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Chapter 4
Stock Investment Vehicles

As alluded to before, there are a variety of ways to invest in stocks or “the stock market.” Here are the most common ways:

• individual stocks
• mutual funds
• open end
• closed end
• Exchange Traded Funds
• Futures and options

We won't talk about the last one, as futures and options for the average stock investor are more speculation than investment.

There are also different types of investment accounts, such as taxable brokerage accounts, accounts you open with a mutual fund company, IRA accounts, Sharebuilder accounts, and 401k accounts.

Let's start at the beginning. Individual stocks can be purchased in a few forms: Directly from the company (direct stock purchase programs), through a DRIP, through a broker, or through a retirement account such as a 401k or IRA. The price you pay is based upon the supply and demand of the particular stock you're purchasing; there is an “ask” price and a “bid” price, the difference being the so-called “spread.” There's almost always a commission expense incurred.

Mutual funds are nothing more than funds investment companies put together that pool individual investors' money to buy individual stocks. There are all sorts of mutual funds: Actively managed funds that focus on a sector, or a country or region, large-cap, small-cap, and medium-cap; passively managed funds that aspire to mirror a particular index, like the S&P 500; you name it, you can find it in a mutual fund!

Open-ended mutual funds are priced solely on their Net Asset Value (NAV), which is determined by the total value of the fund (the addition of each stock's price per share times number of shares) divided by the number of outstanding shares. If you invest one hundred new dollars in a mutual fund, the mutual fund buys $100 worth of one or more stocks (it can also keep your investment in cash) and the total value of the fund rises by $100. Tomorrow, if the fund buys 20 shares of a stock at $5, the NAV will be adjusted due to the new number of outstanding shares and added value that came from your investment in cash.

Closed-end funds have a fixed number of shares outstanding; that is, fund managers do not buy or sell shares in the companies they initially held. Throughout the life of the fund, the same companies are held. The value of the fund may equal the equivalent NAV of the underlying shares or it may trade at a premium or at a discount. The price is driven by the relative prospects of the underlying investments.

Mutual funds are great to use with dollar-cost averaging.

Exchange Traded Funds, or ETFs, are traded just like individual stocks. They're a great way to invest lump sums of money in an index, for example, because their management fees are very low and you pay a one-time commission to buy them. They're bought just like stocks and offer all the advantages and disadvantages (except they do offer diversification), but they are comprised of a basket of individual stocks like a mutual fund.

These are all the stock investments you should consider. Now, we move on to the various accounts.

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Chapter 3
The Stock Market

So, just what is this “stock market” we hear about on the television and read about in the newspaper and Internet? Well, it depends.

Sometimes, when “the market” is referenced, it means the entire global market, as in “The stock market is down today, based upon these 5 indexes.”

Other times, “the market” means the S&P 500, which is not a market but an index (more on that later).

Still other times, “the market” means the New York Stock Exchange or some other “market.”

To be precise, it's this latter use of the term “the market” that makes the most sense and is strictly the best definition.

Think of it this way: When you go to the grocery store, you've gone to “the market” for groceries. You didn't go to 18 different places and check the general level of prices. You didn't check on potatoes at Safeway, oranges at Lucky, and yogurt at Trader Joes. You didn't survey the price of a basket of goods in Chile, Pakistan, and England.

You went to your local grocer and bought some things. That's your market.

In any event, in a very generic way, people say they invest in “the stock market” when they really mean they invest in stocks. When you shop for bread, you may want the cheapest wheat bread. Or you may want the best price for a certain brand; you may shop in two or three different stores to find it. Or you may say, “The heck with this! Bread is too expensive. I'll buy another type of starch to satisfy my starch needs.” Or, “I'm going on the South Beach Diet anyway and can't eat bread for a month!”

All that said, it's obvious that there's more than one way to look at all of this. This is where “stock picking” gets really interesting. I'll go into more detail later, but here are some brief examples of different approaches one can take when investing in individual stocks.

You may know of a stock that you want to investigate, perhaps its a retail store that you think has potential (let's say it's Whole Foods – organic and green is in, cheap is out). In doing your research, you find that it's price is a little depressed compared to where you think it ought to be, but you find that one of its competitors is even more compelling. So, you investigate it, too, and you find that the whole industry is depressed and poised for a run up in price.

You've gone from evaluating individual stocks to evaluating an entire industry. Maybe you found in your research that a grocery competitor based in Canada was an even better prospect. Now, you look into Canada and you find that it is resource-rich, it's currency is strong, and it just signed a trade agreement with, say, China.

Now you're interested in investing in the entire country. See how this works?

