A Guide for Investors
Investors Primer III: Investing in the Philippines Stock Market
A share of stock is evidence of a fractional ownership in a corporation. Buying a share of common stock is in fact buying a share of a business. An individual who owns shares in, say, Petron or PLDT has an ownership interest in that company and is called a stockholder or shareholder. This ownership is also referred to as having equity in a company, hence, stocks are also called equities or equity securities. The percentage or proportion of ownership depends on how many of the company’s share one owns.
For example, 1,000 shares of common stock in a corporation that has 100,000 outstanding shares represent 1,000/100,000 ownership interest. This means you have one percent (1%) ownership interest I the company’s plant, its building, its inventories and other assets.
Ownership of a business is represented by stock certificates. When an individual becomes a stockholder of any corporation, he receives a stock certificate – a written evidence of ownership certified to the corporation. The certificate indicates the investor’s name, total number of shares purchased, the certificate number, the par value and the name of the issuing corporation.
When shares are purchased, the stock certificates will be issued either in street name or in the investor’s name. The difference is important to know since without notice form the investors all stock certificates will be issued in street name, i.e. in the name of the brokerage firm. In this way, the brokerage firm – and NOT the investor – will be the holder of the stock certificates. Only when the investor specifically asks for it will the stock certificates be issued in the investor’s name.
Stock certificates that are in the street name facilitate the transactions by brokers. When the investor decides to sell his shares, the street certificate simply be endorsed by the stockbroker. If it were in the investor’s name, the process would be lengthier since it is the investor who needs to endorse it at the back of the certificate. When shares are bought and sold frequently, it is advisable to have them issued in street name since it will facilitate the quick transfer of ownership.
There are different types of stocks that you can buy or sell at the Philippine Stock Exchange (PSE): common stock, preferred stock, cumulative preferred stock and convertible preferred stock. The difference depends on the right and privileges which you receive as a stockholder.
The majority of securities traded in the PSE are common stocks. Common stocks are usually purchased for participation in the profits and control of ownership and the management of the company – they have voting rights. Common stock holders are entitled to an equal pro rata division of profits without preference or advantage over another stockholder. However, they have the last claim on dividends and are the last to collect in case of liquidation. Common shares can be classified into class A and class B shares. Class A shares are reserved to Filipino investors, while Class B shares are open to foreign investors as well as Filipinos. Thus, Filipinos can own both classes while foreigners can only avail of Class B shares. Both classes have the same privileges and rights, and receive the same amount of dividends.
Preferred stocks are another type of securities issued by corporations. Its name is derived from the preference given to the holders of this stock over holders of common stocks. Holders of the preferred stocks are entitled to receive a fixed minimum amount of dividends (expressed either in pesos or as percentage of the stock’s par value), to the extent declared by the company’s Board and if there are sufficient retained earnings, before any dividends are paid to the holders of common stocks.
Cumulative preferred stocks are special preferred stocks that accumulate unpaid dividends for future payment. Cumulative preferred stock has prior rights to dividends over common stock; therefore the omitted cumulative preferred dividends must be paid before the common stock dividends can be paid. Convertible preferred stocks are preferred stocks which are exchangeable into common stocks at the option of the holder under specified terms and conditions. The conversion ratio specifies the number of shares the holder receives upon surrender while the conversion price is effective price paid for the common stock when conversion occurs.
Warrants are another type of investment which you can buy or sell in the stock market. By definition, a warrant is a security which grants the holder the right but not the obligation to buy (in the case of a call warrant) or sell (in the case of a put warrant), a stated number of underlying shares of stock at a specified price during a specified period of time.
Underlying shares are the shares, unissued or issued as the case may be, of a corporation which may subscribed to or purchased by the warrant holder upon the exercise of the right granted under the warrants. The number of underlying shares a warrant holder is entitled to buy or sell for every warrant he holds is known as the conversion ratio. The exercise period specifies the life of a warrant while the expiration date is the date at which the warrant expires. The exercise price is the stipulated stock price at which the holder can buy or sell the underlying.
