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  9. Wow, I always assumed that the stock made it so you owned part of the company, thanks for pointing me in the correct direction!

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  10. great posts mate. I follow u closly

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  11. I love stock tips, thank you for the advice. I bought my first stock last year and it felt good to jump on the train. Hopefully it will pay out, huh.

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  12. These will really help! Thanks for the advice.
    Nice post, your blog always has interesting stuff!
    supportin' and followin'
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  13. good info man thank you, i didn't know some things you posted

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  14. Great post!

    looking forward to reading the next one

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  15. greatt post man thnx for the info

    ReplyDelete