Have you ever wondered what you can do with stocks? If you are not completely aware of the potentialities, lets us tell you that you may use the stocks you own in numerous exciting ways. For instance, you are able to diversify or branch out, allocate or distribute, compound, split as well as short your shares. Now, let us briefly discuss each of these ideas.
Diversification of stocks is crucial if for a regular stock trader as it helps to minimize the risks involved in investing in the stock market. When we talk about diversification of stocks we actually denote that as an alternative to staking your total portfolio in just one or two stocks, you branch out the risk by endowing in an assortment of securities. The number and precise securities that you will be investing in depends on the exact extent of risk you are willing to take as an investor as well as the period for which you would want to continue with the investment. For the uninitiated, it may be noted that a portfolio is a listing of the securities, comprising stocks, bonds, mutual funds and cash that an investor possesses. The basic concept behind such diversification is that even when one investment does badly, the investor may fall back on other securities, many of which may be performing well.
It may be mentioned here that many people lost their portfolios during the latest bear market as they had deposited their money in one stock - habitually in the company they worked. Enron is an ideal instance in this case. Supposing you worked for the now doomed electric giant Enron and had invested all your savings in the shares of the company, you not only lost your job when the company applied for insolvency, but also lost all your savings.
Now, let us find out how diversification helps an investor when he or she has put all their savings in the stock market. In fact, in order to be able to diversify effectively, one needs plenty of money - something that very few people are able to afford. This is primarily owing to the fact that in order to diversify properly, an investor should have a minimum of 25 to 50 stocks in different types of industries. Most economic professionals are of the opinion that the best way to diversify one's portfolio is to have a blend of growth, value and income stocks along with a small portion of international stocks. At the same time, possessing stocks of both large as well as small firms are an ideal way of diversifying one's portfolio.
Diversifying one's portfolio requires great expertise as you need to decide on the amount of risk you are able to afford or at ease with. In the stock market parlance, the extent of risk that one is comfortable with is also called 'tolerance' and considering the age as well as the endowment objectives of the investor, a lot of things are dependent on it. For instance, during the dot com boom or when the stocks of the Internet companies were soaring, numerous people put all their savings in the stocks issued by these companies. This was certainly not the right way to diversify one's portfolio. Theoretically speaking, putting all their money in the Internet stocks did make some people richer only on paper, but in reality it was a doom for most investors. Unfortunately, by the time these investors realized their blunder, there was no remedy. Many investors thought that they had properly diversified their portfolio by investing in different Internet companies, but this was a wrong notion they nourished. All Internet companies fall under the same sector and when the entire sector busted, they lost all their investments at one go.
Having diversified your portfolio properly, you now need to take a decision on the precise proportion of your money you wish to allocate or distribute to every investment in your portfolio. For instance, if you still have 30 years to retire from your job, it would be wise if you deposit 65 per cent of your money in individual stocks and stock mutual funds. Of the remaining amount, you may invest 25 per cent in bonds and keep 10 per cent with you in cash for any exigency. Distributing your money in the above mentioned way is a wise example of stock allocation.
Like in the case of portfolio diversification, appropriated method of asset allocation is also based on the investor's age, risk tolerance or the risk levels that one is at ease with, and the time when he or she would require the money for allocation. In the past, people followed a simple theory to determine the amount of money they should invest in stocks. The theory was to deduct the investor's age from 100 and what is left determined the percentage of money one could safely put in stocks. Sorry to say, things are not as easy as mentioned above, but getting more complicated by the day. Hence, it is always advisable to seek the counsel of any financial expert before deciding on the perfect asset allocation for yourself.
Mathematicians who formulated the stock compounding theory claim that this will enable an investor to do things that will help him or her to become rich. Actually, in the very first place, the concept behind compounding stocks is the reason that led people to buy and hold stocks. If you simplify the concept of compounding stocks, it means reinvesting the money you have earned on your savings or endowments - interest, dividends or capital gains (profits made by selling your stocks). The theory is that you will earn more profits if you keep reinvesting for a longer period. In other words, to some extent, compounding stocks may be compared to compounding interest on a loan, the difference being you pay a compound interest on a loan, and while compounding stocks, you earn money in multiples.