Warrants can be issued in a number of ways: (a) as part of an initial public offering; (b) attached to a rights issue; (c) attached to bonds; or (d) as stand alone. In the case of debt or equity offerings, warrants are used as “sweeteners” to enhance marketability of the issuances. Under the SEC Rules Governing Warrants, Issuers or warrants may be the issuer of the underlying shares or an entity other than the company underlying the warrants and may be in the form of:
a) Subscription Warrant – a warrant which grants the right to subscribe to the new or unissued shares of stock of the Issuer;
b) Covered Warrant – a warrant which is issued by a party other than the Issuer of the underlying shares and whose performance of obligation is secured by the deposit of the underlying shares for the Covered Warrant with an independent Trustee which is a reputable commercial bank;
c) Non-collateralized Warrant – a warrant issued by a party other than the Issuer of the underlying shares and whose performance of obligation is not secured by a deposit of the underlying shares. Instead, the Issuer normally adopts hedging strategies to provide for its obligations during the life of the Non-collateralized Warrant.
Even if the trading of warrants is relatively new in the Philippine stock market, it has gained some popularity. Currently, there are eight (8) warrants listed at the PSE. The warrant holder has the chance to have the same exposure in the market, as with buying the stock itself, using lesser amounts of money and the advantage of having more time, i.e. exercise period, in which to raise money to purchase more shares (the underlying stock). Also, the investor is protected from the downside risk of the underlying stock’s price depreciation since the exposure of their money is limited to only the price of the warrants.
The stock market is the place where shares of stock are traded while the stock exchange is the organization that provides the facilities for the buying and selling of securities. The trading floor is the place where member-brokers trade daily. The Philippine Stock Exchange (PSE) is the only operating stock exchange in the Philippines and has two trading floors located at the PSE Centre in Pasig City and at the PSE Plaza in Makati City.
Trading at the two trading floors or PSE is electronically linked by a computerized trading system, the MakTrade System, which uses the single-order-book system where all the orders are posted and matched in one computer. All trade orders entered by brokers in behalf of their clients are matched with the best bid/best offer (BBO) regardless of which floor orders originate.
Trading at the PSE is from 9:30 a.m. to 12:00 noon in a continuous session daily, except Saturdays and Sundays, legal holidays and days when the Banko Sentral ng Pilipinas (BSP) Clearing Office is closed.
As the organization that facilitates stock trading, the PSE is not directly involved in the buying and selling of securities. It is the Members (also known as member-broker or member-firms) who can buy or sell stocks for the investors since they are authorized and licensed by the Securities and Exchange Commission (SEC) to transact business as a broker and/or dealer or securities.
A stockbroker acts as an agent or middleman between the investor and other buyers/sellers. As an intermediary, the stockbroker executes orders for clients, purchasing or selling the stocks on the stock exchange. On the other hand, a dealer acts as the principal rather than an agent – buying and selling for his/her own account.
An individual or corporation is considered a PSE Member once they have acquired a “membership seat” and have met all the set requirements for membership. Each Member is entitled to one seat which can be bought from an existing Member or from the Exchange.
a) Choose a stockbroker. In choosing a broker, you must also see to it that the broker (person or corporation) is a member of good standing at the Philippine Stock Exchange. A complete listing of the PSE member-brokers can be found in various publications or from the PSE Membership Department. It is important that you trust your broker and that you are satisfied – with the services it is giving you. Broker services include market reports, advice regarding stock selection and timing of purchases and sales, trade executions, on time delivery of important documents – such as confirmation receipts – and other trading-related activities that the client may require.
b) Open a brokerage account. Once the investor has chosen his brokerage firm, a brokerage account has to be opened. This account allows the client to perform stock transactions (buy and sell shares) any time – similar to bank account which enables you to deposit, transfer and withdraw money.
Opening a brokerage account is relatively easy to accomplish and takes not longer than opening a bank account. A specimen signature card needs to be filled out, containing the: name, address (professional and private), telephone number(s), and most importantly, the client’s signature. Frequently, bank and professional references have to be submitted.
Once an account has been opened, the client may buy or sell immediately according to the trading instructions between the investor and broker. Trading instruction can vary depending on the investors’ objective – whether it is short-term or long-term, minimum or maximum value of trades (trading limit), etc. All transactions are handled confidentially and the broker will not reveal to any person the details of any purchases or sales done for his client.
c) Place your order with your broker. After opening the account, a trader will be assigned to the investor. A trader is a licensed salesman who is authorized to buy and sell securities at the PSE. The assigned trader will be your contact person for all the transactions. He/she will receive your order, most likely by telephone (unless arrangements are made), and will execute the order through the trading terminal connected to the main system of the Exchange.