You can invest in

• individual stocks (like Wal-Mart)
• an industry (like Retail)
• a country (like the USA, in the form of a widely-known index like the S&P 500)
• a region (like Asia, in the form of an Exchange Traded Fund that mirrors the Bank of New York Asia 50 ADR Index)
  

As you can guess from this, there are stocks, mutual funds, ETFs, and other ways to invest in “the stock market.” Next up, we'll talk about these instruments.

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Chapter 2
What Are Stocks?

When a company wants to raise money to expand, it can do so a number of ways. It can raise private equity, where investors give money to the company in return for an equity position. It can bring in more partners, too. A company can raise money by issuing bonds, too, where in return for $1000, for example, the company will pay you interest over a period of time and then return your money. In effect, you've loaned the company money, just like a bank would.

The company can get a loan through the Small Business Administration as well.

Many companies, however, have chosen to go public. The most recent “IPO” (or Initial Public Offering) that made giant headlines was Google (GOOG), which made waves by gaining over 500 percent in a few short years.

Google, and the thousands of other companies that have issued shares of stock to the public, did so to fund new initiatives, expand their marketing campaigns, do more research and development, develop products and services, or a host and/or combination of these and many other things in return for giving up some equity, or ownership, in the company.

That's right, when you buy a single share of a public company that has 1,000,000 outstanding shares, you own 1/1,000,000 of that company! You get to go to shareholder meetings. You are entitled to quarterly and annual reports. You, my friend, get dividends, when and if the company decides to issue them.

You own a piece of Google! Congratulations. In years past, you even got a stock certificate, a piece of paper, suitable for framing, that showed you owned one share of the company. Nowadays, however, you will not get that certificate; you'll have to ask for it and it comes at a pretty stiff price (as in, your $10 stock – not Google, by the way – may cost you $75).

In short, owning shares of stock in a company means that you are an owner of that company. In theory, you have a say on how the company is run. But that's just in theory. All it really means is that you'll get dividends if they're doled out and you get to enjoy the fruits of management's labor in terms of capital appreciation.

There, we've hit on the two – and ONLY TWO – components of stock market performance: Dividends and capital appreciation. If you want to measure the performance of your portfolio in a given year (assuming you buy a stock on January 1 and still own it on December 31 of that same year), you take the difference between the price you it's worth at the end of the year minus the price you paid for it, minus any commissions you paid plus your dividends all divided by the price you paid for it. In equation for, it looks like this:

(Ending price – Beginning price – commission + dividends)/Beginning price

Keep in mind, you'll have to convert these figures to per share values (you generally pay a flat commission – or nearly flat – no matter how many shares you buy).

Things get complicated because there are different classes of stocks: Common stock, preferred, convertible, etc. Even within each of these, there may be different classes (common type A, versus common type B).

Suffice it to say, except for very specific circumstances, we'll be talking about common stocks.

Things aren't all rosy, either, when you're an owner in a public company. If the company loses money, it may reduce its dividend or cut it out altogether. The stock price can decline, too, based upon company-specific fundamentals (more on this later), industry news, or general economic trends. At the end of the year, your stock may be worth less than you paid for it.

In general, stocks of good companies rise over time and stocks of bad companies fall or stay flat, over time. Stock prices really are a good indicator of how the “market” interprets the present and future profitability of any given company.

Take Google again. The stock rose so fast in price due to two overwhelming factors: First, when it had no earnings (another word for “profit”), the market thought that its future earnings had outstanding prospects. Then, when the market was proven right, the future became the present, and the present profitability coupled with the accelerating future expected profitability caused the stock price to rise even more rapidly.

As you may guess, things work in the opposite way, too. Let's look at Enron, THE case study for how to run a company – and its stock – into the ground.

In the late '90s, Enron was one of a few business school case studies for how to run a company. Profits, growth, and future earnings seemed limitless. Nothing could go wrong (this is always the first hint that things are about to go very, VERY, VERY wrong), until the bottom fell out. Enron defrauded everybody. Enron management, along with management from MCI Worldcom and others, basically created false hope of future profitability by booking future revenue in the present and removing current liabilities from present the balance sheet. In short, they put really good lipstick on a really hideously ugly pig.

Here's a telling graphic of the rise and fall of Enron.

But companies can do everything on the up and up and still fail. It all depends on management, the industry, execution, luck, and timing, among many other things. Some companies rise quickly and fall just as quickly. Some slowly rise and slowly fall as they fail to innovate.

It's your job as a potential owner, to pick the right ones and let others pick the wrong ones.