For instance, when you make an endowment of $100 and it increases by the rate of 10 per cent annually, at the end of the year, the total amount in your possession will be $110. If you don't withdraw the money from the endowment, it will grow to become $121 at the end of the second year of reinvestment. This additional $11 is known as compound earnings or, in other words, an earning made on earning. The more that profits your investment is earning, the more rapid will be the compounding. People advocating the stock compounding system suggest that you will be able to make more money if you invest quite early in your life.
Frankly speaking, the compounding process is an efficient manipulation of bookkeeping that is capable of making one rich if they live long enough to witness the fruits. The concept is simple - when the price of the stock owned by an investor rises it compounds in value helping him or her to earn even more profits. It is important to mention that the stock you own will compound more when you leave your savings in it for a longer period.
There is, however, a problem associated with the different compounding formulae. And that is these compounding formulae are generally based on hypothesis that may never happen in actuality. In fact, the compounding system functions like a magic only till the time the price of your stock is performing well or soaring. It is a general problem with the stock market in general and the stock compounding system in particular that there is no assurance that the price of the stock you own will continue to rise for ever enabling you to earn eight per cent or more profits in a year from the market.
Stock split is defines as an augmentation in the number of outstanding shares of a corporation's stock done in such a manner that the equity proportion of every shareholder of the company remains unchanged. Before a corporation decides to go in for a stock split, it needs to obtain the sanction of its board of directors as well as the shareholders. A company whose stock is doing well may opt for a stock split and allocate the extra shares to its existing shareholders. The two-for-one is the most widespread stock split and in this case each share turns into two shares.
Therefore, when a company declares a two-for-one stock split it basically denotes that the price of the company's stock is reduced to half, while the number of shares owned by each shareholder is twice over. For instance, if you own 100 shares of IBM at $80 each and the corporation declares a two-for-one stock split, the price of each IBM share will be half, i.e. $40 per share. On the other hand, the number of IBM shares you will own after the stock split is 200. If you look at it from the arithmetical point of view, basically nothing seems to have changes following the stock split. Although you own double the number of shares, but as the price of each shared is halved, the total worth of your investment remains precisely as before.
On several occasions, a corporation opts for a stock split simply for reasons emotional and nothing else. In the above instance, you have seen that price of an IBM share had dropped to half from $80 to $40 following the stock split. It is likely that many of the investors who basically emphasize on the prices will regard the drop in the price of a share as a good deal - somewhat like a sale with 50 per cent discount. However, actually a stock split does not alter the corporation's fiscal situation in any way. On the contrary, the greatest benefit of a stock split is that it is likely to attract more investors, many of them who were earlier of the opinion that they did not have enough money to purchase IBM shares at $80 each. It has been seen that whenever a corporation has announced a stock split at some point in the bull market, the price of that company's stocks has generally gone up.
A number of companies having low stock prices have made use of another kind of manipulation. They have adopted another measure that is known as the 'reverse split' with a view to falsely raise the price of their stock to avoid delisting by the stock exchange where their stocks are listed. As a case in point, if a corporation's stock is trading for a mere $1 per share, after a one-for-five reverse split, the price of each share will soar five times more - to $5. Like in the case of the habitual share split, basically nothing has actually changed following the reverse split in this case too and the company's financial condition too remains as before. In case, you happen to be a shareholder of this company, the worth of the shares you own have remained the same, but you now own a lesser number of shares, precisely one-fifth of what you owned before the reverse split. Assuming that you own 100 shares of a stock selling at $1 per share, you will own only 20 shares after the reverse split, but the value of these 20 shares will change to $5 each. However, looking at things from the accounting perspective, you still continue to own 100 shares of the company. However, there is a disadvantage with the reverse split and that is the revised or higher prices of such shares do not last for long. In fact, once the stock market and the shareholders come to learn about the trick, the price of each share just drops to $1 again. Besides, the corporation is always under the threat of being delisted by the stock exchange for its stocks trading at much below par.
