There are several types of securities markets. You can buy and sell commodities, currencies, bonds, and stocks. Each of these four types of securities have their own exchanges around the world. A fifth category of securities, although mostly unregulated, includes all the cryptocurrencies. There are many exchanges for those types of investments. Each of these types of securities markets entails its own risks. To mitigate those risks investors usually turn to either mutual funds (which invest in multiple securities) or to contracts.
The “contracts” category of risk mitigation is nearly as complex, perhaps more so, as the five groups of investment markets. You can buy and sell “futures contracts” which pre-determine fixed prices in advance of actual sales. You can buy and sell “options contracts”. An option is a right of first refusal. If you sell an option on 1000 shares of stock, you set a price at which you’ll part with the stock and determine a maturity date for exercising the option. If someone agrees to buy the option they pay a contract fee (not for the stock but for the right to buy the stock at your predetermined price upon maturity).
Futures contracts are a form of derivative contract. Derivatives are considered to be riskier investments as they are based on changes in values of securities or assets, and not directly on the securities or assets themselves. Investopedia provides a nice overview of derivatives.
Options, futures, and other derivatives are advanced methods of investment. They are used by speculators and people who want to hedge their investments (mitigate their risks) by offsetting potential losses in one class of investment with potential gains in another (usually a derivative) class of investment. I just want to focus on the basic methods for making money in stocks. To some extent these principles apply across all five major classes of securities.
Buy Low, Sell High Investing
This is in my opinion the most common form of stock investing. The idea is to find stocks (or mutual funds) that are about to increase in share price. Share prices can increase for any number of reasons. You want to avoid confusion arising from, say, a reverse stock split (where the number of outstanding shares is reduced). When a company announces a new line of products, promising new acquisitions, better-than-expected earnings or profits, or other positive news investors are more likely to pay higher prices for shares in that company.
Most stocks have a trading range, a low point and high point in their price volatility. The prices of the stocks may move up and down within this range throughout the year. If the range is broad enough investors may be able to make a profit by buying at the low end of the treading range and selling at the high end. More likely the investors have to wait for the stock’s trading range to expand upward toward new highs and higher lows.
Investors who buy low and sell high are said to be long in the investment if they hold their security for more than a year. When you hold an investment for less than a year you are short in the investment. But being short is different from shorting the market or shorting an investment.
Sell High, Buy Low Investing (Shorting)
When you short the market or short the investment, you are trading on the assumption that the price of the security will drop far enough for you to make a profit. If a company expenses a downturn in profitability, earnings, or prospects, investors tend to sell some or all of their positions in that company. The increased selling activity drives down the price of the security. Stock prices may also decline simply because the market is in decline.
A mutual fund may be forced to sell off shares in some of its holdings to maintain the balance of securities it promises to its investors. Or some of the fund’s shareholders may cash out their positions, thus also forcing the fund to sell off securities. Either way, mutual funds can drive stock prices down for reasons that have nothing to do with the business prospects of their companies.
Investors who anticipate a significant decline in stock prices may short them by selling shares at the current price and then buying them back at a lower price. The most common way this is done is to use a margin account, where the investor borrows the shares from a broker. The broker requires that a certain amount of reserve be on hand. The investor will be forced to either deposit more cash into their margin account or pay for the shares they borrowed and sold if the reserve drops too far.
Another common way of shorting a stock is to sell your existing position at the current price and then to wait until the price has dropped much lower. Then you buy back your position at a lower price. Investors do this because they believe the stock represents a good investment but they are taking advantage of a market downturn.
Dumping schemes are illegal. While speculative selling and buying is permissable, you should never engage in activity with the intention of influencing the market to drive prices up or down.
Income Investing
Investors who seek income buy stocks that pay dividends. Dividends are paid on a monthly or quarterly basis and they must be declared in advance. Most dividends are relatively small. Income investors look for high (above average) Dividiend Yields, typically calculated by dividing the annualized dividend by the current share price. A Dividend Yield changes either as the share price changes or as the dividend changes.
