Here's another smart post from our friends at InvestingAnswers:
After the Facebook public offering debacle and the August trading glitches that nearly tanked Knight Capital Group, the Securities and Exchange Commission has stepped in with promises of tightening controls on computer trading.
More oversight sounds like it could be good for investors. Except there's one problem: Few average investors understand how the stock market actually works.
We thought now would be a good time to ask the question: How does the stock market work and what broke? The answers to these questions could improve your portfolio's return and how you approach the market.
The market had a phenomenal performance over the last three years. Despite the grumbling, the Standard & Poor's 500 Index is up about 100% since the market bottomed out more than three years ago, says David Abuaf, chief investment officer at Hefty Wealth Partners.After surveying several financial experts, we compiled a list of ten things you didn't know about the stock market (but should):
- Social media predicts the stock market. Scientists reported an 87.6% accuracy rate in predicting daily changes in the Dow Jones Industrial Average when they studied the mood of large-scale Twitter feeds.
- The market is run by robots, not people. The vast majority of trades placed every day aren't done by big asset management firms, but floor traders and computerized algorithmic models looking for short-term price discrepancies, Abuaf says. We saw what happened when a software bug helped trigger broker-dealer Knight Capital's trading errors to the tune of $440 million.
- A broker's allegiance may not be with you. There may be times with a stockbroker allies himself with his shareholders rather than with his clients, says Sam Seiden, vice president of education at Online Trading Academy.
- The "hottest deal" may in fact be an overvalued investment. Facebook's $38 initial public offering price should have been a red flag for investors. The social media giant lacked strong earnings or cash flow, but it also suffered from "technical errors" and "trading issues" on its Nasdaq debut. The SEC continues to investigate who's to blame.
- Education has a higher return on investment. The Brookings Institution reported that long-term investments in stocks, bonds or housing may return less profit than getting a college degree. The benefits of a four-year college degree are equivalent to an investment that returns 15.2% annually, says Richard Gardner, CEO at Modulus Financial Engineering Inc.
- Online traders don't have a direct connection to the market. You might expect that when you push send or call your broker that the trade is instantly placed. But your broker decides which market to send it to, and prices can change before it reaches its destination. Investors may not always receive the price they saw on their screen or the price their broker quoted over the phone, according to investor.gov.
- You'll always pay more for a stock than it's worth, and you'll always sell it for less than it's worth. It's called a bid-ask spread. The reason for the discrepancy? Purchasers pay theask price while sellers receive the bid price, Abuaf says.
- Your fully invested portfolio's returns and volatility depend on whether you've chosen high or low beta stocks. Never heard of it? High-risk stocks that have a beta of 2 will have higher volatility in the market. Apple has a beta of .74, while McDonald's has a beta of .40. If you want to reduce risk (and some profit) increase the number of low beta stocks in your portfolio.
- Big bank institutions buy when the stock tanks and sell when it's high, Seiden says. We're all buying in the same market, so what's the catch? Most investors are wired to buy when the market is rallying. But institutions do the opposite.
The stock market is a giant game of chance, but you can't win if you don't know the rules.
The Investing Answer: Research your stock broker to ensure he has your best interests in check. Don't follow the crowd. Think like an institutional investor and buy low, sell high.