Summary: This page discusses the most important stock market basics and explains many of the vital terms and phrases that you might encounter. Hopefully this glossary of information provides a useful vocabulary to get you started.
The phrase stock market is actually an imprecise description. More accurate terms would be capital market or equity market, though the official name used is always stock exchange.
The earliest stock exchanges were physical locations in which people came to buy and sell their holdings and interests in businesses and ventures. A number of these formed in coffee shops or Masonic temples and then over time grew into many buildings in the surrounding alleys and streets.
People would agree prices at which to trade their certificates of ownership in companies and these changes were stored in official ledgers.
Needless to say, the march of time and progress has made any sort of physical location obsolete. These days a stock exchange is essentially a collection of servers and computer hardware. Typically there will be several locations in which duplicates are housed for safety.
Despite this lack of a requirement for a fixed location, the major financial centres are still tightly-knit geographically. In New York, the Wall Street area houses many investment banks, stock brokers, law firms and hedge funds. Similarly, in London, 'The City' is also known as The Square Mile and close by lies Canary Wharf where there are many more companies.
The more accurate stock market definitions - capital market and equity market - relate to the real purpose of a stock market, to enable companies to raise money that will be used as working capital to help them operate or grow their business. In exchange for this money, the company owners agree to sell a share or portion of their equity in the company (hence the words shares, equity and equities which are frequently used). Another phrase often used is securities since the ownership of an individual of secured.
In the United States, each portion of a company is called stock, while in the United Kingdom it is typically called either shares or equities. The owners are known as stockholders or shareholders (depending upon where you are reading this). While this may seem very basic, there are many stock market terms that can be easily confused.
There are other areas in which the stock market definitions used seem a little odd - why not use the same words everywhere? For example, an integral element of a stock exchange is a debt market where companies and the national government borrow money at bulk rates. Rather than being called a debt market (which would make sense) it is actually known as a bond market.
These bonds are often referred to as fixed income investments because the conditions of the issue are spelled out at the beginning, meaning that an investor that buys and holds for the entire term knows exactly what the total return should be before purchasing.
However, the word bond is one that can be used relating to insurance, an investment policy or the debt market. And the word stock - as in stock market - is also used as loan stocks (with the same meaning as government or corporate bonds).
Once again, there is a trans-Atlantic divide on the use of language. In the United States, the word stocks is used regarding investment and equities whereas in Britain it relates to loans and debt.
Is that clear...?
While these are obviously very basic differences in interpreting the same words, it is surprising just how many people struggle with the terminology or glossary of a securities exchange and financial market basics.
More than meets the eye
Most stock exchanges have a number of other useful functions too. With the growth of complex trading and hedging strategies since the late 1990s, a derivatives market is a very common - and profitable - addition to the services offered by an exchange. Derivatives are high risk financial engineering that are not typically designed for the private investor, but still have a massive influence over our lives.
Often derivatives are traded between parties with no middleman because of their complexity. This is known as OTC or over the counter. There are lower transaction costs, less regulation and much less investor protection for such deals.
The frightening reality is that the derivatives market is both shrouded in secrecy and incredibly complicated. As much as people might want a slimmed-down, fast track guide, there is nothing basic about derivatives! This combination has made it virtually impossible to regulate and - as was learned in the financial meltdown of 2008 - manage. Estimates vary as to just how large the trade in global derivatives is, but the numbers are either in the tens or hundreds of trillions of dollars. Whatever the actual number, it is many times the total GDP of the world.
In theory, the notional amount of derivative positions is zero, since when a company takes one side of a transaction, there must be a company on the other side of the transaction. However, it does not take a genius to recognise that the global position may theoretically be zero, but within a company there may be some considerable imbalances and aggressive positions in play. Many informed commentators describe derivatives as being a gigantic risk to the global economy (information here).
Some stock exchanges also operate commodities markets (though the largest in the world is CBOT - the Chicago Board of Trade), money markets and currency markets. Thanks to entrepreneurial zeal and quirks of history, much of this happens through London, thanks to the eurobond market and LIBOR (the London Interbank Offered Rate).
The animal kingdom
Equity market prices tend to trade in one overall direction for some time. This is because an equity market is a reflection of the underlying companies and those companies are a reflection of the economy that they operate in. This is obviously a gross simplification in a world of multinational companies and globalisation, but it makes the ideas easier to understand.
