Top Ten Terms You Should Know About Stocks

Top Ten Terms You Should Know About Stocks

OK, I think it’s about time we talked about stocks.  The stock market seems to evoke different feelings in everyone.  People that experienced the Great Depression or had a parent that did are very distrusting of the stock market and do all they can to avoid it.  Those that had a significant portion of their net worth invested in the stock market in the 2008-9 recession are also quite wary of it.  Many people simply don’t understand the stock market and liken it to gambling under the guise of investing.  All the while younger, more aggressive investors with longer time horizons are eager to invest all they can in the stock market. 

Regardless of where you tend to fall on this spectrum, facts are facts.  The stock market has been the single best performing asset class over time.  So why do so many people lose money in the stock market?  Well, that’s because it is such a bumpy ride.  Basic human nature causes us to buy high and sell low, which translates into losing money.  When a company’s stock is on the rise and everyone else is buying it, human nature is such that we don’t want to miss out.  So, many investors jump on the bandwagon and end up buying stocks when prices are high.  Likewise, when prices drop and people panic, human nature is to follow the crowd and get out like everyone else.  So, many investors sell their shares of stock when prices are low.  This disastrous combination causes many investors to lose money in the stock market.  Those who have the ability to weather these storms of volatility are the ones who actually benefit from the high returns of the stock market.  

The first step to investing in the stock market and actually making money is to understand what you are investing in.  You have to know the lingo.  Today we will review the the top ten basic terms I think you should know about stocks to increase your financial literacy as part of my FI Top Ten Series of posts.

Before we begin, it is important to understand that I don’t advocate buying individual stocks or stock picking.  I recommend that when you invest in the stock market you buy low cost, passively managed index funds which are a form of mutual fund that holds stocks within them.  But before we get to that point, you have to understand the basics of individual stocks and what they represent, even if you aren’t buying them directly. 

With that, let’s begin.

Stocks

A stock is a type of security that gives its owner, a stockholder, a share of ownership in a given company.  Basically, when you buy a stock, you literally own a small piece of that parent company.  Another name for stocks are equities.  You might hear phrases like “I invest 50% of my portfolio in equities” or “I limit my exposure to equities due to their volatility.”  This is just another fancy way of saying stocks. 

Why would a company sell shares of stock?  Good question.  When a smaller private company has grown to the point that it is ready for more significant expansion, it needs to raise more money (capital) for this expansion to occur.  This money can then be used for paying off debts, expanding to new markets or regions, developing and launching new products, or other activities that help the company grow.  The company raises this money by selling small portions of the business (shares) to the public.  This is what is meant by “going public.”  The first time a company offers shares of stock for sale to the public, it is called an initial public offering or IPO.  When an investor buys a share of that company, she now owns stock in the company.  

How do stocks make money? Stocks typically make money in one of two ways: appreciation and dividend payments.  Appreciation is the rise of value in a share of stock.  For example, let’s say you purchased one share of stock in a company for $100 and after one year it was worth $110 because the company did well.  If you were to sell the stock at that point for $110 you would have made a 10% profit due to the appreciation in the value of the stock.  I will cover how dividends make money below.  Investors buy stocks with the hope that it will make them money over time through these two means.  

Dividends

Dividends are a way that a publicly traded company can share its profits with its shareholders.  When a publicly traded company is profitable, it can use those profits in one of two ways.  First, it can use the profits to grow larger and expand the business.  Younger companies tend to reinvest their profits in this manner so they can continue to grow.  Stocks in these types of companies are often referred to as growth stocks.  On the other hand, more established companies that are not trying to aggressively grow will often choose to pay a part of their profits back to their stock shareholders in the form of dividends.  

Dividends are typically paid back to shareholders on a quarterly basis, but some companies do so semi-annually, annually, or even monthly.  How much are dividends?  This is best understood by the term dividend yield, which is the amount of the dividend divided by the share price of the stock.  For example, if you purchased one share of stock in Company X for $100, and the dividend yield was 4%, you would make $1 per quarter for a total of $4 that year in dividends, assuming dividends are paid quarterly and there is no change in share price of the stock.  To give you a ballpark range of how much you can make in dividends, dividend yields typically range from 0-4%.  While there are some stocks that may be paying higher than this, those higher rates are generally not sustainable. 

What do you do with the dividends?  There are two basic options.  First, the dividends can be reinvested to purchase more shares of stock through a dividend reinvestment program or DRIP.  This is what I recommend if you are young and investing with a long time horizon or if the investment is in a retirement account and dividends could not be accessed without penalty.  Reinvesting dividends is how you really harness the power of compound interest over time.  The second option is so take the cash and use it as you choose.  This is a good option for those who are near or in retirement and need income more than further investing.  One popular investing strategy is to invest in stocks that have very high dividend yields, with plans to live off of the dividend income stream in the future rather than selling their shares of stock as a stream of income.  

Stock Exchange

Now that we’ve talked about stocks, let’s talk about how they are traded.  In order for investors to buy and sell shares of stock, there needs to be some sort of marketplace or forum to oversee and regulate these transactions.  You need a stock exchange. 

