The stock market is arguably the best wealth creator in the world, yet it remains one of the most elusive and confusing concepts for many Americans.
The Financial Industry Regulation Authority offers a five-question financial literacy quiz that tests basic financial concepts, such as risk, interest, and financial instrument relationships. As FINRA notes, just 24% of millennials were able to answer four or five questions correctly -- essentially a passing grade. This is a scary reminder that few of America's young adults are truly prepared for retirement, or even investing at all.
Seven concepts and terms all investors should know
With that in mind, we're going to focus on a handful of stock market basics today by looking at seven concepts and terms that all prospective investors should understand before investing a dime of their hard-earned money.
1. Bull market vs. bear market
These are perhaps the two most common terms thrown around when discussing the stock market, but that doesn't mean prospective investors truly understand what they mean.
By definition, a bull market is just a 20% (or greater) rise in stock market indexes (often the broadly followed S&P 500 or Dow Jones Industrial Average) from a recent low. It's meant to signify a growing U.S. economy. Conversely, a bear market represents a downtrend of 20% or more from a recent high-water mark in the indexes, and could be indicative of an upcoming or current recession in the economy.
Prospective investors should understand that these terms are somewhat arbitrary, but never hurts to understand where investor sentiment lies.
2. Short-selling, or short-sale
In my nearly 17 years of investing there's probably no term I get questioned about more than "short-selling" (or "short-sale").
Consumers are typically comfortable with the concept of buying a stock and betting that the value of their shares will rise over time. If the stock price moves up you make money, while if it moves lower you lose money.
However, there's a completely different side to trading that you may not be aware of. Short-selling allows you to bet against a stock, such that if its price goes down you make money, while if it rises you lose money. Your broker will sell shares of stock, either from its own account or the account of one of the firms' customers. This sale and the proceeds are credited to your account until you buy back the same number of shares (which is known as a "buy to cover" trade) to close the position.
One thing to remember, though, is that while your losses are limited to 100% when buying a stock, and your profit potential is unlimited, a short-sale allows a maximum profit of 100% (stock prices don't drop below $0) and unlimited loss potential -- so choose your bets wisely!
3. Growth stock vs. value stock
Among stock market basics, one of the toughest decisions you'll need to make as an investor is determining what your risk tolerance is. If you're younger you're more liable and willing to take risks while investing, while older adults are more likely to focus on capital preservation and safer investments. This is where an understanding of growth stocks versus value stocks comes into play.
A growth stock is usually going to be volatile relative to the broad-market indexes, and its growth is often tied to the health of the U.S. economy. Growth stocks are typically found in sectors like technology and biotechnology. Growth stocks de-emphasize dividend payments in exchange for reinvesting their cash flow back into their business. They usually come with a lot of risk, but they pay the greatest rewards when successful.
On the other hand, value stocks are perceived to be far less volatile than growth stocks. Instead of huge growth prospects, value stocks are usually mature businesses with steady growth prospects that emphasize shareholder yield (dividends plus share buybacks) over rapid business expansion. By name, value stocks are also valued attractively relative to both peers and the overall market.
4. Dovish vs. hawkish
It's possible you may have heard the stock market terms "dovish" and "hawkish" uttered before, but I'd be willing to bet more people than not aren't familiar with these words.
In simple terms, dovish and hawkish refer to the Federal Reserve's consensus opinion on where lending rates are likely to head next. Though the Federal Open Market Committee doesn't directly set interest rates, it does influence them by setting the federal funds target rate and the discount rate that banks charge to borrow and lend from one another.
A "dovish" view implies the Fed has taken a favorable stance on lending rates and/or is offering policies suggestive of long-term low interest rates. Conversely, a "hawkish" view implies the Fed is taking a stance that's suggestive of a rising interest rate environment. Over the past six-plus years the Fed's stance has been firmly dovish, helping to spur lending by banks and consumers, but a Fed Funds target hike seems to be in the offing with the U.S. economy on the mend and the unemployment rate falling.
5. Inflation vs. deflation
These terms refer to the effect that consumers are seeing on the prices of the goods and services they buy. Inflation refers to the rising price of goods and services, while deflation refers to a situation where the prices of the things we buy are falling. Typically this only happens during a recession.
As you might imagine, falling prices allow consumers to buy more, which for a short time can be a positive for the economy (and consumers' wallets). However, lower prices also mean generally weaker profitability for businesses, and can potentially lead to less hiring and business expansion. You'll find economists arguing to no end as to what level of inflation/deflation is ideal, but in general low levels of inflation tend to be best for businesses, the economy, and the consumer in general.
6. Ex-dividend vs. record date vs. date of payment
Chances are good that if you invest in individual stocks, or even ETFs, at some point you're going to receive a dividend payment. However, there are so many terms and dates involving dividend payments that it can be somewhat confusing for relatively new investors.
Once a dividend has been declared by a company in your portfolio the next important date is the ex-dividend date. This is the second business day before the record date, and is the first day on which a stock will trade without its dividend. For example, let's assume a fictitious stock is paying a $1 quarterly dividend and it closed at $40 per share the previous day. When it opens for trading on the ex-dividend date it'll open at $39, since the $1 has been removed for the upcoming dividend payment.
The record date is nothing more than the date on which companies reconcile their shareholder list to determine which shareholders will receive the dividend payment.
Finally, the date of payment is exactly what it sounds like: the day the dividend is actually paid to shareholders who are entitled to receive it. In order to receive a dividend you'll need to buy a stock at least three business days before the record date.
7. "Sell in May and go away"
There is a long-standing belief among investors that the stock market tends to be cyclical, and that selling your holdings in May could be a wise idea.
As the idea goes, the holiday season incites consumers to buy, pushing up economic growth and stock prices. However, when May rolls around (and the nice weather hits) this belief suggests it's time to sell your stocks and head for the hills. Also referred to as the "summer doldrums," the summer months translate into warmer weather and less trading volume, since Wall Street traders and consumers are on vacation.
Although this theory is bound to prove true once in a while, trying to time the market over the long-term is rarely worthwhile. Selling in May over the last couple of years would have resulted in you missing out on substantial market gains. Thus, while this particular phrase could signify the beginning of a drop-off in overall trading volume, it should have little bearing on your investing thesis.
Understanding these stock market basics may not make you the next Warren Buffett, but being in the know should put you on the right track to taking charge of your investments.