Typically, if a Central Bank decides to use monetary policy to try and influence an economy any changes they make to interest rates will take between 18 and 24 months to have an impact. This is because an economy is a large - and generally - slow moving organism. Changing the course of an economy is much like changing the course of an ocean going liner - it takes time and distance.
As information speeds have increased and the world has become more connected, the words of the Governor of the Bank of England, or President of the Federal Reserve have an impact on markets without any actual rate changes. As time goes on, it seems more and more likely that real impacts to the underlying economy will only need words and not actions. Who knows how long this situation may last for? Basically, it is often faster and easier to talk about changing interest rates than it actually is to change them.
Considering this, it is often the case that the general trend of an equity market will be in place for many months, or more likely, years (information here).
When prices and valuations are rising and the economy is doing well, it is known as a bull market. In economic terms, this is the expansion phase.
When prices and valuations are falling and the economy is struggling to grow or shrinking in size, it is known as a bear market (information here). This would typically be the contraction phase in economic terms. A period of two (or more) consecutive quarters of negative economic growth is known as a recession. As and when there is a depression in place - there is typically one in place somewhere in the world at any time, currently Greece could be described as being in one - expect there to be a stock market crash or a very long period of falling prices. Depressions are very destructive to wealth, wherever it may be stored.
When size matters
The largest stock markets in the world are the ones that you have already heard of: the New York Stock Exchange (NYSE) and NASDAQ, both in America; the London Stock Exchange in England; and the Tokyo Stock Exchange in Japan.
Each has it's own leading index. An index is the collection of the biggest companies quoted on the exchange (in order of size as measured by market capitalisation). There are several very well known indices - these are the ones whose movements make it onto the evening news.
On the NYSE is the Dow Jones Industrial Average (DJIA) which makes up the largest 30 industrial companies.The index is named after the financial publisher, Dow Jones (publisher of the Wall Street Journal and Market Watch online), because of sponsorship. The S&P500 (obviously has 500 firms) and is named after the ratings agency, Standard and Poor's.
In London, the FTSE100 comprises the largest 100 companies and is named - in part - after the Financial Times. There are many other FTSE indices, 250, 500, Fledgling and on and on. Some of the other leading indices includes the CAC40 in Paris and the DAX (30 companies) in Frankfurt, Germany.
The companies quoted on these strange blurs of letters and numbers include many of the largest firms in the world. These are businesses that operate in multiple countries or on multiple continents, employ tens or hundreds of thousands of people and are very powerful economic forces. What they say and do matters. How and where they decide to deploy their assets can mean prosperity or destitution for communities and people.
These indices are important for many different types of contracts and benchmarking, but they are also useful shorthand for an amateur investor to glean some very basic information about the day's trading: did the index go up or down?
We all have images in our minds about the people atop the financial pyramid. Typically these images are based on something from the movies, characters such as Gordon Gekko from Wall Street or from The Bonfire of the Vanities.
While Gordon Gekko might have been written as a capitalist devil, he inspired a generation of fund managers, traders and financiers and helped to make financial markets far more ruthless. One does not need to be a cynic to suggest that the overall impact upon society of some of these ruthless financiers and traders is not positive.
There have been some very real casualties throughout the world as the primacy of global financial markets has been established. Typically, examples of financial ruin are contained within the financial services or investment banking sector, but the financial collapse of 2008 brought the dangers of Wall Street to the people of Main Street in a way that nobody will soon forget.
The 2008 crisis showed that financial literacy is something that everyone should take seriously. There are far too many people in society (worldwide) that only have a basic or lower understanding of personal finance, debt and investment and with markets being so interconnected this is not good. Well done for reading this far today!
However, very few of the real life Masters of the Universe are there simply because of their own brilliance. Mostly they sit atop a financial giant that has billions of dollars of assets under management and in play. Firms such as Goldman Sachs, an investment bank, have a history that stretches back well over 100 years and so are much bigger than any one person.
There are a few power players that have amassed enormous fortunes in their lifetime and head their own firms. One of the most famous examples of this is Steven Cohen, founder of SAC Capital Partners, a hedge fund. With a fund worth over $10 billion and a personal fortune estimated at over $8 billion, he is a true power player.
