The stock market is a scary, complex place – or so most financial advisors would prefer you believe. Financial jargon and abbreviations get tossed around to create authority. Hopefully this article will help readers feel less like stock market dummies and more like prudent investors. Financial literacy is the key to holding your own against the “smartest” financial guy in the room. Don’t let the second home and fancy car fool you, a lot of financial advisors are empty suits.
Whether you’re a first-time investor or have been investing for many years, there are some basic finance fundamentals you should always understand before committing your hard-earned money to an investment. As a culture, Americans give blind credit to people with lots of letters behind their names who promote safe investments with guaranteed returns. As the old saying goes, “If it sounds too good to be true, it probably is.” There is no such thing as a safe investment nor can anyone predict the future of stock returns. Arming oneself with those two golden rules is a key step toward investing like a pro.
Bulls and Bears
If ever you catch an episode of Jim Cramer’s Mad Money, you will see stuffed bears being tossed around and animated bulls charging across the screen. A stock market dummy may get confused and think they landed on The Disney Channel instead of CNBC, but the bull and bear concept is pretty easy:
- Bears hibernate during the winter which creates an idea of rest or decline. In the case of stocks, a bear is a stock predicted to decline or hibernate.
- Bulls charge and snort, tossing their horns upward! In the case of stocks, a bull is a stock predicted to increase or charge upward!
“Large Cap,” “Small Cap.”
The idea of owning a diversified mix of large, mid, and small “cap” stocks is crucial to portfolio returns. But stock market dummies may find this confusing. Market capitalization has little to do with trucker hats and everything to do with company net worth.
- Companies with large market capitalization may include the likes of 3M, GE, and Coca-Cola. The Grand Pu-bahs. By definition “large cap” refers to any company with $10 billion (with a B) or more.
- Companies with medium market capitalization include Starbucks and Jewel/Osco. A mid-cap company has an estimated market value between $2 billion – $10 billion.
- Companies with small market capitalization may be less recognizable. Biotechnology and online websites exist in the small cap space. Companies with market value under $2 billion fall into the small cap sector of the stock market.
It should be noted in this section that Wal-Mart didn’t enter the large-cap space overnight, it had to grow to get there. Starbucks is a great example of a company recently promoted to mid-cap from small-cap. Public opinion of Starbucks currently supports that promotion. As companies grow (or shrink) their market value fluctuates.
There is truly no such thing. As a stock market dummy, turned prudent investor, it is important you understand some key reasons why safe investments do not exist. The potential for greater returns comes with greater risk. Understanding this crucial trade-off between risk and reward can help you separate legitimate opportunities from unlawful schemes. Financial literacy will stop investing dummies from walking into a bad idea. Investments with greater risk may offer higher potential returns, but they may expose you to greater investment losses. Keep in mind every investment carries some degree of risk and no legitimate investment offers the best of both worlds. Here are five reasons why no investment is safe:
- Market Risk, also the most familiar risk for stock market dummies. Market risk expresses volatility of the stock market.
- Systematic Risk, or the effect of a large scale political event on the stock market.
- Unsystematic Risk, a small event that could have a large impact such as a union labor strike.
- Default Risk, is the risk that a company will be unable to pay its bills.
- Foreign-Exchange Risk, when global currencies decline or increase.
- Political Risk, which can be seen in developing countries with fragile government policies.
Guaranteed Stock Market Return
I know the Seahawks won the Super Bowl last year, but I cannot predict who is going to win next year with complete certainty. Same goes with financial advisors predicting future stock returns. He or she may know which stock performed well in the past, but that fact is zero indication of the future. FINRA, the governing body of stock brokers, established a rulebook registered advisors must play by. In this playbook exists many regulations concerning advisors making promises they cannot keep, namely guaranteed stock market returns.
Whether checking out an investment professional, researching an investment, or learning about new products or scams, unbiased information can be a great advantage to stock market dummies. Learning how to invest safely can assist you in reaching your financial goals and will mean a huge difference in your retirement years.