How The Markets Work
How The Markets Work
Scott Leonard, CFP (President, Leonard Wealth Management, Inc.) gives expert video advice on: What is a "bull market" and how does it impact me?; What determines the price of a share of stock?; Do share prices in an IPO always go up? and more...
What is "bear market" and how does it impact me?
A bear market is a sustained downward market where the value of stocks as a whole is going down over a period of time. How that affects our investment portfolio is that obviously the value of our overall investments are going down, but it shouldn't affect us if we're owning stocks for the right reason. If our goal is a long term goal - which is really the only reason you want to own stocks - then that bear market isn't bad. It almost could be considered good. That is the risk that we're assuming is going to give us a higher long term return.
What is a "bull market" and how does it impact me?
A bull market is sustained upward movement in the market. The value of the underlying companies of that market are increasing. The way a bull market affects our portfolio is the value of our portfolio is growing. Bull markets are the reason we invest in stocks is for the long-term growth that we are going to receive from the stocks in a stock market.
What determines the price of a share of stock?
The price of a stock is really determined from the classic economic philosophy of supply and demand. Stocks are traded freely in the marketplace, it's one of the few true freely traded securities out there. And so, the price is going to represent the value that everybody as a whole feels that stock is worth. So, with a stock in the stock market, if somebody looks at this company and it's selling for twenty dollars a share, they may say "Wow, you know, the company's worth more than that." And so they're going to buy the shares of that stock until the price gets to a place in which that buyer no longer feels that it's a great deal. And then there's always a seller on the other side of that transaction. And they're really thinking for that twenty dollars, that's a terrible price, so they're wanting to sell stock. And so what happens is, the price comes to this equilibrium, where all the buyers think it's a fair price, and all the sellers think it's a fair price, and that's what establishes the price of a stock.
What is "investment rate of return"?
The investment rate of return is simply the growth of our investment, whether it's an individual security or our overall entire portfolio. As an example, if we had a 10% rate of return on a $10 investment, that's a dollar. Ten percent of $10 is $1, so our investment now becomes $11.
What are a company's "earnings"?
A company's earnings are, in the simplest terms, its profit. 'Earnings' are what the company earns above its cost of supplies and goods, and after paying it's employees.
How do earnings reports affect the price of stock?
Earnings are one of the classic measurements that people use when they're trying to evaluate how good a company is. Usually it's a relative measure, so companies in the same industry, you might want to look at their earnings. Who's earning more money? Which company is more profitable? Earnings could be a sign of which is a healthier company, a better company, a company which might be safer and with less risk associated with it.
What is the "price-to-earnings ratio"?
The price-to-earnings ratio is a ratio that measures a company's value, in the sense that the top of that ratio is going to be the value of the company. The bottom of the ratio is its earnings. We call that a PE in the market. On average, the market really has a PE of about 20. That's going to represent a good solid growth company. The PE ratio can be a good relative indicator within an industry of the relative value someone might put on a company. A higher PE ratio is going to be a growth company. It has good earnings relative to its price. A low PE ratio can be an example of a value company. Its price relative to its earnings are low, and so people just don't feel that it has a lot of great prospects and an example of a company that could be in distress.
What is an "IPO"?
An IPO stands for initial public offering, which means when a private company is going to go public. Why are they doing an IPO? They're doing and IPO because they need to raise money. They're raising money because they want to grow the company. They need to acquire other companies. So, they offer stock out to the marketplace. As they sell the stock during the IPO, the ownership in their company to the public, they're going to raise capital to invest within the firm itself, to hopefully grow the firm.
Do share prices in an IPO always go up?
When a company initially makes its public offering, there's usually a lot of hype surrounding that. As a result, the price of the stock is bid up as people want to get in and buy this. Shortly after that, reality sets in to some extent and prices will tend to decrease in the value of the stock with that IPO.
What is a "stock split"?
Traditionally when people buy stocks, they have to buy in round lots, usually lots of one hundred, although this is not as important today. However, if the price of a stock got really high, for example one hundred dollars, it would be a thousand dollars to be able to buy that one hundred shares. What a company does is to split the stock - 'stock split.' With the hundred dollar example, they might do what is called a two-for-one stock split, so they'll give you twice as many shares but decrease the value of those shares to fifty dollars. In doing that, they feel that it makes it easier for smaller investors to buy that round lot of a hundred shares, with less cost to going to do that. How a stock split affects an investor is purely psychological. The reality of a stock split is that nothing is happening. A stock split just changes the number of shares and the value of those shares. Now, what it might represent is that a company had just gone through a good upturn, a good growth period, and that's why it's doing the stock split. There's a lot of belief that if a stock split happens, the company must be great. It's just really a way in which a company is trying to keep its share price at a place where they think is appropriate for it in the marketplace.
What is "market timing"?
When you think about market timing, it's someone saying, "I want to be in stocks." A true market timer just wants to be in all stocks. They may want to buy the S&P 5 index and be fully invested in the stock market, or be in real estate, so they get into a broad basket of real estate. A market timer is making a prediction on the broad class of an asset category as opposed to any of the individual securities within that asset class.
Can anyone really time the market?
Over time there are lots of people who say they have the ability to time the market. What becomes interesting is if you use really and antidotal way of thinking about this is that, in order for someone to be a successful market timer, no one can really believe that they are a successful market timer. Because, they become a self fulfilling prophecy. So if people believed you could really time the market and you said the stock market is going to crash on friday, well, its not its going to crash on Thursday because everybody is going to get out a day early because everyones going to believe youre actually correct. So, if you kind of think that through it would be impossible to actually be successful enough meaning that your performance as a market timer goes beyond any disbelief. Because, then you go really become a self fullfilling prophecy and historically we just haven't found people that over time can consistenly time markets.
What is a "market correction" and how does it impact my investments?
A market correction, generally, is a downturn in the market. I personally dislike that terminology because it's assuming that the market was wrong and it's correcting itself to what is now right. We really never know that. It could be that the market is right and people panic and are putting the market into an incorrect place. In general terms, a market correction represents some form of downturn; a bare market, basically.
What is "profit taking" and how does it impact my investments?
Profit taking is really the process of selling stocks and taking your profits that you've made. It's really analagous to taking your chips off the table. You've made a good gain in your investment and you want to take that money out of the market, out of the risk of the market. And that's the traditional sense of profit taking. Usually, as an investor, it's going to cause the value of our portfolios to go down. If people are taking profits, then we're assuming that there are more sellers in the market than buyers which should just cause a downturn in the market. Those tend to be very short term market movements. For a true investor, true long term investor, it really doesn't affect the true value of our stocks towards meeting our long term goal.