Another type of fund is a private equity fund. These do not typically have retail private investors (like you and I). Instead they are funded by very wealthy individuals and companies. Their job is to find undervalued companies and make a total purchase and take them private. They tend to use very high amounts of debt, forcing the firm to become "more efficient" because of the weight of the debt on the balance sheet. While this strategy seemed to work amazingly well for some funds in the 1990s and 2000s, the 2008 Wall Street crash was in large part related to borrowed money and a number of very large firms with histories stretching back many decades have been forced into bankruptcy by these abnormally high levels of debt.
There can be little denial that financiers have enormous power in the modern world. In almost every area of finance there are people whose decisions impact tens or hundreds of thousands of people. For example, there are many mutual funds with total assets under management of $1 billion or more. Equally, there are many pension funds of that size and larger. Due to the magnifying power of borrowed money there are many hedge funds with multiple billions under management.
Sitting a quantum level above these power brokers are sovereign wealth funds. These funds invest the savings of nations - typically a percentage of the national income from oil or natural gas revenues. Countries such as Norway, the United Arab Emirates and China have multiple hundreds of billions of dollars under management. Your author has read that it was believed that in 2010 Norway owned 2% of all stock market assets, worldwide!
While it is natural that those with the most money have the most assets, it is perhaps troubling that they are relatively unaccountable. Most hedge fund managers have a board of Directors and are guided by a Terms of Reference, but sometimes these are deliberately vague to allow them to invest wherever they see potential. Beyond that, they are subject to the laws of the land, but having arranged their corporate structure through multiple tax and privacy havens, the law has limits. Additionally, as we all know, prosecuting an individual with a personal fortune in the tens or hundreds of millions is not easy.
As for the sovereign wealth funds, often their investment decisions are made not only with returns in minds, but also with an eye on the geopolitical impact. It is not easy to reprimand or criticise an investment fund when that could turn into a diplomatic dispute...
The Government Pension Fund of Norway is renowned for considering ethics when making investment decisions, but most other sovereign wealth funds do not.
Despite these financial powerhouses, there is one name that is more important in the minds of investors than all others: Warren Buffett. With his business partner Charlie Munger, Warren Buffett has turned a former textile company called Berkshire Hathaway into one of the largest conglomerates in the world. This is thanks, in very large part, to their skill and decision making prowess (information here) as investors and asset allocators.
Buffett uses a variation on the theme of value investing (information here) originally developed by Benjamin Graham (author of The Intelligent Investor), with a twist from Philip Fisher. Based in Omaha, Nebraska, Buffett has managed to prove just about every investment maxim wrong during his career. He focuses on the merits and trading performance of the underlying business, placing little regard on the day-to-day movements of the stock price, Wall Street gossip or the economy at large.
He has bought many defensive stocks, typically when the stock market is undervaluing them focusing on the predictability of the future cash flow rather than looking for some exciting new technology that many growth stocks might be developing.
Buffett has been explaining his methods for years in interviews and his annual shareholders letters. He explains things in a very logical and understandable manner that makes everything seem easy and obvious. However, his strategy is anything but basic. There is a great deal of nuance and copying him has proved to be very difficult for other money managers.
Another of these certified immortals is Peter Lynch. For many years Lynch (information here) was the fund manager in charge of the mighty Fidelity Magellan Fund. He is also author of two very well regarded books about investment. His annual returns were almost as amazing as Buffett's earning him kudos from the investment community.
Lynch's books helped to grow his fame in part because he seemed to use equity market basics to guide his stock picking in a way that most of us could - in theory - replicate. Of course, if it were this simple we would all be millionaires! However, it does highlight that things can work without being too complicated and that there is very real value to learning the stock basics.
There are also a number of very successful and famous traders that have made very large personal fortunes from their skills. One, Steve Cohen is mentioned above. The first was Jesse Livermore, a long deceased legend in books about investing. Perhaps the number one financial trader of all time is George Soros. The record of his hedge fund was awesome and many aspire to be him.
However, Soros traded largely in the currency markets and is most famous for his assaults on sterling and the Italian lira. Others of his generation, such as Julian Robertson focused more on stock trading. These are people that were looking to make what are known as asymmetrical bets - where they used very large sums of money and believed that the downside was very limited, but the upside was potentially unlimited.
A very good book that describes these characters and their famous trades is called More Money Than God by Sebastian Mallaby and is about the history of hedge funds.
The rise of the machines
Despite their successes, the dramatic increase in computing power has had a profound impact on the world's stock exchanges and the way funds operate. At first the computing power was used to analyse lots of data and help determine which features or characteristics made up profitable trades and investments.