Selling short or short selling is a method used by investors who try to earn profits from the falling price of a stock. For instance, let's suppose that an investor wants to sell short 100 shares of a company, believing it is overpriced and will fall. In this case, the investor's broker will borrow the shares from someone who owns them with the promise that the investor will return them later. The investor right away sells the borrowed shares at the prevalent market price. If the price of the shares drops, the investor "covers the short position" by buying back the shares, and his or her broker returns them to the lender. The profit made by the investor through short selling is the difference between the price at which the stock was sold and the expenses incurred in buying it back, minus commissions and expenses for borrowing the stock. However, in case the price of the shares increase, the investor faces unlimited potential losses.
Contrarily, when you invest in a stock assuming that its price will go up, you are known to be 'long' the stock. In this case, your objective is to sell the stock at a price more than what you had spent to purchase it. Hence, the profit made by you in the process is the difference between the amount you received by selling the stock and the money you paid to buy the stock. While this is simple to comprehend, the reverse of this policy is known as 'short selling' a stock. In this case, when you assume that price of a stock you own will fall soon, you sell it immediately. Later, you purchase the same stock at a lower price when its value has plummeted in the market. Your profit margin in this case is the difference in the price at which you sold the stock and the money you paid to re-purchase it after its price had dropped. Investors who do not have any experience of short selling stocks may find this technique strange, until they themselves do it a couple of times.
Many people just cannot imagine that it is possible to earn profits from a stock whose price goes down in the market. There are plenty of people who even consider making money from a falling stock as something not like the American way of life or even dishonorable. However, you must always remember one thing and that is you have joined the stock market with the sole objective of making money. So, it makes little difference whether your profits are coming from short selling or long selling of stocks. Let's assure you that earning profits from short selling stocks in neither immoral nor un-American. On the contrary, short selling is a complicated tactics that enables an investor to earn profits even when the fiscal situation is gloomy and the stock markets are down.
There are a few rules that one is required to adhere to when short selling stocks. What is foremost is that the investor must purchase the stock when it is rising for the interim - known as an 'uptick' in the stock market parlance. It is important to note that if the price of a stock is going down rapidly and most buyers have discarded it, you possibly will not be permitted to short sell it. In this case, the investor will have to hang around till the subsequent uptick when the buyers have adopted a stand on the particular stock - a procedural regulation that thwarts the short sellers from stacking on any stock that is going down. Another important stock market rule is that no one is allowed to short sell a stock having a current price of below $5 per share.
Apparently, short selling of stocks may seem to be a very simple affair, but the fact remains that there are many things that may go awry while doing so. In fact, when an investor goes in for long stock, the maximum loss that he or she will suffer is losing all the money they have endowed in the stock. In contrast, when an investor goes for short selling any stock, he or she may lose more than what they have endowed. And this particular aspect makes short selling a very chancy affair.
For instance, if an investor short sells 100 shares of Bright Light at $20 per share, he or she will receive $2000. If the value of each Bright Light share goes down to $18, the investor will make two points, or a profit of $200. Now, let's assume that the investor's speculation goes awry and the value of the Bright Light share goes up. In such a situation, the investor will lose $100 for each point rise in the value of a Bright Light share. Now, the question is how high can the Bright Light stock go up? Well, the answer to this is really upsetting, for actually there is not limit for the stock to soar! Hence, the problem with short selling is that if the stock continues to go up instead of going down, the investor may suffer immeasurable losses.
It is important to note that very often the investors try to deceive themselves by believing that the stock market will always continue to rise higher. On the other hand, expert short sellers are proficient at poking holes in market bulls' declarations that appear to be so excellent that there must be something wrong with them. In this case, the trick is to listen to the arguments put forth by both sides but only do what you personally think is actually sensible.
It has already been discussed that different corporations issue shares of stock with a view to raise money to expand their business and the different stock exchanges make them available to the investors. It may be mentioned here that the overall number of shares issued by any corporation is known as that particular company's outstanding shares.
Here is a piece of advice for all wanting to put their money in the stock market. If you wish to save a lot of your precious time, you should surf the Internet to find out the number of outstanding shares in the market. As a case in point, placing a search in this regard in Yahoo! Finance may often prove to be fruitful. Always remember that the bigger the corporation is, the larger is its outstanding shares in the stock market. However, as the stock market is always volatile and keeps going up and down depending on the supply and demand, no corporation would like to issue too many outstanding share as it may result in a plunge in the price of its stocks.