Thus, when placing an order to buy or sell, you have to call your trader and give the details of your order. The trader need to know the following specifications: buy or sell order, which stock to buy or sell, the number of shares to buy or sell, and preferably also the bid price (when buying) or asked price (when selling).
d) Settle your transaction. Buying and selling transactions are settled by book-entry. This means the ownership of shares and cash is transferred electronically to the brokerage account, without the stock certificates and cash being handed over physically. The account is credited when buying shares, and debited in the case of selling shares.
The paperless or scripless trading, now in place, has eliminated the physical handover of stock certificates when buying or selling. The system replaced the scrip-based system where stock certificates are handed over for transfer for the next owner, which may take more then 3 to 4 weeks. Instead, stock certificates are simply immobilized and kept in a safe place – the Philippine Central Depository, Inc. The book-entry system clearly advantages over the paper-based system. It has dramatically reduced paper work, facilitated the trading and eliminated the loss or forgery of shares.
Currently the PSE settles trades on T+4, i.e., four (4) days after the transaction date. Therefore, payments and/or securities must be delivered to your broker on or before 1:00 p.m. of the fourth trading day following the sale. Be sure to always verify the settlement deadline with your broker for future developments.
The minimum amount of money needed to invest in the stock market depends on the minimum amount of shares to be traded for the stock. This minimum amount will be determined by the prevailing market price of a particular stock. For each stock the minimum amount of shares to be traded is fixed and depends on the price range of the stock, as shown in the table below (otherwise known as the Board Lot Table). To determine the minimum amount of shares, the investor takes the market price of the wanted stock, looks for the price range in the table below reads the minimum amount of shares in the same row.
Table 1
Board Lot Table
|
Minimum Amount of
|
Price ranges
|
Shares
|
| | | | | |
| 0.001 |
to
| 0.0024 | | |
1,000,000
|
| 0.0026 |
to
| 0.005 | | |
1,000,000
|
| 0.0055 |
to
| 0.01 | | |
1,000,000
|
| 0.011 |
to
| 0.025 | | |
100,000
|
| 0.026 |
to
| 0.05 | | |
100,000
|
| 0.0525 |
to
| 0.10 | | |
100,000
|
| 0.105 |
to
| 0.25 | | |
10,000
|
| 0.26 |
to
| 0.50 | | |
10,000
|
| 0.51 |
to
| 1.00 | | |
10,000
|
| 1.02 |
to
| 2.50 | | |
1,000
|
| 2.55 |
to
| 5.00 | | |
1,000
|
| 5.10 |
to
| 10.00 | | |
1,000
|
| 10.25 |
to
| 25.00 | | |
100
|
| 25.50 |
to
| 50.00 | | |
100
|
| 50.50 |
to
| 100.00 | | |
100
|
| 101.00 |
to
| 250.00 | | |
10
|
| 252.50 |
to
| 500.00 | | |
10
|
| 505.00 |
and
|
upward
|
| |
10
|
| | | | | | |
For example, an investor wishes to buy a stock whose market price is P100.00. This price is in the P50.50 to P100.00 price range; consequently, the minimum number of shares to be bought at a regular transaction is 100 shares. In this case, the minimum amount of the investor needs is just about P10, 000.00 (100 shares x P100.00 share price) exclusive of other charges for buying stocks.
For shares in the lowest range (from P0.001 to P0.0024) a minimum of P1, 000,000 shares have be bought. If the share price is P0.001, the minimum capital outlay is P1, 000.00 (P0.001 x 1,000,000 shares).
Brokerage commission. When buying and selling listed securities, the brokerage firm always acts as an agent between you, the buyers and sellers. His function is to execute the client’s order and to give advice when required. For the services rendered, the brokerage firm charges its clients a commission. When you buy stock, the brokerage firm adds the commission to the value of the shares bought. When you sell shares, the commission is deducted from the proceeds that you receive. The maximum fee is 1.5% of the gross value of the transaction (i.e., the number of shares multiplies by the price) plus 10% value added tax (VAT). This means that 10% is added to the brokerage commission to be paid with a maximum of 1.65% (1.5% + 10%).