Then the exchanges began to computerise offering many more opportunities. The most obvious of these opportunities fell to stock brokerages. The brokers that dealt by telephone or perhaps even by post became dinosaurs. The advice that a broker or private wealth manager offered was in part due to the exclusivity of information. As the internet flattened this hierarchy of information and the same facts became available to the entire planet almost simultaneously, the informational advantage that many brokers relied upon dwindled.
In their place came trade only (or execution only) stockbrokers that traded only when an individual gave specific instructions. The firms that embraced this change and invested heavily in their technical abilities were able to take large market shares from the old style regional brokers. Firms such as Charles Schwab and eTrade now dominate this sector.
These days the use of computing power is huge in the many hedge funds of the world. Hedge funds now employ computer programmers to do similar work as firms like Google - write and code algorithms. These mathletes (as they are often known) use their math and computer skills to build software that scours the markets of the world for opportunities to trade. At first these algorithms were looking for options trading opportunities (arbitrage - buying and selling almost simultaneously to squeeze out a tiny sliver of profit).
Many still do this, but now the theories are much more complex. This is known as high frequency trading (information here) and it has had a dramatic impact on financial markets. Many of these systems buy and sell their positions within seconds - certainly under one minute - meaning that they are jumping in between the actual seller and a prospective buyer just before a trade and for long enough to extract a tiny amount of value. Unfortunately I cannot explain more than this, their world is very secretive as these algorithms are a means of potentially making hundreds of millions or billions of dollars per year and so very little is known about them apart from the general concepts.
Critics complain that high frequency trading (also known as HFT) increases volatility which may be true. The hedge funds reply that they provide liquidity, which may also be true, though if most trades only last for a matter of seconds, it would appear that there is someone ready to buy and sell already, suggesting that liquidity already exists. The subject is both complicated and secretive enough that very few people outside of these firms understands their terminology and even fewer know the truth.
Spreading the risk
For these investment heavy-hitters taking on risk is vital to their long-term performance. However, for most of us mere mortals investment risk is something that we might not be able to take much of.
For this reason there are many different types of collective investment vehicle that pool the money of many thousands of people into one pot and then invest in a wide range of assets. This enables the individual investor to gain 'market exposure' but without having a relatively large percentage of their personal net worth tied up in just one or two companies.
These types of fund are known as mutual funds (in the United States), unit trusts (in the United Kingdom) and SICAVs (in much of Europe). A similar type of fund but with a different investment perspective is an index tracking fund. A newer type of fund, exchange traded funds (known as ETFs) are also gaining popularity. Both index tracker funds and ETFs are popular (in part) because they have very low annual management fees. These are types of investment fund that are most likely to be recommended by a financial planner and ought to be suitable for the vast majority of potential investors. While these funds can offer some complex options, they are aimed to be simple and basic enough for the vast majority of people to understand.
If you are looking for a way to get started (information here) in your investment career, you could do worse than look into the funds offered by both Vanguard and Fidelity. Please do not take that as a recommendation, consider it as a great place to start your research. Both companies have very high reputations for their funds and are amongst the largest companies in the field.
For the very wealthy and risk tolerant investor, there are many hedge funds that cater to their investment needs. Hedge funds are at the other end of the scale to ETFs, they charge very high fees (typically 5% or more upfront to get money into the fund, then 2% annual management fee and a 20-25% annual performance bonus if the fund beats pre-set targets). As with private equity, hedge funds tend to use large amounts of borrowed money to juice their investment returns.
Knowledge is power
Access to information quickly is very important in financial markets.This has always been the case and always will be, which why publishing firms have traditionally been sponsors of bourses.
To this end, investment banks and other trading operations spend significant amounts of money on the latest equipment, news services and smart employees.
For those of us that are just investment part-timers, getting our daily news from the Wall Street Journal or Financial Times might be enough. For more up-to-the-minute coverage, the general public would typically use TV stations such as CNN, MSNBC or Fox News. Online, they might refer to Yahoo! Finance or Market Watch.
For the professionals, there is almost no limit to the lengths they will go for information. De rigeur in investment banking is a terminal from Bloomberg or Reuters. These have minute-by-minute updates about prices, market news and colour and constant stock tickers and are the multi-screen monsters that movies use to evoke the feel for a trading floor.
