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Welcome to the Stock Market

Chapter Summary In this chapter, the reader is introduced to various types of investmentscash equivalents, mutual funds, futures and commodities, options, bonds, and, last but not least, stocks. It is important to note that stocks have provided the greatest return of any of the trading instruments, and I thoroughly endorse their use as an investment. But how you choose to invest in them is a personal decision based on your time availability, risk tolerance, and capital restraints. Trading and investing are the ultimate balancing act. No one can tell you the best way to trade, and I certainly will not try to. But I do hope to give you a strong foundation of knowledge, a clear picture of the choices at hand, and enough tools to help you get where you want to go. In this initial approach to the stock market, weve addressed what the stock market actually is and the keys to making money in the market. The rst key to winning as an investor is to develop a healthy respect for and clear understanding of risk. Know what the risks are beforehand, and become comfortable with them. Dening your risk tolerance is critical. The second task is to develop a low-stress investment plan that will enable you to build your knowledge base systematically. The old adage Look before you leap applies nicely here. Know what you want to accomplish, then look for a way to achieve that goal. Third, beginners need to start by specializing in one or two markets at a time. Focusing on one aspect is crucial. Dont fall into the generalist trap, looking at everything. By becoming informed about a particular sector, you can then transfer the lessons learned there to another sector, and so on up the learning curve. 3

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QUESTIONS AND EXERCISES Fourth, dene your limits in terms of the amount of money you can afford to lose.

Before you know where youre going, you need to know where you are. By doing this youll reduce your personal anxiety, and, further, youll know how much you can afford to put at risk. Doing nothing is also a risk because of ination, so the time to act is now. No step is too small to take. The aura of the market is scariest for those unfamiliar with it. Learn by observing and by reading. Watch the daily investing programs on CNBC and CNNfn, or evening broadcasts, and read the major nancial newspapers. Look for information regarding market breadth as well as the sector youre most interested in. Its important to become better informed about the economy; but dont try to be an expert. When you are ready to place that rst trade, whether its for a mutual fund or a stock, go slowly. Learn the procedures brokers and mutual fund representatives take; these people are usually very patient and friendly. They wont bite! Questions and Exercises 1. To assess your nancial condition, completely ll out the nancial investment worksheets in Figures 1.1, 1.2, and 1.3. Keep these sheets handy and update them regularly as changes occur in your life. 2. What are the four key approaches to becoming a successful investor? 1. ___________________________________________________________ 2. ___________________________________________________________ 3. ___________________________________________________________ 4. ___________________________________________________________ 3. What is the difference between gambling and investing as a speculative process that encompasses the element of chance? _______________________________________________________________ _______________________________________________________________ 4. What can make an investment a gamble? _______________________________________________________________ 5. True or False: Like real estate, a brokerage account can be purchased with no money down. 6. What is the difference between investors and traders? _______________________________________________________________ _______________________________________________________________ 7. True or False: Stocks are denitely the least lucrative and the least risk free of the three investment products.

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WELCOME TO THE STOCK MARKET

PERSONAL BALANCE SHEET Amount Liabilities Short-Term Debts __________ Credit card debt __________ Medical/dental debt __________ Vehicles debt __________ Short-term loans __________ Miscellaneous debt __________ __________ __________ Long-Term Debts __________ Mortgage __________ Tuition loans __________ Long-term loans __________ __________ __________ __________ __________

Assets Finances Cash Checking account Savings account Trading account Mutual funds 401(k) IRAs SUBTOTALS Long-Term Assets House (mortgage) Vehicles Fixtures Recreation Equipment Miscellaneous SUBTOTALS NET TOTALS Assets Liabilities =

Amount __________ __________ __________ __________ __________

__________ __________ __________ __________

__________ __________ __________

Figure 1.1

Personal Balance Sheet

MONTHLY INCOME STATEMENT Amount Monthly Expenses Basic Living Expenses __________ Rent/mortgage __________ Food __________ Utilities __________ Phone/ISP bill __________ Heating __________ Transportation Clothes Entertainment Miscellaneous Insurance Payments House/renter's insurance Health insurance Dental insurance Car insurance Life insurance Long-term care insurance Debt Payments Credit card (minimum payment) Alimony Child support Tuition loan Miscellaneous loans __________

Monthly Income Cash Received Wages after taxes Alimony income Child support Rental income Business income Additional income

Amount __________ __________ __________ __________ __________ __________ __________ __________ __________