Transfer fee. A transfer fee of P100.00 plus 10% VAT is charged to the buyer by the transfer agent for every security traded. The transfer agent maintains the ledgers for each issuer the company showing the details about each registered stockholder. It also has the responsibility to cancel the old certificates and change the name when the shares have been sold.
Cancellation fee. Sales transaction and/or direct transfers are subject to a cancellation fee of P20.00 per bearer certificate plus 10% VAT.
Philippine Central Depository (PCD) fees. For the book-entry-settlement system, buying and selling transactions are subject to an ad valorem rate of 0.00009174 (inclusive of VAT), without any maximum or minimum amount, in lieu of transfer fee and cancellation fee. If the client buys a PCD-eligible issue and still wants a stock certificate issued to his name, he must pay the PCD ad valorem charge, a P25.00 upliftment/withdrawal fee per request and transfer fee. Also, if a client sells a PCD-eligible issue and still has the stock certificate for delivery to the broker, he is charged with the PCD ad valorem rate and a cancellation fee.
Documentary stamp tax. The documentary stamp tax is charged to the buyer on every purchase transaction at the rate of P1.50 for every P200.00 par value of the stock being transferred or a fraction thereof.
Stock transaction tax. The stock transaction tax is charged to the seller for every sale of stocks listed and traded on the Exchange at the rate or ½ of 1% of the value of transaction, in lieu of the capital gains tax.
It should be noted that these tares are subject to changes. Please ask your brokerage firm for the current tax rates and charges.
Illustration 1: Buying securities
If we assume that an investor buys 2,000 shares of stock at a market price of P5.00 per share with a par value of P1.00, the computation for the total cost of the transaction is as follows:
| Investment cost (2,000 shares x P5.00) | | P10, 000.00 |
| Add: | | | | | |
| Brokers' commission (10,000.00 x 1.5%) |
150.00
|
| 10% VAT on brokers' commission | |
15.00
|
| Transfer fee | | | |
100.00
|
| 10% VAT on transfer fee | | |
10.00
|
| PCD fee (10,000.00 x 0.00009174) | |
0.92
|
| Documentary stamp tax | | | |
| [(2,000 shares x P1.00) x P1.50] | |
15.00
|
200
| | | | | |
| Total cost of the transaction | | | P10, 290.92 |
This computation will be reflected on the Confirmation of Purchase which contains the details of the buying transaction and which will be delivered by the broker to his client.
Illustration 2: Selling securities
For an investor who sells 500 shares at a market price of P20,00 per share, the computation is as follows:
| Sale proceeds (500 shares x P20.00) | | P10, 000.00 |
| Less: | | | | | |
| Brokers' commission (10,000.00 x 1.5%) |
150.00
|
| 10% VAT on brokers' commission | |
15.00
|
| Stock transaction tax (10,000.00 x 0.005) |
50.00
|
| Cancellation fee | | | |
20.00
|
| 10% VAT on the cancellation fee | |
2.00
|
| PCD Fee (10,000.00 x 0.00009174) | |
0.92
|
| Net amount to be received | | |
P9, 762.08
|
This computation will be reflected on the Confirmation of Sale which contains the details of the selling transaction and which will be delivered by the broker to his client.
As part owner of the corporation, stockholders are granted several rights.
Rights to receive dividends When dividends are declared by the company’s Board of Directors, shareholders are entitled to these dividends, but in proportion to the number of shares held. However, shareholders cannot claim dividends when the company decides not to declare any.
Voting rights The common stockholders have the right to vote and to decide on a broad range of corporate issues, e.g. reorganizations, mergers, issuance of new stock and, last but not the least, the election of the company’s Board of Directors at the stockholders’ meetings.
Pre-emptive right This is the right given to existing stockholders to purchase additional shares before they are offered in the general public, usually at a lower price. For example, a corporation decides to issue additional shares to the public and gives the right to all of its stockholders to subscribe to the new shares at the ratio of 1:2. For every 2 shares owned, present shareholders have the option to buy one additional share, if they so desire.
Limited liability and last claim to the company’s assets liquidation If the company in which you own stocks goes bankrupt your total loss as a stockholder is limited to the amount that you paid for the security. You have the claim against the company’s remaining assets; however, your is the last behind all other creditors, such as suppliers, employees and bondholders. The biggest risk you face is the loss of capital that you have invested because the company’s stock becomes worthless. Neither the corporation, the banks from which it borrowed money, nor the bondholders to which it owes money have any claims on your personal assets.
