Sneak Peak

It is important to understand the basics of investing. You need to understand certain principles. One of them would be what is a stockbroker. The stockbroker is the company or person who is the go-between for you and the stock market. You cannot go out on your own and buy 20 stocks, you have to go through somebody. And that is your stockbroker. There are many good stockbrokers around one that I highly recommend is called TD Ameritrade. Now I do not get any commission from them, but I can highly recommend them. 

Stockbroker

You do need to have a stockbroker before you invest then once you get a stockbroker what you need to transfer money to your stockbroker. It’s very important to use a reliable stockbroker do not find somebody in the back corner somewhere. This is why I would highly recommend TD Ameritrade you can also go with Chase Manhattan Bank, several ones work well. Make sure you go with a well-known name and trusted source. 

Once you’ve deposited your funds, you’re now ready to start making trades. Whenever you buy stocks, you must realize that somebody is selling the stocks. It’s not as if you’re buying stocks directly from the company, although this does occur from time to time. The most common occurrence of a stock sale transaction is where you have one buyer, and one seller. Let’s say for example you want to buy 100 shares of Coke. You put in a request to buy 100 shares at a given price. If that price is accepted it means that somebody has agreed to sell at that price. Then you have a buyer, and you have a seller. 

So you would pay your broker that amount, and then that broker would pay that amount to the seller. Of course, there would be some fees involved. But the goal here is to reduce your fees as much as possible. 

Earnings Per Share (EPS)

Earnings per share are taking the total earnings of the company and divided it by the total number of shares, and this is called earnings per share or EPS for short. To give an example, let’s say we have a company that has $100 million in profit. Let’s say for simplicity’s sake, they have 100 million shares outstanding. This would mean that that company has $100 million divided by 100 million shares which are equal to $1, so that company would have an EPS of one or $1 per share.

Price-Earnings ratio (P/E)

The price-earnings ratio is really important and that’s the ratio between the price of the shares and the earnings per share. Now the P/E ratio is the division between the price of the shares divided by the EPS. If in the example above, those same shares are trading at $10. Then the P/E ratio would be $10, divided by $1, which is equal to 10 and would have a 10 to one ratio. It is important to understand that the P/E ratio. 

Rate of Return

If you take the inverse of that you get the rate of return of the stock. This is an important number for many reasons. If you take a P/E ratio of 10, and you take the inverse of 10, you get 10%, that 10% will be the approximate rate of return for your investment. This assumes of course that you get a similar level of earnings per share in the years that follow, which is generally the case. That’s a good assumption to have unless you know otherwise. 

Imagine if the earnings per share are 40. Well, the inverse of that is 2.5%. So that means that those shares that have a P/E ratio of 40 are expecting a return of 2.5%, which doesn’t sound like much, but the difference here is the reason for a large P/E ratio can generally be explained by an expectation of growth. If the company is expecting growth of 100% per year for the next four years you’re going to have instead of earning $100 million per year at that level of growth, you would have two to the power of four which is 16 so you would be having $1.6 billion in profit, four years from now. 

Growth and P/E Ratio

That’s a huge growth and that’s going to be reflected in the P/E ratio. So your P/E ratio can all of a sudden jump to 160. If we assume that there’s going to be $1.6 billion in profit, four years from now. That would mean that those shares should trade at about $160. If we assume a consistent P/E ratio of 10. Your earnings per share has now jumped up from $1 per share to $16 per share. All of a sudden, your price will go to about $160, which is a P/E ratio of 160 (the EPS today is still $1). It’s very important to understand how growth can greatly increase the P/E ratio. In that sense, because there’s such a growth rate, the reason for this is the expected growth in EPS. 

You would not have a rate of return, which is the inverse of the P/E ratio, it would be quite different. This is important to understand. If there was no extreme growth, then you wouldn’t have an extremely high P/E ratio for that stock and as well, a very low rate of return. If investors believe that there will be growth, this will be reflected in the price and the P/E ratio. If that growth is not realized, you will get a price correction. 

Passive Vs Active Funds

You need to understand what is a passive investment and what is an inactive investment, and why the beginner needs to stick with passive investments. You can beat most stockbrokers, and most investors by following a simple strategy. The simple strategy is to find a strong ETF and stay with it for a very long time. The active fund has active managers looking for ways to beat the market, they trade more and have higher fees. The passive investment aims to meet the market, as such, has far few trades than an active fund. The increase in trades and the hiring of an active fund manager will have higher costs, which the investor will need to pay.As such, active funds have much higher fees than passive funds. Passive funds generally tend to outperform active funds.

Investor versus Trader

You should understand the difference between a long term investor, and a short term trader. Long term, generally, in finance means something over one year, and short term, generally means less than one year. If you’re investing in stocks for the long term, that could be 10 – 20 years or longer. You are going to be an investor. If you’re investing in stocks, but for the very short term, such as a day trader you would be a trader. Traders you fall into two categories you could be a day trader or you could be a swing trader. Day traders are very short term, they look to do their trades in hours and look to complete trades within the day. While swing traders are extended out from days to weeks and even months, but they do not invest for years. 

Focus on the Long Term

As a beginner, you want to focus on being an investor. This will greatly increase your likelihood of success. If you follow these rules, it would be very hard for you not to earn a profit in the stock market. 

Chapter 2 – How the Stock Market Works

To understand the stock market and how it works. It’s good to think of a stream with two currents. You have the lower current and the upper current. The lower current represents intrinsic value, so the true value of the stock and the upper current represents what people believe the stock is worth. The bottom current is slow and consistent it constantly moves in one direction, and very rarely changes direction. In fact, in 100 years it probably only changed direction one time now. You can imagine this current being linked with GDP, this generally grows, so it has one direction. This is a very consistent, but slow-moving current and that’s your lower current. This lower current represents the true value.

Emotions

The upper current is much faster and can move in any direction. This is based on the emotions of investors. It’s not based on real hard data, but it’s more based on emotional factors. For this reason, it can go a lot faster in both directions. The way the stock moves is the summation of the two currents. Now, generally speaking, the upper current is much faster than the lower current. That plays the greatest role in the change of prices. However, the upper current always goes back and forth, so it changes direction frequently. If you think about it, over a long period, the upper current is stationary. At any point in time, the upper current is very fast in one direction could be fast in the direction of the lower current, or it could be faster than the direction to the left. The left can represent prices that are decreasing and the right represents prices that are increasing.

The low current is always going to the right, so it’s always moving very slowly but to the right. This way the prices are increasing. Now, if you had the stream just based on the lower current, you would be earning a good living. You could put your investment in there and you would earn anywhere from 8% to 9% return, which is very good. What happens is the upper current can play havoc on this lower current because it has a much larger effect. It can completely change the direction of the lower current, you can gain even that much faster, but it can also move the left. This can overtake your lower current and prices could drop, selling here could cause you to lose money. However, you need to understand that this will only be for a short period because this negative direction has a history of reversing itself for further gains. Let’s review this in effect with NASDAQ.

Chart 2.1 NASDAQ

You can see that in 2000 to 2003, the prices for NASDAQ fell dramatically. They fell again in 2008, but overall the prices recouped their full loss and gained much more over the years. They are now more than twice their value that it has in its height in 2000. It is important to understand, that while this is a good investment in the long run, now is the time to wait for a correction, then to buy….read more

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