Basics of Stock Trading: How Do Investors Choose Stocks?
You’ve likely heard about the recent drama involving GameStop, but unless you’re familiar with how the stock market works, the intricacies of what’s going on may have been lost on you.
And if that’s the case, we don’t blame you—the world of investing can feel like an intimidating place, especially if you’re relatively new to the scene. So for those looking to learn the basics of stock trading, this video by TED-Ed is a good place to start.
We touch on some key takeaways from the video below, like why stock prices fluctuate, how investors choose which stocks to purchase, and differences between active and passive investing.
Stocks, and Why Prices Fluctuate
If you’re still reading this, we’re going to assume you’re fairly unfamiliar with the world of stocks. So let’s start with the basics—what even is a stock?
A stock is a partial share of ownership in a company. Units of stock are called “shares,” and these are mostly traded on stock exchanges, like the New York Stock Exchange (NYSE) or Nasdaq.
The price of a stock is determined by supply and demand, or the number of buyers versus sellers. When there are more buyers than sellers, the price increases. On the flipside, if there are more sellers than buyers, the price goes down.
Essentially, a company’s stock price is a reflection of how much investors think a company (or a portion of a company) is worth. That’s why a company doesn’t actually need to make profit to be valued by the market—investors simply need to have faith that it’ll become profitable eventually.
Because of the speculative nature of stocks, prices can fluctuate quickly and drastically, depending on public perceptions.
Passive Investors vs. Active Investors
So how do investors choose which stocks to purchase? Well, there are two main styles of investing—active and passive:
- Active investors try to beat the market by purchasing shares they believe are undervalued, with the intent to sell once price goes up
- Passive investors track the market, and tend to hold onto their stocks with the belief that over time, their value will increase
In the U.S., there’s a fairly even number of passive versus active investors—in 2019, about 45% of assets in U.S. stock funds were managed passively.
And while active investors have the potential to make a lot more money, passive investments have generally shown higher returns in the last decade.
Active Investors: Picking a Stock
Despite the risk involved (or perhaps because of it) many investors choose to actively manage their stocks. To assess a company’s potential value, and ultimately find undervalued stocks, an active investor may:
- Investigate a company’s business operations
- Review its financial statements
- Track price trends, with the goal of finding a company that’s undervalued
An active investor may also choose to put money in one or more actively-managed funds, or simply hire a financial planner to do the work on their behalf.
Finding your Comfort Zone
Since there are pros and cons to both styles of investing, how you decide to invest, and where you fall on the investment continuum, ultimately depends on your expectations, risk tolerance, and long-term goals.
It’s also worth noting that these investment styles aren’t mutually exclusive—a combination of both can be used in order to cover all your bases.
The 20 Most Common Investing Mistakes, in One Chart
Here are the most common investing mistakes to avoid, from emotionally-driven investing to paying too much in fees.
The 20 Most Common Investing Mistakes
No one is immune to errors, including the best investors in the world.
Fortunately, investing mistakes can provide valuable lessons over time, providing investors an opportunity to gain insights on investing—and build more resilient portfolios.
This graphic shows the top 20 most common investing mistakes to watch out for, according to the CFA Institute.
20 Investment Mistakes to Avoid
From emotionally-driven investment decisions to paying too much on fees, here are some of the most common investing mistakes:
|Top 20 Mistakes||Description|
|1. Expecting Too Much||Having reasonable return expectations helps investors keep a long-term view without reacting emotionally.
|2. No Investment Goals||Often investors focus on short-term returns or the latest investment craze instead of their long-term investment goals.
|3. Not Diversifying||Diversifying prevents a single stock from drastically impacting the value of your portfolio.
|4. Focusing on the Short Term||It’s easy to focus on the short term, but this can make investors second-guess their original strategy and make careless decisions.
|5. Buying High and Selling Low||Investor behavior during market swings often hinders overall performance.
|6. Trading Too Much||One study shows that the most active traders underperformed the U.S. stock market by 6.5% on average annually. Source: The Journal of Finance
|7. Paying Too Much in Fees||Fees can meaningfully impact your overall investment performance, especially over the long run.
|8. Focusing Too Much on Taxes||While tax-loss harvesting can boost returns, making a decision solely based on its tax consequences may not always be merited.
|9. Not Reviewing Investments Regularly||Review your portfolio quarterly or annually to make sure you’re staying on track or if your portfolio is in need of rebalancing.
|10. Misunderstanding Risk||Too much risk can take you out of your comfort zone, but too little risk may result in lower returns that do not reach your financial goals. Recognize the right balance for your personal situation.
|11. Not Knowing Your Performance||Often, investors don’t actually know the performance of their investments. Review your returns to track if you are meeting your investment goals factoring in fees and inflation.
|12. Reacting to the Media||Negative news in the short-term can trigger fear, but remember to focus on the long run.
|13. Forgetting About Inflation||Historically, inflation has averaged 4% annually.
Value of $100 at 4% Annual Inflation
After 1 Year: $96
After 20 Years: $44
|14. Trying to Time the Market||Market timing is extremely hard. Staying in the market can generate much higher returns versus trying to time
the market perfectly.
|15. Not Doing Due Diligence||Check the credentials of your advisor through sites like BrokerCheck, which shows their employment history and complaints.
|16. Working With the Wrong Advisor||Taking the time to find the right advisor is worth it. Vet your advisor carefully to ensure your goals are aligned.
|17. Investing With Emotions||Although it can be challenging, remember to stay rational during market fluctuations.
|18. Chasing Yield||High-yielding investments often carry the highest risk. Carefully assess your risk profile before investing in these types of assets.
|19. Neglecting to Start||Consider two people investing $200 monthly assuming a 7% annual rate of return until the age of 65. If one person started at age 25, their end portfolio would be $520K, if the other started at 35 it would total about $245K.
|20. Not Controlling What You Can||While no one can predict the market, investors can control small contributions over time, which can have powerful outcomes.
For instance, not properly diversifying can expose you to higher risk. Holding one concentrated position can drastically impact the value of your portfolio when prices fluctuate.
In fact, one study shows that the optimal diversification for a large-cap portfolio is holding 15 stocks. In this way, it helps capture the highest possible return relative to risk. When it came to a small-cap portfolio, the number of stocks rose to 26 for optimal risk reduction.
It’s worth noting that one size does not fit all, and seeking financial advice can help you find the right balance based on your financial goals.
Another common mistake is trading too much. Since each trade can rake up fees, this can impact your overall portfolio performance. A separate study showed that the most active traders saw the worst returns, underperforming the U.S. stock market by 6.5% on average annually.
Finally, it’s important to carefully monitor your investments regularly as market conditions change, factoring in fees and inflation. This will let you know if your investments are on track, or if you need to adjust based on changing personal circumstances or other factors.
Controlling What You Can
To help avoid these common investing mistakes, investors can remember to stay rational and focus on their long-term goals. Building a solid portfolio often involves assessing the following factors:
- Financial goals
- Current income
- Spending habits
- Market environment
- Expected returns
With these factors in mind, investors can avoid focusing on short-term market swings, and control what they can. Making small investments over the long run can have powerful effects, with the potential to accumulate significant wealth simply by investing consistently over time.
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