Investor Education
Stock Market Basics: How Do Investors Choose Stocks?
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.
Investor Education
Visualized: A Step-by-Step Guide to Tax-Loss Harvesting
In Canada, tax-loss harvesting allows investors to turn losses into tax savings. This graphic breaks down how it works in four simple steps.
A Step-by-Step Guide to Tax-Loss Harvesting
Market ups and downs can be unnerving, but the good news is that tax-loss harvesting allows investors in Canada to capture tax savings when their portfolio drops in value.
While it sounds complicated, a tax-loss harvesting strategy is actually fairly straightforward. An investor can use capital losses to offset capital gains found elsewhere in their portfolio, leading to a lower tax bill. While there are important conditions to keep in mind, investors can use this strategy to enhance portfolio returns over time by reinvesting these tax savings.
This graphic from Fidelity Investments shows how tax-loss harvesting works and why it may improve tax efficiency in an investor’s portfolio.
Breaking It Down
Consider a person who invested $50,000 in a mutual fund held in a non-registered account that has dropped by $10,000 in value. To help minimize losses, they took the following steps in a tax-loss harvesting strategy.
For the sake of this example, taxes are based on the maximum federal rate and the average maximum provincial tax rate.
- Sold investment with a $10,000 loss
- Invested $40,000 into a different mutual fund
- Used the $10,000 capital loss to offset capital gains realized elsewhere in the non-registered portfolio
- Achieved up to $2,550 in tax savings
The investor realized as much as $2,550 in tax savings by utilizing a $10,000 loss against a $10,000 capital gain. Without tax-loss harvesting, this $10,000 capital gain would be taxed at a 50% capital gains inclusion rate ($10,000 X 50% = $5,000). This $5,000 in applicable gains is then taxed at a 51% combined federal and provincial tax rate ($5,000 X 51% = $2,550 in taxes owed).
In contrast, by using tax-loss harvesting, the investor would have achieved up to $2,550 in tax savings.
What’s more, you can reinvest your tax savings over each year—which may help boost portfolio returns over time if the new investment increases in value.
Tax-Loss Harvesting Tips
With a tax-loss harvesting strategy, here are some key tips and considerations to keep in mind:
- Investment Timeline: A capital loss can be used to offset capital gains not only in the current year, but in the three years prior and/or any year indefinitely in the future.
- New Investment Type: After selling an investment that’s dropped in value, it’s important to buy a different investment to avoid triggering the ‘superficial loss rule’. Investors can aim to choose an investment with similar long-term returns.
- Plan for Year-End: In order to achieve a capital loss, plan to sell an investment at least two to three days before the year’s final trading day so the investment settles before year-end.
Together, these tips can help investors strategically execute a tax-loss harvesting strategy.
Tax Made Easier
During volatile markets, investors can seize the opportunity to turn losses into tax savings using tax-loss harvesting as a key tool to help generate higher after-tax returns.
Explore Fidelity’s tax calculator to discover tax-saving opportunities.
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