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Chapter 1
Axioms

In mathematics and logic, we are introduced to the term “axiom” which is nothing more than a starting point from which we will begin to formulate theories and draw conclusions. There is no logical “proof” that these axioms are “correct;” in other words, their truths are taken for granted.

Of course, these are my axioms and are subject to debate. But stay with me for a few minutes.

AXIOM #1
Never invest money in an investment vehicle (stock, bond, or hard asset like gold or silver) that you cannot afford to lose.

Invest as if you will never see that money again. Sure, you're investing your money, hoping that it will grow over time. But investments rise and fall, and if you need the money tomorrow, next month, or even in the next five years, either don't invest it or call it a speculation.

AXIOM #2
Stocks and bonds can be investments. Futures and options are speculations. You will lose your money in speculations just as easily as you do in Vegas. The “house” always wins, over time. Of course, you can win, and win BIG, on occasion, but you'll find, over time, the your losses outpace your gains. Factor in commissions and taxes, and these speculations nearly always result in net losses for you, “the little guy.”

AXIOM #3
Invest early. Compounding your dividends and/or interest, tax free in many cases, is a huge advantage that you'll want to leverage. The sooner you begin investing, the sooner you'll reap the benefits. Wouldn't it be better to begin investing at 5 and attain your goal of $1 million (or whatever) at 35 than to wait until you're 35 and attain that goal at 65? Plus, $1 million will be far worth less at 35 than when you turn 65.

In other words, you'll need $2 or $3 million at 65 to have the equivalent amount of money at $1 million at 35.

AXIOM #4
Invest often. Dollar cost averaging works. In effect, you're putting the investing maxim, “Buy low and sell high,” to work in a systematic fashion – if you invest a set amount each and every month in a mutual fund, for example, you'll be buying more when stocks have fallen in price and you'll be buying less when stock prices rise.

AXIOM #5
Take advantage of employer-sponsored savings plans like 401k or 403b. Max the match (more later). It's free money so take it!

AXIOM #6
Don't be greedy. Establish limits, especially with stocks, that set prices where you'll sell (do the same on the buy side). In doing your research, you'll come up with an upper price valuation where, once reached, the stock you've purchased will have become fully valued. Any rise after that, and you're being greedy (or, you've underestimated the stock's fundamentals, but more often than not, the price will fall precipitously and you'll be back to square one).

AXIOM #7
Don't put all of your eggs in one basket. OR, if you do, watch the basket!

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Introduction to
Stock Investing Basics

Everybody wants to win big in the stock market. I can recall a time not long ago where scads and scads of people quit their jobs to become “day traders.”

I'm reminded of The Simpson's episode where Homer became a stock trader in his own company. He amassed a tiny gain, bought something with it, and found that he sold far too soon when all of his working buddies drove into work the next day in fancy cars, sporting facelifts and other signs of the nuevo riche.

Many of us made small fortunes during the last bull market. Some of us amassed HUGE amounts of cash. All that happened in the late 90s and early 2000s, ending abruptly in 2001, when the recession came, 9/11 exacerbated it, and the NASDAQ tumbled.

Guess what? Those day traders became unemployed and homeless. Some went bankrupt. Some undoubtedly lost everything: Money, homes, and cars. Marriages were broken. It's a safe bet some died from the stress.

But that's not why you're here. You didn't acquire this book to be discouraged. You got it because you wanted helpful advice on navigating the “stock market.”

Let's get a couple of things out of the way.

• First, there is no single stock market. In fact, there are many. Some are physical, like the New York Stock Exchange, and some are “virtual” or computer-driven, like the NASDAQ.
• Second, there are fundamental differences between investing in the stock market and speculating in it. We'll get to that a little later. Suffice it to say, for now, that investing is about the long-term and speculating is about the short-term.
• Nobody involved in the stock market cares about your particular plight; they're in the market for the same reasons as you are. They want to increase their wealth.

The inspiration behind this book is the readership of my personal finance sites, Money Hacks and Your Money Is Your Life. I owe it to my readers for energizing me and compelling me to embark on a quest to educate, encourage, and inspire others to make their lives – both financial and non-financial – better.

My initial foray into the personal finance world was back in the late 80s while I was in college when I became interested in stocks, the markets, how they worked, and how one could amass a sizable portfolio over time if one followed a few simple rules, which I will call axioms, the subject of the first chapter.

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I'm currently writing an eBook that I will give away, tentatively titled "Stock Investing Basics." I will post working drafts of the book on this site. Please read them at your leisure and if you have any constructive criticism, please let me know in the comments. Note that these are rough drafts and not in any way, shape, or form are they to be considered finished or polished. Please take that into consideration when commenting.

First post will be coming out shortly.

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