Stocks
Understanding equity investments and how to own pieces of companies.
What Are Stocks
When you buy stock, you own part of a company.
Ownership rights:
- Share of profits (dividends)
- Voting rights (usually)
- Claim on assets if company liquidates
- Price appreciation if company grows
How Stocks Make Money
| Source | Description |
|---|---|
| Capital gains | Sell for more than you paid |
| Dividends | Company distributes profits to shareholders |
| Total return | Capital gains + dividends |
Historical returns: US stocks have returned ~10% annually over the long term (7% after inflation).
Stock Market Basics
Major US Exchanges
| Exchange | Description |
|---|---|
| NYSE | New York Stock Exchange, largest by market cap |
| NASDAQ | Technology-heavy, electronic exchange |
Market Indexes
Indexes measure performance of a group of stocks:
| Index | What It Tracks |
|---|---|
| S&P 500 | 500 largest US companies |
| Dow Jones | 30 large "blue chip" companies |
| NASDAQ Composite | All NASDAQ-listed stocks |
| Russell 2000 | 2,000 small-cap stocks |
| Total Stock Market | All US stocks |
Why they matter: Indexes are benchmarks. If you can't beat the index, just buy the index.
How Prices Are Set
- Buyers bid, sellers ask
- Price is where they agree
- More buyers than sellers → price rises
- More sellers than buyers → price falls
Stock price reflects: Expectations about future earnings, discounted to present value.
Types of Stocks
By Company Size (Market Cap)
| Category | Market Cap | Characteristics |
|---|---|---|
| Large cap | $10B+ | Stable, slower growth, often pay dividends |
| Mid cap | $2B-$10B | Balance of growth and stability |
| Small cap | $300M-$2B | Higher growth potential, more volatile |
| Micro cap | Under $300M | Highest risk, least liquid |
By Investment Style
| Style | Characteristics | Example |
|---|---|---|
| Growth | High earnings growth, reinvest profits | Amazon, Tesla |
| Value | Underpriced relative to fundamentals | Banks, utilities |
| Blend | Mix of growth and value | S&P 500 |
By Dividend
| Type | Dividend Yield | Focus |
|---|---|---|
| Growth stocks | 0-2% | Price appreciation |
| Dividend stocks | 2-4% | Income generation |
| High-yield | 4%+ | Maximum income (higher risk) |
By Geography
| Category | Coverage |
|---|---|
| Domestic | US companies |
| International developed | Europe, Japan, Australia |
| Emerging markets | China, India, Brazil, etc. |
Valuation Basics
Key Metrics
| Metric | Formula | Meaning |
|---|---|---|
| P/E Ratio | Price / Earnings per share | How much you pay per dollar of earnings |
| P/B Ratio | Price / Book value | Price relative to assets |
| Dividend yield | Annual dividend / Price | Income as % of price |
| PEG Ratio | P/E / Earnings growth rate | P/E adjusted for growth |
Understanding P/E Ratio
| P/E | Interpretation |
|---|---|
| 10-15 | May be undervalued or slow-growing |
| 15-20 | Fair value for average company |
| 20-30 | Growth expectations priced in |
| 30+ | High growth expected or overvalued |
Context matters: Tech companies often have higher P/Es than utilities.
What Drives Stock Prices
Long-term:
- Earnings growth
- Competitive advantages
- Industry trends
- Management quality
Short-term:
- News and sentiment
- Economic data
- Interest rates
- Speculation
Individual Stocks vs. Funds
Individual Stock Picking
Pros:
- Potential to outperform market
- Control over what you own
- No management fees
- Can be interesting
Cons:
- Most people underperform indexes
- Requires significant research
- Concentration risk
- Emotional decision-making
Index Funds
Pros:
- Instant diversification
- Very low costs
- Beat most active managers
- No research required
- Tax efficient
Cons:
- Only market returns
- Own everything (good and bad)
- No excitement
Recommendation: Most people should use index funds for the bulk of their portfolio.
If You Pick Individual Stocks
What to Look For
| Factor | Why It Matters |
|---|---|
| Competitive moat | Sustainable advantage over competitors |
| Strong financials | Low debt, good cash flow |
| Quality management | Aligned with shareholders |
| Reasonable valuation | Don't overpay for growth |
| Understandable business | Know what you own |
Red Flags
- Excessive debt
- Declining revenue
- Management selling shares
- Accounting irregularities
- No clear competitive advantage
- You don't understand the business
Position Sizing
- Never put more than 5-10% in single stock
- Even high-conviction picks can fail
- More positions = less impact from any one failure
Practical Stock Investing
Dollar-Cost Averaging
| Lump Sum | Dollar-Cost Average |
|---|---|
| Invest all at once | Invest fixed amount regularly |
| Historically better returns | Reduces timing risk |
| More emotional difficulty | Easier psychologically |
For most people: DCA works better because it's easier to stick with.
When to Sell
Good reasons to sell:
- Company fundamentals deteriorated
- Better opportunity for the money
- Need to rebalance
- You need the money
Bad reasons to sell:
- Price dropped (may be time to buy more)
- Price went up (winners can keep winning)
- General market fear
- Short-term news
Tax Considerations
| Holding Period | Tax Rate |
|---|---|
| Less than 1 year | Ordinary income (up to 37%) |
| More than 1 year | Long-term capital gains (0-20%) |
Strategy: Hold winners more than a year when possible.
Common Mistakes
| Mistake | Better Approach |
|---|---|
| Chasing hot stocks | Buy based on fundamentals, not momentum |
| Selling in panic | Have a plan before volatility |
| Checking daily | Check quarterly at most |
| Overtrading | Buy and hold, minimize transactions |
| All in one stock | Diversify broadly |
| Ignoring fees | Keep costs minimal |
| Market timing | Stay invested, don't try to predict |
Building a Stock Portfolio
Core-Satellite Approach
Core (80-90%): Low-cost index funds
- Total US stock market
- International stocks
Satellite (10-20%): Individual picks (if any)
- Companies you understand
- Position sizing discipline
Sample Allocation
| Component | Allocation |
|---|---|
| US total market index | 50% |
| International index | 30% |
| Individual stocks | 20% |
Adjust based on your knowledge and interest in stock picking.
Key Takeaways
- Stocks = ownership - You own part of real businesses
- Long-term focus - Stocks are volatile short-term, reliable long-term
- Index funds win - Most stock pickers underperform
- Diversification protects - Don't concentrate in few stocks
- Costs matter - Keep expense ratios low
- Understand what you own - Don't buy what you don't understand
- Emotions are the enemy - Have a plan, stick to it