As owner of a corporation’s share of stock or stockholder, your return can come from either dividends or capital gains.
Dividends are periodic payments made by the company to its shareholders from its current and past profits. It is paid in either of two ways. The first and most common method is cash; the second method is known as stock dividend.
Cash dividend This income is computed by multiplying the number of shares held by the cash dividend rate declared. For example, if a company declares a P0.25 per share cash dividend to tits shareholders, a stockholder with 10,000 shares of stock will receive a cash dividend income of P2,500 (P0.25 x 10,000).
Stock dividend This dividend is given to shareholders in the form of additional stocks, instead of cash. For example, a company with one million outstanding shares declares a 25% stock dividend. A stockholder who owns 10,000 shares will receive an additional 2,500 shares (355% of 10,000) for free as a stock dividend. This stockholder now owns 12,500 shares.
Dividend payments are not automatic. All dividends must be declared by the company’s Board of Directors, but it is the decision of the company whether to declare dividends or not, the amount and when it will be paid. Usually, the higher the company’s profit, the higher the dividends paid to the stockholders. But if the Board decides not to declare a dividend, the common stockholders receive nothing. Common stockholders cannot demand dividend payments even if the company is profitable.
Capital gains This results form capital appreciation, or an increase in the market value of the stock you own. For example, an investor buys 10,000 shares of stock at P2.00 per share. After several weeks, the market price of the stock increases to P3.00. If the investor decides to sell all his shares, he will be getting a total value of P30, 000 which represents a 50% capital gain form his purchasing value of P20, 000. Thus, capital gains are profit made due to an increase in the market price of a stock form the purchase price.
The combination of the dividend income and the capital appreciation made constitutes the total return. The nominal rate of return is calculated by assign up the cash dividend income and the capital gains (pr losses) and dividing the sum by the purchase price.
| | capital appreciation + dividend income | |
| nominal rate of return = | -------------------------------------------------------- | (in %) |
| | purchase price of the stocks | |
For example, a company declares a cash dividend of P5.00 annually. In the meantime, the stock price reaches P30.00 form a purchase price of P20.00 a year ago. An individual who owns shares of stocks of the company and sells his 100 shares after receiving the cash dividend, has a total return of P1,500 (P5 x 100 +P10 x 100). The total rate of return would be 75% or P1,500 divided by the purchase value of P2,000.
Having placed an initial amount in stocks, the next step is to keep track of the stock price and to follow closely the developments of the company. It would not be wise to put your stock certificates in a safe and have them locked away for years. There have been too many cases of companies that performed badly for years, or even worse – got bankrupt. It would be too bad for an investor to discover after years that the shares have little or no value anymore.
A wise investor always keep track, on a regular basis, of the sock price and the company’s performance. This way, an investor is able to foresee possible consistent poor performance and low profits as well as consequently low stock prices. One of the most important factors influencing the amount of success achieved by an investor is the quality of information used to make investment decisions.
Investors should therefore spend some time and effort in studying their investment and keeping up-to-date with the developments in the company, the industry and the economy.
Stock market information For price and other stock market information, investors can rely on the following sources: stockbrokers, Philippine Stock Exchange, media (newspapers, television and radio), and information service companies (i.e., Bloomberg, Reuters, Technistock, etc.)
Daily quotation of stock prices can be obtained from your stockbroker. Investors can call their broker any time to inquire about the status of the stock market which includes stock process, closing and opening prices, bid and asked prices, and traded volumes. Usually brokers can also provide you with reports on the company and industry analyses which give you an in-depth look into the performance of a particular corporation, industry or sector that will lead to an advice to buy, hold or sell.
Stock price information can likewise be obtained from the Philippine Stock Exchange. It also keeps a copy if all corporate statements that have to be disclosed to the public and the PSE as part of its disclosure requirements. Annual, semi-annual and quarterly reports have to be submitted to the PSE on a regular basis by every listed company. These reports and other financial statements are kept in the PSE library and are available to the public.