Sometimes this desire for the best information crosses the line of legality (as was brilliantly shown in the movie Wall Street by Charlie Sheen as Bud Fox). Insider trading, as it is known, is notoriously difficult to prosecute and can be very lucrative. However, since the 2008 Wall Street bailout, there has been significant political pressure to clamp down on financial markets (information here). There have been more prosecutions and convictions with the guilty being sentenced to substantial prison sentences to make a statement to Wall Street that insider trading on information is illegal and will be punished.
In the age of the smart phone, having an app that brings prices and latest news to your phone 24/7 is the norm and so the information cycle on markets is speeding up once again. This has become the latest decision making aid for individuals that are options trading or day trading. With wifi or internet access, it really is possible to trade global markets from a coffee shop!
Just two ways
There are only two ways to make money in financial markets as an investor. The first is to sell assets at a price higher than was paid to buy them. This would create an increase in the amount of capital, known as a capital gain.
The second is to hold the asset for some time, often many years, and receive a dividend income from the company. Either or both of an interim dividend and a final dividend can be paid by a company to shareholders. A shareholder must be an owner on a specific date to qualify. Dividend payments are normally made from the profits generated by the business. Some profit will be retained by the business and used to reinvest for growth, repay debt or other things, while a smaller amount will be paid to the owners.
If this sounds simple, it is. The basics usually are. It is, however, often overlooked by novices who buy stocks in depressed companies hoping for a turnaround in the trading of the company. Such companies are not paying a dividend and will struggle to improve their share price.
Companies that have a reputation for always paying a dividend are known as income stocks. They are often recommended to older investors that are seeking an income from their capital to replace some or all of their working income. There are many mutual funds whose sole purpose is to invest in such companies. While this does not sound particularly racy or exciting, it does tend to be profitable over the long-term.
Typically, companies that pay dividends every year have some sort of advantage in their business model and are strong earners. After all, they earn enough profit to reinvest some money (hopefully profitably), conduct things like stock buybacks before they pay anything to investors.
The rise of the individuals
Those using this knowledge to trade are often day trading. There are many day trading strategies, the overall concepts are similar to the high frequency trading algorithms mentioned earlier, with the exception that they are typically operated by the individual! Needless to say, day traders operate in a world that uses a very different range of stock market terms than the rest of us do.
For various reasons, the large number of small, high growth technology companies listed being the main one, NASDAQ is the centre of the day trading world. The QQQQ is traded in extraordinary quantities by individuals. Many of the main day trading strategies involve following the stock ticker and what is known as Level 2 information to see the direction a company is trading in at that moment and where there are buyers waiting to purchase. By jumping in the middle, it is possible to squeeze out gains. By using leverage (borrowed money) and trading on margin, it is possible to magnify these returns.
Hot stocks that are rising quickly are also a favourite of day traders. Typically these are very small companies - often referred to as penny stocks (or penny shares in the UK) - and can make major price moves when positive news is released.
Once an investor moves into the world of options trading or day trading there is a huge leap in understanding the stock market required and a whole new world of baffling stock market terminology. You have been warned.
For a few years in the 2000s, during what was a raging bull market, there were many thousands of people across America that gave up their jobs and simply day traded for a living using their savings as the seed capital to get started. This is a very high risk - and probably very stressful - way to make a living, but for many it beat a daily commute and reporting to a boss they did not like. As the 2008 stock market crash caused mayhem around the world many were wiped out (information here) and left trading to return to more normal occupations.
Risk management always has been and always will be one of the key skills in investment. Your author is willing to bet that many of these day traders presumed that they were above such matters.
To give an insight into the required mindset of a day trader, your author has a friend that trades on NASDAQ and NYSE very frequently. He is based in Europe, but still chooses to trade in the US, or in oil. For him, it is a catastrophe if he holds a position overnight. The potential for change in the morning prices because of global news overnight terrifies him. The idea of holding a position over a weekend is simply unthinkable. In fact, he never trades after lunch on a Friday to ensure that it cannot happen.
This is clearly a very different mindset to the rest of us who buy stocks and plan to hold on to them for "a few years", or Warren Buffett who considers some positions to be "permanent".
My friend describes the use of leverage in his trades thus, "It's all madness, sometimes I am geared 99 to 1. If it goes wrong, I'm dead."
It seems that day trading is a very serious business indeed. Not for the faint of heart...
Buy long, sell short
When making an investment, there are only two ways to go, either buy or sell. These are known as being long (expecting prices to rise) or selling short (expecting prices to fall).
