Dec 27, 2012

The language of stocks

People who invest in stocks or follow the progress of the stock market encounter a wide variety of terms unique to these investments. These terms include price-to-earnings ratio, earnings per share, market capitalization, mutual fund, bull market, bear market, and day trading, among others. Understanding this vocabulary helps explain many of the workings of the market in stocks.

1.  Price-to-Earnings Ratio and Earnings Per Share

Investors use several techniques to determine whether a particular stock should be purchased. Some investors examine a stock’s fundamentals such as its earnings per share or its price-to-earnings ratio. Earnings per share is calculated by dividing the corporation’s total earnings or income by the number of shares the corporation has outstanding. A corporation’s price-earnings ratio is calculated by dividing the current price of a share of the company’s stock by its earnings per share. These calculations represent fundamentals in the sense that they reflect the effectiveness of a company’s business operation (earnings per share) and the market’s current assessment of the company’s worth in relation to its earnings (price-earnings ratio).
In making a decision to buy or sell a particular stock, expectations are formed regarding future fundamentals. If expectations about the corporation’s operations improve and investors expect higher earnings per share, then the price of the stock is likely to rise. Investors expect that more people will want to buy shares to participate in the increased profitability. If, however, expectations turn pessimistic and shareholders anticipate lower earnings per share, then holders of the stock will try to sell their shares, reducing the stock’s price.

2.  Mutual Fund

Investors can own stock in two different ways. The first is direct ownership, in which investors add a corporation’s stock to their personal portfolio or account. The second type of ownership is indirect and involves participation in a mutual fund. A mutual fund is operated by a management-investment company that combines the money of its shareholders and invests that money in a wide variety of stocks. A mutual fund is thought to be safer because it is diversified. Diversification means that shareholders are less likely to lose their investment because the risk is spread among the stocks of many corporations rather than just a few. Investors add the stock of the mutual fund to their personal accounts. However, the mutual fund has direct ownership of the corporations’ stocks.

3.  Bull Market, Bear Market

Bull market is a term applied to a period when stock prices on average experience a sustained increase. During a bull market investors are optimistic about future business conditions and expect corporate profits to rise. So they will want to acquire stock to participate in the expected higher profits. A bear market describes the opposite situation, when stock prices on average experience a sustained decrease. Pessimism regarding the economic future dominates investor thinking during a bear market.

4.  Dealers and Brokers

Investors typically employ the services of dealers and brokers to execute the purchase and sale of securities. Some of these brokers are considered full-service brokers. Full-service brokers provide a wide variety of services for the investor, including the provision of investment advice. Other firms are considered discount brokers. Discount brokers basically provide the single service of executing the buy and sell orders of investors. For mutual fund transactions the investor can deal directly with the mutual fund. Thus, the investor need not use the services of a broker or a dealer for these types of transactions. Even in these instances, however, an investor may seek the advice of a financial adviser to determine which mutual fund to buy or whether to sell fund shares.

5.  Day Traders

Some investors are known as day traders. These are individuals who sit at computer terminals continuously monitoring stock prices for profit opportunities. They typically own stocks for very short periods of time, usually for less than a day. Day trading became popular with the development of computer technology and with the bull market of the 1990s. But day trading became significantly less popular with the advent of the bear market in 2000. (Encarta encyclopedia)