__________ __________ __________ __________ __________ __________

Totals Income Total Expenses Total =

__________ __________ __________ __________ __________ __________ __________

Figure 1.2

Monthly Income Statement

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QUESTIONS AND EXERCISES

RISK TOLERANCE AND INVESTMENT GOALS
Risk Tolerance Investment Goals __________ __________ __________ __________ __________ __________ Investment goal Years until retirement Annual return goal Financial Potential Tax bracket Utilities Phone/ISP bill Heating Transportation Clothes Entertainment Miscellaneous Insurance Payments House/renter's insurance Health insurance Dental insurance Car insurance Life insurance Long-term care insurance Debt Payments Credit card (minimum payment) Alimony Child support Tuition loan Miscellaneous loans __________ __________ __________ __________ __________ __________ __________ __________ __________ __________

Monthly income Monthly expenses Net prot/loss Total assets Total liabilities Net worth 3 monthly expenses (aggressive) 6 monthly expenses (moderately aggressive) 9 monthly expenses (conservative)

__________ __________

__________

__________ __________ __________ __________ __________ __________

Totals Income Total - Expenses Total =

_________

__________ __________ __________ __________ __________ __________ __________

Figure 1.3

Risk Tolerance and Investment Goals

8. Name and dene the three types of risk. 1. ____________________________________________________________ 2. ____________________________________________________________ 3. ____________________________________________________________ 9. When investors talk about the bond market, they are referring to the: A. ____ 30-year bond market B. ____ 20-year bond market C. ____ 25-year bond market D. ____ 50-year bond market

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WELCOME TO THE STOCK MARKET

10. Match up the three basic investment products with their dening statements: A. ____ Stocks 1. Easy conversion B. ____ Bonds 2. Company ownership C. ____ Cash equivalents 3. Cash debt obligations 11. What are your three basic rights as a shareholder? 1. ___________________________________________________________ 2. ___________________________________________________________ 3. ___________________________________________________________ 12. Decipher these acronyms: A. OTC: ______________________________________________________ B. Nasdaq: ____________________________________________________ C. NYSE:______________________________________________________ D. AMEX: _____________________________________________________ E. ECN:_______________________________________________________ 13. How is the Nasdaq different from the other exchanges? _______________________________________________________________ _______________________________________________________________ 14. If your stocks are listed on the Nasdaq, why would they sometimes be referred to as four-letter stocks? _______________________________________________________________ _______________________________________________________________ 15. True or False: Where a trade takes place does not depend on whether that particular company is listed on the New York Stock Exchange, the Nasdaq, or the American Stock Exchange. 16. Based on margin rules, a trader needs to put up only _________ of the total amount to purchase shares, while the brokerage lends the trader the rest at a small interest rate. A. One-third B. One-fourth C. Two-thirds D. One-half E. One-tenth

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QUESTIONS AND EXERCISES

17. When a stock surges up on heavy volume, it is a very good indication of: A. ____ Declines in the ofng B. ____ Trend reversals C. ____ Further price increases D. ____ Technological developments E. ____ Financial losses 18. When a stock sells off on heavy volume, its a fairly reliable indication of: A. ____ Declines in the ofng B. ____ Trend reversals C. ____ Further price increases D. ____ Technological developments E. ____ Financial losses 19. Correctly match these three descriptions of the chief players in the stock market today along with the terms that follow: A. ____ A person hired to make buying and selling decisions who is paid for his or her work B. ____ A person who buys and sells often, even intraday C. ____ A buy-and-hold kind of guy 1. The short-term trader 2. The individual investor 3. The professional 20. If your oor broker cannot ll your order, it is left with a _____________ who keeps a list of all the unlled orders, matching them up as prices uctuate. A. Trader B. Specialist C. Investor D. Floor broker E. Market maker 21. The market maker makes a prot by bringing together buyers and sellers and taking a small amount from each of them to process the transaction. This is called the ______, ______, or ______. Check those that apply. A. Bid B. Spread C. Hedging instrument D. Slippage E. Bid/ask spread