In addition, the PSE Research and Public Information Department issues statistical Weekly and Monthly reports and Fact Book in a regular basis. These contain among others, trading statistics, the composite index and sectoral indices, market capitalization of listed companies, volume and value traded. These publications are available at the PSE Library. The Library is open daily form 8:00 a.m. to 12:00 noon and from 1:00 p.m. to 5:00 p.m., except Saturdays, Sundays, and legal holidays. Also, these publications are on sale at he Public Information and Assistance Center in Pasig City.
Most leading daily newspapers cover the stock market and publish the previous days closing prices and traded volume.
For more in-depth news about the stock market, investors can turn to TV programs which gives updates about the company, the various industries and particular companies while stock price information is shown simultaneously. “Stock market Live” on Channel 21 (Sky cable) covers the stock market every morning during trading hours.
Those who have a computer can access the World Wide Web for the latest stock market information. Numerous brokerage houses provide closing prices as well as the composite index and the indices of the different sectors. And give background information about the stock market along with the market recommendations. You can visit the PSE at http://www.pse.org.ph.
Information about a listed company Apart from keeping track of the stock prices and other indicators, the investor should likewise monitor closely the companies he/she invested in. The financial performance, dividend declarations, future outlook, the management of the company, corporate developments, development plans – in short, anything that could affect stock process – should be looked into. The following sources of information can be consulted for company analysis:
Corporate annual reports. The annual reports of a corporation are probably the best source for facts about a company. The most valuable information contained in these reports are the financial statements, the company overview, the achievements and developments, and future prospects.
Prospectus. When a corporation wants to issue new shares to the public, it must prepare a complete report about he company’s activities and development plans, called a prospectus. Particularly, the prospectus must mention how the raised funds will be used and attributed, This report is generally detailed and contains accurate information since it has to be approved by the Securities and Exchange Commission before the company is allowed to issue the shares.
A copy of the annual report and the prospectus can be obtained from the issuing corporation or from the underwriter. Copies are also available at the PSE Library or form your broker.
Another source of information are company reports prepared by brokers’ research staff. Full-service brokers regularly analyze listed companies and consolidate their findings in a report which is usually available to their clients.
Before making any investment, you must first evaluate your current and potential means, and determine the goal or purpose of making the investment. Every investor should ask himself the following questions before making the first purchase:
“How much money do I have to invest and can I afford to invest without adversely affecting my life-style?”What you want to invest may be quite different from what you have to invest. It is true that the bigger your investment, the bigger the possible capital gains. Consider an annual rate of return of 20%. If you had invested P100,000 you would have gained a profit of P20,000. But an investment of P500,000 would have yielded P100,000. Therefore, it might be tempting to put as much money as possible in the stock market to get rich quickly. Butt investors should only invest extra money; they should not borrow to be able to purchase more shares. Remember that stock investment carries a certain risk. Stock priced can very substantially from day to day. Borrowing money acts as leverage: if stock prices are increasing, the profits realized will be higher due to a bigger initial investment. But what if stock prices are declining and you are incurring a capital loss? There might not be enough money left to repay the borrowed money in the stock market – money in excess of that required for their living expenses, savings, the necessary insurance coverage and cash reserves for emergencies. Determining your capital available for investing should be considered first.
“What is the purpose of my investment?” To generate cash immediately or to build capital? For receiving dividends or for capital appreciation? For a child’s education or your retirement? For short-term benefits or long-term gains?
“How much return would you accept as reasonable for your investment?” Be realistic about the returns the stock market can give you. Don’t expect extraordinary returns.
“How much risk am I willing to accept?” Stated differently: How much money are you able and willing to risk. Each individual should set a limit and be prepared to get out of his stock when the limit is reached.
These are the questions you must answer before making any investment. Based on the answers, a particular investment strategy has to be designed to achieve those goals. More specifically, investments instruments have to be chosen – stocks, debt securities and deposits – that will give you the expected return at the desired moment, and with their specific risk characteristics.
These are the questions that your broker will ask in order to create your financial profile. It becomes part of the information he or she considers when making investment recommendations and selecting specific financial assets.
Investigate before investing. Investors should spend some time ____________________________________ and particular stocks to invest in. It is not advisable to put your money into any stock without first looking at the corporation. Issues that have to be looked into are: market share and sectoral importance, the financial performance of the company as shown in the annual and other financial reports, the management, development plans, growth opportunities, etc. Please ask your broker for assistance in selecting the stocks.