There are many stock exchanges throughout the world.  These include the Tokyo Stock Exchange, London Stock Exchange, and Euronext.  The two biggest (by far) and well known are located in the United States.  They are the New York Stock Exchange (NYSE) and the NASDAQ (National Association of Securities Dealers Automated Quotation).  

The NYSE has been around since 1792 and is located on 11 Wall Street in Lower Manhattan in New York City, NY.  It has been nicknamed “The Big Board” and has more than $23 trillion in listed market capitalization (the value of all the stocks of all the companies traded through the NYSE).  While it started as a place stock traders had to physically go to trade stocks, today the vast majority of the stock trading through the NYSE is done electronically.

The NASDAQ, started in 1971, was the first electronic stock exchange and does not have a physical trading floor like the NYSE.  Trading is done through an automated network of computers.  It is the world’s second largest stock exchange with more than $11 trillion in listed market capitalization.  The NASDAQ is where most technology stocks are traded, like Apple, Amazon, Facebook, Microsoft, and Tesla.  

Stock Broker

Alright, so how do you interact with a stock exchange to buy and sell stocks?  Good question.  For that, you need some type of stock broker that is licensed to trade stocks through the stock market on your behalf.  Traditionally this was an individual, often associated with a large brokerage firm, that would meet with you in person or over the phone to discuss stock transactions.  Traditional stock brokers often had large investment minimums and would charge significant commissions for their services.  This prevented all but high net worth individuals from investing in the stock market.  

Today, however, this model is much less common.  Most investors today don’t use an individual stock broker, but rather an online brokerage firm such as Charles Schwab, TD Ameritrade, or Fidelity.  These online brokers are licensed to buy and sell stocks on your behalf in the stock market, often for little to no commission since you don’t have to meet with an individual broker to make a trade.  Furthermore, these discount online brokerages have little to no minimums to open an account.  This opens up the power of the stock market to the everyday investor.

Stock Ticker

Have you ever watched a program on CNBC or some other business channel and seen the stream of numbers and letters rolling along the bottom of the screen, looking like gibberish?  Well, this is the stock ticker or ticker tape and it actually has information you can easily understand once you learn how it works.  

A tick is any upward or downward movement in the price of a stock.  Back in the day, these ticks were recorded on a narrow strip of paper from a machine (ticker tape) and physically taken from the stock exchange to brokers so they could track the valuation of stocks based on recent trades.  Today this information is all communicated electronically, but the stock ticker or ticker tape name remains.  

Below is an example of what you might see today on the electronic stock ticker tape at the bottom of your TV screen.  Let’s review the 5 pieces of information in the stock ticker that will help you look like a seasoned pro the next time someone brings up stocks while shooting the breeze around the water cooler.

Symbol or Ticker

The first key piece of information is the stock symbol or ticker for the company.  In the above example this is AAPL, which is the ticker for Apple.  It typically has 1-5 letters based on the stock exchange where it is traded.  On the NYSE it must be 3 letters or less.  Some examples include Ford (F), General Electric (GE), and American Airlines (AAL).  Stocks traded on the NASDAQ typically have four letters, such as Microsoft (MSFT), Netflix (NFLX) , and Amazon (AMZN).  NASDAQ stocks that have 5 letters are usually foreign stocks and end in F or Y.

Shares Traded

The next piece of information is the volume of shares traded in the trade upon which the rest of the information is based.  In the above example, it says 35K@.  This means that the information quoted is based on a trade of 35,000 shares of the stock at the price that is listed next.  If no letter is listed after the number, then it represents hundreds of shares (so 5 would mean 500 shares).  K is used for 1 thousand, M for 1 million, and B for 1 billion.  

The number of shares traded can potentially give some insight into market trends.  However, it tends to be less important for most investors and is often omitted in more abbreviated stock ticker tapes.  

Price

The next number is the price per share of the quoted trade.  In this example that price is $269.42 per share.  This is the number I tend to look at right away because this approximates how much the stock is currently worth.  

Change Direction

Next is an arrow that is pointing up or down.  In this example, it is pointing up.  This tells us that the stock is trading higher than the valuation at the previous day’s market closing price.  If it is pointing down, it is trading lower.

Another common way this trend is communicated is by color.  Green typically represents the stock is trading higher, red means lower, and blue or white means no change.  

Change Amount

The last number is the difference in the current price compared to the price at the previous day’s closing.  In this example it is $1.44.  Since the arrow is up, we know that the current price of $269.42 for Apple stock is $1.44 higher than the price of Apple stock at the time the market closed yesterday.

Now that you better understand the stock ticker tape, let’s review what the above graphic shows us.  We are looking at a recent trade of 35,000 shares of Apple stock that sold at $269.42 per share, which is up $1.44 per share compared to market closing yesterday.  

See, you can do this!

