This is a series of study notes I took while taking PurdueX PN-17.2.

How do companies raise money?

There are generally 2 ways: Selling shares of themselves and borrowing money from the capital market by selling bonds. Most of them can’t load money from the banks like individuals because the banks just don’t have the deep pocket to lend at that scale.

Common Stocks V.s. Preferred Stocks

Preferred stocks is a hybrid of common stocks and bonds. These are usually held by another institution or corporation but not by individuals. This course will only cover common stocks.

Capital Asset Pricing Model (CAPM)

In summary, the model claims that “the risk of a stock is directly proportional to the expected return from owning that stock”.

There are multiple ways to categorize stocks:

1. Growth stocks v.s. value stocks
2. Market caps: Large (>5 Billions), mid (1~5B), small(<1B), micro (<750M)
3. Blue-chip companies v.s. non-bluechip ones: market leader(s) in its sector v.s. the others.

The bottom line is you need a mix of “risky” and (relative) “non-risky” stocks in your portfolio. And the definition of “risk” varies from person to person.

Growth V.s. Value

The first one is inherently more risky because they haven’t reached maturity and don’t have a lot of track records. On the other hand, the value stocks have data out there for them, but often provide relatively less return.

Market Capitalization (Market Cap) Categories

First, let’s define what’s the market cap: It is a relatively fixed number calculated by: current share price * number of outstanding shares, where the “outstanding shares” refer to a company’s stock currently held by all its shareholders, exclusive of treasury shares that are held by the company itself.

In general, the larger the market cap of a company, the smaller the risk.

Blue-Chip Stocks v.s. Non-Bluechip Stocks

Blue-chip companies are usually the leaders in their sector and carry less risk.

Buying and Selling Stocks

Buying

There are a few steps for buying a stock:

1. Determine the investment/holding period: how long would you hold the stock?
   1. For longer-term investments, focus on the company fundamentals, such as its balance sheet, income statements, cashflow statements, expansion plans, etc.
   2. For short-term investments, focus on trading characteristics, such as trading volume, average daily trading volume, price volatility, etc.

Selling

Selling is generally considered to be much harder than buying due to the Disposition Effect: Sell winner too soon and hold on to losers too long. To avoid this, you’ll need to have a clear selling strategy based on your risk tolerance, even before investing. For example, “if the per share price drops by X%, I will definitely sell”.

Primary Residence

Every publicly traded stock has to be listed somewhere that is called the primary residence of that stock. In the US, there are 2: NYSE/Amex (physical) and NASDAQ (virtual, that is, a cluster of computers). It’s rare but possible to have a stock listed on both.

It turns out that you can characterize a stock by examining its primary residence. It’s harder to be listed in NYSE but relatively a lot easier to get listed in NASDAQ. Almost all tech companies are listed in NASDAQ.

If a company’s stock ticker (for example, AAPL, AMZN) has >=4 characters, then it’s listed on NASDAQ. Otherwise, it’s listed on NYSE.

Price Discovery and Market Fragmentation

Ideally stock exchanges want 2 things:

1. More trading volume
2. “Informative” stock price: “Informative” means new information. That is, exchanges ideally want their exchanges to be the place where price is discovered. In other words, new information comes in there because traders who have those new information, trade in those exchanges based on that information. Thereby incorporating that information into the price subsequently.

Up until 1997, there were only 3 major exchanges: NYSE, Amex and NASDAQ. However, after 1997, a new lay is passed so more smaller exchanges showed up and the market become fragmented. That is, it’s unclear where the price discovery/trading volume happens.

Nowadays, there are additional places to trade like dark pools and light pools. And big Wall street brokerage firms also set up localized trading exchanges.

The fragmentation led to unstable stock prices because a news on a specific stock can ripple across multiple exchanges.

Mutual Funds

A collection of stocks put into a portfolio and managed professionally and actively (Disclaimer: Being managed professionally does not always translate to better return). One main benefit of investing in them is because they are diversified.

A useful tool for researching and comparing investment options is Morningstar.

Index Funds

Compared to mutual funds, these usually have lower expense ratio (i.e. lower management fee) because they are passively run funds. Generally, it’s a great idea to have some exposure to the entire market and index funds are great options for doing just that.

References:

1. Outstanding shares v.s. treasury shares
2. Morningstar: Independent Investment Research