Warren Buffett is famous for buying dividend-paying stocks but not paying dividends to his own investors. Berkshire Hathaway, Buffett’s company, has only paid one dividend since he bought the company many years ago. Buffett’s philosophy is simple: if he can increase shareholder value by investing the earnings that could be paid as dividends, he feels it’s better for his investors if he doesn’t pay them dividends. Many companies follow in Berkshire Hathaway’s path, refusing to pay dividends to their shareholders.
Income investors may buy shares directly from companies if they offer Dividend ReInvestment Plans (DRIPs). The DRIPs simplify the investing experience, compounding the dividends by converting them to additional (fractional) shares of stock. Over time the investors’ positions in the companies increase.
Opportunity Investing
Investors may occasionally see opportunities to buy shares in companies they would normally avoid. For example, if a company splits its stock, issuing more shares and driving the price down, investors may start buying shares at a lower price. The company’s book value really doesn’t change. If it had 10,000,000 shares before a 2-for-1 split and was valued at $1 billion, it will still be valued at $1 billion after the split creates 20,000,000 outstanding shares. But investors may assume that the company has a good reason to split the stock.
Companies that don’t pay dividends occasionally buy back shares of their stock. If they split shares regularly (every 3-7 years) then their shareholders can take some profit off the table when corporate buybacks are announced. The investors can retain the same number of shares they had before the last split. By purchasing shares back companies not only return equity to investors, they help keep the prices of their shares lower.
Investors may buy shares of dividend-paying stocks right before the qualifying period for the next dividend ends. After they receive their dividends the investors sell part or all of their shares.
Investors may sometimes “buy the rumor” and pick up shares of stocks at really low prices. They anticipate some big development that will drive up the price of the stock. Sometimes all it takes is good research and a thorough understanding of a company’s industry, products, and plans. Sometimes all that is needed is enough cash to move in after the market has bottomed on a stock, an entire sector, or across the board. Calling a bottom is not easy because that means the stock price will stabilize or start increasing again. We only learn in retrospect when a bottom has formed.
Calculating Time to Recoup An Investment
The one factor always working against you in the securities markets is that you cannot predict the future. You have no way of knowing if a commodities market will suffer defaults (failures to deliver), or if a market will crash or expand quickly. Investing with the idea of returning a profit is always a risk.
Many investors buy in at the wrong time and they anxiously watch the book value of their investments decline. There is an old saying: it’s only a loss when you sell. But if you buy a security at $25 and three years later it’s selling for $15, how do you recoup that lost $10 value if you sell your position at $15.
Income investors are more likely to ride out a bear market on their positions of they receive good dividends on a regular basis. The lower the price of the stock the higher the dividend yield may become. However, you have a personal dividend yield that only applies to your shares based on the price you paid for them.
If a stock pays a high annualized dividend yield of 10% that means you’ll recoup the cost of your shares after 10 years of approximately equivalent value. This is a very aggressive projection. Most dividend yields are much lower. However, if the dividends you earn on your investments are higher than current interest rates and if the share prices of the stock remain stable, you can sell your position within 1-2 yeas and still have realized a sizable profit.
Losing Stocks May Be Discounted Investments
Although I don’t recommend browsing investor forums, if you do this sooner or later you’ll come across people complaining about stocks that have lost value since they bought positions. These investors may be suffering from Sunk Cost Fallacy, where they are afraid to sell out of positions that have disappointed them. Sometimes an expensive stock can come back but the rule of thumb is that if you lose 20% of book value on an investment it’s probably better to sell out and put your money to work elsewhere.
All that aside, if you come across a stock that has lost 40-80% of its value over the past 5 years, it may be a bargain for you even if it was a loser for others. You’ll want to look at the company’s reasons for losing book value. You’ll also want to verify that it has revenues, is making a profit, and has a future. If you’re in doubt about the quality of a company then don’t buy the stock.
But why bother investing in a company that has lost the market’s faith? That’s a personal decision. You’re taking on some risk. Even so, if the company pays dividends on a regular basis it will take less time for you to recoup your investment through dividends if you buy at, say, $6 per share than it would for someone who bought at $18 or $24 a share.
You won’t find a good discounted investment very often. The company was probably in trouble and has made a turn around. Investors may come back to buy the stock but you could be holding on to a very low-value stock for many years. Hence, don’t buy into it for resale value. If you don’t see enough activity to justify the risk, it’s not a good investment.