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WELCOME TO THE STOCK MARKET

22. Fill in these blanks with the following terms: The ______ is the highest price a prospective buyer is prepared to pay for a share of a specied security. The ______ is the lowest price acceptable to a prospective seller of the same security. These two prices constitute a ______. The difference between them is called the ______. A. Ask B. Spread C. Bid D. Quote 23. Check the items associated with the Small Order Entry System or SOES: A. _____ The ability to trade directly from ofces using telephones and continuously updated computerized prices B. _____ Signicant reduction of the current position held in the market C. _____ Permitting the little guy to compete with institutional traders D. _____ Market makers who create liquidity by narrowing the spread E. _____ Financial web sites that cater to individual investors F. _____ The birth of day trading G. _____ Detailed research reports on the stock market and companies H. _____ Permitting lightning-fast executions for orders up to 1,000 shares I. _____ A trading account hosted by a rm that acts as an agent for a customer J. _____ The market crash of 1987 24. True or False: With a mutual fund, a professional investor who is hired by the investment company makes the investment decisions on which stocks to buy or sell. 25. True or False: The net asset value (NAV) of a mutual fund is calculated by dividing the market value of the funds portfolio by the number of shares. 26. What is the difference between a load and a no-load mutual fund? _______________________________________________________________ _______________________________________________________________ 27. What are the advantages and disadvantages of the three different classes of load funds? Class A: Advantage:_____________________________________________ Disadvantage: __________________________________________ Class B: Advantage:_____________________________________________ Disadvantage: __________________________________________ Class C: Advantage:_____________________________________________ Disadvantage: __________________________________________

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QUESTIONS AND EXERCISES

28. What are two reasons why an investor would want to mirror an index rather than have a professional make individual buy and sell decisions that reect the sensitivity of market movement? 1. ___________________________________________________________ 2. ___________________________________________________________ 29. How are index shares, which are similar to index funds, also like a stock? _______________________________________________________________ _______________________________________________________________ 30. True or False: When the economy is hot, ination begins to accelerate and adds to the purchasing power of money over time. 31. What are three basic methods of stock investing? 1. ___________________________________________________________ 2. ___________________________________________________________ 3. ___________________________________________________________

Media Assignment If youre not already doing it, make it a habit to read the business section of the newspaper daily. You may want to subscribe to the Wall Street Journal or Investors Business Daily. Both of these papers are mainstays of the investment world and have a big effect on the markets. You should also keep yourself informed on a state and local level by reading the local papers. The Internet is a media world unto itself. There are multitudes of sites that report about the markets, and some that have a hand in swaying public opinion. You need to incorporate all of these news sources into your daily investment habits. Start by looking for trends and industry movements in the stories provided. Keep in mind that most stories originate as press releases from corporate public relations (PR) desks, so recognize that there is an agenda and underlying strategy behind every company announcement. Find stories about one or two companies that pique your interest. Start a trading journal and make notes on why these stories draw your attention. Follow their progress to get a feel for your instinctive abilities. How do they affect the market in general? What other stocks are affected? How are their respective industries affected? As a story fades, does the stock rebound? Remember, learning is a cumulative experience. If you are new to the investment world, you have to make a start by just getting to know the markets one story at a time.

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WELCOME TO THE STOCK MARKET Vocabulary Study Be able to use these terms: Annual report Ask Auction-style market Bid Bond Brokerage account Cash equivalents CD (certicate of deposit) Closed-end fund Commodities Currencies Day trading Dividends Earnings Executed The Fed Float Floor trader Futures Gap-down Hedging Index Index fund Index share Ination Institutional investor Interest rates Investor Liquidity Load fund Margin Market maker Mutual fund National Association of Securities Dealers (NASD) Net asset value (NAV) No-load fund Open-ended fund Quotation Risk Risk tolerance Rule 144 Shorting a stock Specialization Stock Stock market T-bill Ticker symbols Trader Trading pits

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12 Useful Web Sites

QUESTIONS AND EXERCISES

CBS MarketWatch cbs.marketwatch.com An absolute must for any trader who wants to stay aware of scheduled and breaking news. Excellent journalists and plenty of timely market data are mainstays of this premier news-oriented web site. E*Trade www.etrade.com The mother of all online brokerages hosts this excellent site to help you get your bearings with quotes, company proles, and trading tools. Microsoft Investor moneycentral.msn.com/investor/home.asp This site has it allquotes, charts, graphs, market reports, nders, screeners, research, online workshops, custom portfolios, feature news and investment articles from MSNBC, as well as impressive commentary from prime nancial journalists. Red Herring Online www.herring.com This site offers a plethora of insider news, analysis, and commentary by highly respected journalists, as well as an excellent e-mailed newsletter. Look for Wolf picks, option picks, and the Catch of the Day column for investment ideas. Check out the search tools and the featured links to hot web sites. TheStreet.com www.thestreet.com Controversial and extremely popular, this site has cornered the market on public appeal through its clever journalism, insightful articles, and everyday analyses of market performance.