As might be expected, the vast majority of all business is on the long side. Pension funds, mutual funds and most direct retail investors are making some sort of bet on an improving future for the company, sector or country in question. Buying and hoping for a price rise and a dividend income is the natural order of business in the stock market.
However, it is clearly silly to believe that all prices will simply rise forever. If this is true - and it is - then it must be possible for people to take a position expecting price falls. This is short selling and it generally involves borrowing stock in the market and then buying it back at a lower price in the future (presuming that price does indeed fall).
This is a more complex trade than most investors will ever make and since the global 2008 stock market crash and Wall Street bailout it is actually illegal to sell short in a number of countries. Selling short (information here) is also something that few people have much experience in, including most financial advisers. Therefore, you will probably need to take full responsibility for such a position yourself and learn the mechanics in advance.
There are other, more simple, ways to sell short including options trading and spread betting. However, these are typically very high-risk and substantial preparation is advised before undertaking such positions.
There are a number of investment funds that enable investors to take a downward position. These are known as bear funds and in theory are a good idea for diversification. However, if the market trend is upwards, investors in these funds tend to take something of a beating.
For investors that believe that prices are likely to fall, corporate or government bonds and gold are other traditional asset classes. These are often referred to as safe havens and when volatility is high and prices are falling, positions are often switched out of risky assets and into these safer assets.
A risky business
There is a paradox in investment. Most potential investments are classified with regards to their expected risks. Despite this, most retail investors seem to overlook the risks being taken and focus solely on the potential returns. A professional asset allocator (information here) will generally do exactly the opposite.
It is the job of pension fund managers to invest in a very wide range of assets and try to diversify away much of the risk. These pension fund managers are not investing in the stock market for dummies but for people who have no interest to learn or understand these stock market terms.
There are many pension funds with assets under management of $1 billion or more - these are very powerful forces in the ways and movements of the markets.
Mutual funds and unit trusts are typically given some sort of risk rating to guide potential investors. For simplicity these are usually broken down into three main groups:
High risk / Adventurous / 60-40
Medium risk / Balanced / 50-50
Low risk / Cautious / 40-60
The numbers above relate to the suggested weightings between stock market and bond investments. This is clearly a simplistic approach aimed at the masses and not a sophisticated investor. However, we should probably all start with an approach that is as basic as this.
There are a number of different theories for how an investor should allocate money using these guidelines. These typically relate to the age / net worth / existing assets of the investor. After years of working in and reading about investments, I am of the opinion that these guidelines are philosophical - so much relates to the mindset and risk tolerance of the individual that there can be no absolute right or wrong answer.
There are, of course, situations at the extreme where something is obviously misguided - for example, a 63 year old, who is planning to retire and wants to invest his or her entire net worth in shares would seem to be wrong. When investing in the stock market terms of ownership can be very important. It would be wise to let your financial planner help guide you on the matter of asset allocation (information here).
Typically, the risk profile is linked to time. Most equity investments are considered to be risky enough that the investor should be prepared to hold them for the medium to long-term. The medium-term is usually classified as being in the region of five years. The reason for this is that valuations and prices fluctuate on equity markets and it is possible that the current stock quotes fall below the original purchase price. The investor might need to hold on for some time before prices rise above the level of the purchase price.
This is, of course, a gross simplification of the situation, stock market 101 if you will. It is very possible that the investor has purchased a lemon and the price may never rise again! These kinds of mistakes are less likely when buying into a mutual fund or other collective investment scheme.
Much of this theory was called into question in late 2014 when Anthony Robbins published a book called Money: Master The Game. In the book he interviewed hedge fund manager Ray Dalio - widely acknowledged as one of the most successful asset allocation investors of all time. While his approach seems basic and simplistic because he is able to explain it so clearly, very few have been operating as he does.
His portfolio described a much lower allocation into stocks than most people would expect, because the risks are much higher in stocks than a 60/40 or 50/50 ratio can cope with. He also allocates a small percentage to both commodities and gold.
Two factors made his portfolio stand out: good long-term annual returns and lower than average volatility. These are factors that ought to be the holy grail for most private investors. For a full explanation, the book is highly recommended and written in such a way - both basic in places and using lots of metaphors - that it ought to be accessible to the majority of people in society.
When buying stocks direct in the market, private investors need some form of stockbroker (information here) to match both sides of the trade. This might be done over the telephone, or more likely, online.