Dow Jones Industrial Average (DJIA)

“The Dow is up 200 points.”  “The Dow is down 500 points and Armageddon is looming.”  These are headlines we all hear on a regular basis.  But what is the Dow?  There are three numbers, or indices, that are commonly reported as measures of the U.S. economy.  The first is the Dow, so let’s start there.  

Its full name is the Dow Jones Industrial Average (DJIA).  It is an index that tracks 30 of the largest publicly traded companies in the United States.  It is named after Charles Dow and his business partner Edward Jones.  It was created in 1896 and is one of the oldest and most closely followed financial indices.  

The index is meant to be a measure of the broader U.S. economy.  When the index first launched it included only 12 companies that were primarily industrial in nature.  Among these industries were railroad, gas, sugar, and cotton.  As the U.S. economy has changed over the decades, so have the companies included in this index.  In fact, none of the original 12 companies are part of the DJIA today.  GE was the last standing of the original 12 companies, but was dropped from the DJIA in 2018.  

The DJIA has grown from the original 12 companies to 30 of the largest U.S. companies today.  These are all household names and include 3M, Apple, Boeing, Coca-Cola, Intel, Johnson & Johnson, McDonald’s, Merck, Nike, Pfizer, Verizon, Visa, Walmart, and Disney.  

How is the DJIA calculated?  A detailed explanation of this is beyond the scope of this blog post.  But put simply, the DJIA is a price weighted index. It is a mathematical average of the stock prices of the 30 companies divided by a number called the Dow Divisor which compensates for the effects of stock splits, dividends, and other complex factors.

When the 30 companies in the DJIA do well, “the Dow is up” and investors generally feel the U.S. economy is doing well.  Conversely, when the Dow drops, so does confidence in the U.S. economy.

S&P 500

The second commonly reported measure of the U.S. economy is the S&P 500.  This is an index that tracks the performance of 500 of the largest publicly traded companies in the United States.  S&P stands for Standard and Poor, which are the names of the two founding financial companies.  Because there are many more companies included in the S&P 500, many investors feel it is a better indicator of the U.S. economy than the  DJIA.  

The S&P 500 is calculated differently than the DJIA.  While the DJIA is a price weighted index based on individual stock prices, the S&P 500 is a float-adjusted market capitalization weighted index.  Whoa, what does that mean?  Well, first we need to understand market capitalization, or market cap for short.  This is the total dollar value of all of a companies outstanding shares of stock.  So if a company had 100 million shares of stock selling at $100, it would have a market cap of $10 billion.  To calculate the S&P 500 index, the market cap of all 500 of the companies are added together and then divided by a divisor that adjusts for stock splits, special dividends, and other complex factors beyond the scope of this post.  Float adjusted means that the index only includes in its calculation those shares of stock readily available in the stock market, excluding those held by company insiders, promoters, or governments which are not available to the general public.  This results in a better reflection of market movements.  

We will discuss index funds in more detail in a future FI Top Ten post. But for now I think it is important to mention that one of the most commonly recommended types of low cost passive index funds in the FI community are those that track the S&P 500 index.  

NASDAQ

The NASDAQ is the third measure of the broader U.S. economy you typically see at the top of financial headlines and webpages.  This gets a little confusing because the NASDAQ actually represents two different things.  It not only refers to a stock exchange (as discussed above), but also to the NASDAQ Composite Index.  This index is composed of all the companies that trade on the NASDAQ stock exchange.  This is unique to the NASDAQ; no other stock exchange has its own popular index.  The NASDAQ Composite index tracks more than 3,300 stocks, of which many are technology related.  Like the S&P 500, the NASDAQ Composite Index is also a market capitalization-weighted index.  

Bull Market

OK, let’s wrap this up with two simple, but very important terms, used to describe the overall condition of the market.

The first is a bull market.  This is the good one.  A bull market generally means that stocks prices are on the rise and the economy is doing well.  Everyone tends to be pretty happy in a bull market.

Bear Market

The second is a bear market.  This is the bad one.  A bear market means there is a decline in the market of 20% or more.  Many investors tend to panic during a bear market and sell their shares of stock as the market declines, resulting in permanent losses.

Conclusion

I hope this post helped you increase your financial literacy on stocks and the stock market.  I strongly believe one of the key components of success in investing is understanding what you are investing in.  Here are some take home points to consider:

• The stock market has been the single best performing asset class over time, so understanding it is key to becoming a successful investor.

• While it is important to understand what stocks are, I do not recommend investing in individual stocks.  Instead, I recommend investing in broad based low cost passive index funds that hold hundreds of stocks for better diversification, simplicity, lower costs, and better returns. More on this to come.

• You tend to remember things you use regularly.  I challenge you to check out the Stocks app on your phone and see how much more you understand now.  Or check out CNBC and look at the stock ticker tape at the bottom of the screen.  It‘s pretty rewarding to finally understand something that may have been a black box to you for so many years.  

Thanks for reading.  I hope you are doing well in your progress towards reaching FI.  If you have any questions or comments that might help other readers, please list them below.  In the meantime, keeping working towards Freedom Through FI!

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