Diversify your portfolio. Diversification is the opposite of “putting all your eggs in one basket,” a practice that is as risky as putting all your funds in one stock. Although temptation of putting everything into one stock might be very great, especially when the price is moving upward, it should be avoided. It is one of the basic rules in stock market investing. Diversification, on the other hand, is the investment strategy of investing in different industry sectors and if possible, different stocks from different reduce your risk considerably.
Don’t rely on rumors. Frequently, rumors circulate in the stock market, especially when there is heavy trading. At such times, people launch rumors as to where the stock price will go, often to make money out of it. Rumors and hearsay should be carefully checked and verified by the investor. Consider the source and the motive behind the launching of the information and never act on the basis of a rumor that cannot be verified.
Monitor your investments. As discussed in number 13, having placed an initial amount in stocks, an investor should now keep track of the stock price and the company’s performance on a regular basis. Only in this way you are able to foresee possible consistent poor company performance which will be reflected in low stock prices. Investors should therefore keep up-to-date with the developments in the company, the industry and the economy.
Don’t be greedy. The principle of making a profit in the stock market is simple: buy low sell high or buy when the stock is inexpensive and wait till its price increases to sell. But investors should not try to buy at the bottom or sell at the top. It is difficult to foresee when the stock price has reached its bottom or top. Even trained experts with the best tools cannot accomplish this feat frequently. Instead, investors should set objectives in terms of expected return and profit and act accordingly. When the stock is still rising and the investor feels that the price has reached the desired level yielding the expected profit, it is time to start selling. He should not cling onto his shares for that extra bit of profit. For at the peak many investors will get nervous and start selling, pulling down prices sharply and quickly. When this happens, it may be difficult to sell, resulting in a lower-than-expected gain or profit. Greed in this case, will cause much disappointment. Investors should therefore sell according to the previously set profit objective and not wait for the very last moment. Simple: don’t be greedy.
Limit your risk. Remember that stock investments are subject to risk. Very few people like to sell at loss and, consequently, hold on their shares, even when the stock price keeps falling. A better attitude would be to limit and manage your risk. A maximum level of loss should be set (e.g. 20% stock price decrease) and get out of the stock when this level has been reached. In that way, a further loss of capital is prevented, which can be used for other investment opportunities.
All financial assets carry some risk – the risk that the actual return might be lower than expected or promised. However, the risk characteristics are distinct depending on the type of investment instrument.
Fixed-income securities, such as bonds, preferred stocks and convertible securities, generally carry a low level of risk. The buyer of these assets know in advance how much interest payment he will receive at the end of each month. This is true for treasury bills, savings, and time deposits, and to lesser extent, also dollar deposits. The risk is related to the failure of the financial institution – bank, private company or government – to pay the promised interest at regular intervals. When a bank goes bankrupt, its assets might not be sufficient to pay all the debts, including the interest to the account holders. They will receive less, or nothing at all. Likewise, when the government’s deficit becomes too large, it might not be able to pay the holders of treasury bills the promised interest. Fortunately, private and government organizations have generally proven to be able to hold their promises and repay the money they borrowed.
The returns from stocks, however, are less predictable. Remember that stock provides potential income in the form of cash dividends and capital gains when the stock price appreciates. As outlined earlier, cash dividend payments are not fixed. It depends on the Board of Directors of the company if dividends will be paid out, the amount of it and the time. Therefore a stockholder is never sure of the cash dividend he will receive. This is the first type of risk he encounters when buying stock.
Secondly, the capital gains an investor is entitled to depend on the price movement of the stock. Since stock process can be very volatile, i.e. can vary substantially from one day to another, the increase in the market value of the shares held varies too. As history has shown, stock prices can speed up, but can also take a sharp dive. As stock prices go down, the capital gains decrease, or even result in capital loss. Thus, this type of risk refers to the volatility of the capital gains. Together, the variability of the cash dividends and of the capital gains constitutes the total risk of stockholder.
To summarize, stocks are by far the most risky of financial instruments, but also the most profitable. On the long term, they have proven to substantially outperform other financial assets, and be the best hedge against inflation and loss of buying power. Fixed-income securities generally provide less than half the return on stocks but exhibit substantially less risk.