While the price of a stock might be quoted in the daily newspaper with one number, in reality there is more than one number. The bid/offer spread are the prices at which the parties are brought together. The gap in between the two is taken as a fee by the broker.
The 'bid price' is being offered to entice you to sell your holdings. The offer price is being 'offered' to you to make you want to purchase.
Large companies with lots of daily transactions will have lots of brokers covering them and there will be competition amongst prices. This competition reduces the spread (their profit). These firms with lots of transactions are considered to be highly liquid - it is easy to buy and sell.
In smaller, illiquid company stock, there will be fewer transactions, fewer brokers and much higher spreads. It may not even be possible to complete a trade in the very smallest firms, simply because there are not enough people on the other side of your transaction.
There are actually brokers operating in all areas of a securities market. For example, your author has a close friend that works as a broker for a boutique investment house on their "Delta One Hedging" desk. Exactly... In the market slang of the City of London, these people are "bookies" - operating in the middle.
There are many theories about how and why prices move as they do. Mass psychology and herd behaviour certainly plays a part. However, there is a very well regarded theory, the Efficient Market Hypothesis, that suggests that all price movements are random and impossible to predict. The creator of this theory Eugene Fama is a university professor of great renown.
It was Fama that first coined the phrase "random walk" as it relates to stock prices in his PhD. It was in an article in 1970 that he proposed the Efficient Market Hypothesis and markets have not been the same since.
There are many academic papers that back up this theory and expand upon it. There are also many papers that try and debunk it. There are also people like Warren Buffett and Peter Lynch (information here) that have generated outsized returns that the theory suggests are impossible. For most investors, this is a debate which will bring them little benefit. It is interesting to read about though and learn to understand some of the mathematical background to much of the modern algorithmic trading.
In an area as complex as finance and capital markets, it would be very easy for knowledgeable insiders to perform small tricks that separate investors from their money. Needless to say, there has been a lot of that in the history of financial markets!
Thus, the regulations that oversee the stock exchange are complex and growing all the time, mostly for the protection of investors. In the United States regulation is mostly conducted by the Securities and Exchange Commission (SEC). There are some other agencies that have powers, but the SEC is the main driver. In the United Kingdom the Financial Services Authority (FSA) is in similarly in charge.
As mentioned above, since the 2008 Wall Street meltdown there have been a number of successful insider trading cases brought to trial, information about the most important of those can be found here.
The government's share
There are taxes to pay in all major jurisdictions (information here) either at purchase (normally known as Stamp Duty), on dividend income or at sale on any capital gains. The range of potential taxes can be a little mind-numbing, so individual investors are best advised to research their own specific situation in the country in which they reside with a qualified tax or financial professional.
The avoidance of these taxes provides opportunities for some financial firms because of the jurisdiction in which they are based. We have all heard of Swiss banks, for example. However, there are a number of countries that are not "tax havens" per se because they do charge income and capital gains tax to their residents. However, some locations act as asset havens, meaning that some transactions receive special tax treatment under the law.
Perhaps the largest of these asset havens is the United Kingdom. A very successful part of the City of London is the eurobond market where there are no transaction taxes. Similarly, the tiny state of Luxembourg offers certain types of funds advantageous tax treatment, which is why so many fund management companies are based there. Some other famous examples (with their own special benefits) include the Channel Islands and Isle of Man (both off the UK) and Bermuda. It is not by accident that so many hedge funds establish parts of their businesses in these tiny jurisdictions - and it is not so that they can visit once per year and claim the travel costs as a business expense...
These jurisdictions also help to lower the legal burdens faced by some funds and companies. By using different locations for different elements of their business, it becomes very hard to oversee their operations. This has been cited as a contributing cause to the 2008 financial crisis (there are trillions of dollars of derivatives located out of sight offshore). Hedge funds use these tricks most successfully, but investment banks and even high street banks use asset havens as a fundamental part of their business. This picking and choosing of locations is known as regulatory arbitrage and financial regulators in the US and EU are doing their best to remove many of the differences between their new legislation.
It is worth noting that most of these asset havens do not have a major stock exchange or financial market themselves. They are simply a home and conduit location in the global money management machine by virtue of their willingness to help companies and individuals pay less tax elsewhere.
Clearly, no stock market glossary can ever be complete. The range of terms and concepts that underpin a modern stock exchange are incredibly large and growing. However, we hope that this guide to the stock market basics helps to set you on the right path to learning.