The first purchase
Until this past winter, I had not dabbled with stocks. My status changed to stock rookie when on one cold January day, I made my first purchase – 30 shares of The Coca-Cola Company at $37.94 per share. In this post, I will share my beginner experience with stock investing.
My online brokerage of choice
During my high school senior year, I worked at McDonald’s as a grill boy, flipping mystery meat patties by the dozen. I saved most of my earnings (at the robust federal minimum wage of $7.25 per hour) and after a year, I had amassed a respectable sum. Before heading off to college, I opened an online brokerage account with TD Ameritrade and deposited my savings in it. Opening an online brokerage account is fairly easy; don’t let the potential hassle of opening an account dissuade you from getting into stocks. I did not, however, touch my account for nearly five months. I did not want to rush my first investment; buying stocks carelessly is akin to gambling. Patience is the best virtue when it comes to investing. I first did some research on investing on the Internet. What did I learn?
Warren Buffett (left) and Peter Lynch (right) are among the greatest investors of all time
Two of the greatest investors of the last several decades, Warren Buffett and Peter Lynch, have offered quite a few nuggets of investing wisdom. There’s one tip in particular that stands out: “Invest in businesses you understand.” The more clearly you can understand a particular company’s business and its industry, the better prepared you are at becoming its stockholder. Keeping this advice in mind, I needed to find a company or two that I could start tracking. But where would I start? I came across many stock recommendations on the Internet but I wanted to pick a stock on my own.
The start came from a “Business Management and Organization” course (see my post on this course) that I took in in my first semester in college. In this course, I, as part of a group, had to write a 30-page company research paper; my group analyzed The Coca Cola Company. We capped our analysis with a summary report about the company’s short-term viability, long-term viability, business strategy, and stock price valuation. My familiarity with Coca Cola as a consumer was reinforced with what I learned about the company through my project. Suddenly, there was one company I knew a lot about. A lot more than what I knew about any other company. And, I liked a lot of what I learned about Coca Cola. Coca Cola is facing some serious business challenges too… more about this in a separate post.
Now that I had identified a stock, I had to decide when to buy it? For a long-term investor, which I intend to be, the stock entry point is not as important as it is for stock traders. Still, I wanted to get a good price on my first stock. At the time I submitted my research paper, Coca Cola (ticker KO) was trading at $40.46 with the price fluctuating within a tight range. I was itching to buy. A mistake that a rookie investor is likely to make is to pull the trigger too early. It is best to set a price target at which you believe the stock is attractive. Seeing that the stock had fluctuated between $39 and $40 for several weeks, I decided to buy at $38.50, or if it looked possible, below $38. But before I could brag about my first purchase I had to place a buy order.
The two most common types of buy orders are the market order and the limit order. A market order is filled immediately at the prevailing price. In a fast moving market, the market order might get filled at a price higher than what you expected. In a limit order, you set a price to buy the stock at; the order will be filled once the stock reaches that price or goes below it. In this order, you control the buy price. You could set a limit order at a very low price; sometimes, during a temporary market panic your limit order will get filled and then the market will regain its original level and you would have lucked out. But, it’s possible that the stock will not reach your limit if you set the limit price too low. Limit orders expire after a certain time period though. I placed a limit order for $37.94 and it got filled at that price. I now owned a piece of a company. A great company too. Just like all of my other firsts, I am unlikely to forget my first stock purchase.
Negative news seems to be everywhere…here is the most recent cover to Businessweek
After purchasing the stock, I have gotten into the habit of regularly tracking it. Suddenly, there seems to be a lot more negative news about Coca Cola then there was before I purchased it. The “sudden” barrage of bad news may be mostly perceptual though. I knew about the problems Coca Cola is facing before I bought the stock. But, I guess now that I own the stock, the company’s problems just appear worse than what they appeared to be when I had not bought the stock. Should I be concerned? Not if I had researched the stock well before buying it, which I had done. All the negative press about Coca Cola is already discounted in the stock price.
How have I have done so far? Because I haven’t sold the stock, I don’t have an actual gain/loss. Any gain/loss at this time is unrealized. My unrealized return will vary with the date I choose for determining it. For example, on July 24, the stock closed at $40.97, which would give me an unrealized gain of $3.03 per share. As of this date, I had also received $0.61 per share in dividend payments (2 payments of $0.305). Thus my total return on July 24 was 9.59% [($3.03 + $0.61)/$37.94]. However, on August 1, when I started writing this post, the closing stock price was $39.29; the stock had slid quite a bit after the company reported quarterly earnings. As of August 1, my return is 5.17%. In this instance, just a few days made a lot of difference to my return. Thus, unrealized returns are sensitive to the time period being considered.
Is my current unrealized return of 5.17% good or bad? During the same period, the stock of an upcoming pharmaceutical company returned 94.6%. It doesn’t, however, make sense to compare these two returns. The pharmaceutical company’s stock had a much higher return but it had a very high risk too. Coca Cola’s risk, as measured by its beta, is very low. Comparing the return of Coca Cola with the return of a stock that has a similar risk profile would make more sense. The risk return trade-off is a fundamental concept in finance. I should evaluate my return within the context of its associated risk. During the six-month period that I earned 5.17%, the risk-free return was .02% (return on U.S. Treasury bill). This gives me a 5.15% premium over the risk-free rate. This premium as a ratio of the stock’s risk (beta, which for Coca Cola is .34) is 15.14 (5.15/.34). This ratio, called the Treynor ratio, measures the return per unit of risk and can be used to compare the performance of different stock portfolios.
A common benchmark used to evaluate stock returns is the S&P 500. During the time period when my return was 5.17%, the S&P 500 returned 8.51%. Thus, in terms of return, my stock underperformed the S&P 500 but when adjusted for risk it outperformed the S&P 500. The S&P 500 by definition has a beta of 1, so its Treynor ratio is 8.49 ((8.51 – .02)/1) while the corresponding ratio for Coca Cola is 15.14.
The S&P 500, or the market, is the benchmark
The S&P 500 is actually an appropriate comparison index for a portfolio of stocks. At this time, I just have a one-stock portfolio; I need to expand my portfolio. Finance theory says that a diversified portfolio will reduce my overall risk because the returns on different stocks are not perfectly correlated with each other. Besides buying stocks, I could also consider buying other assets such as bonds, commodities, currencies, or just staying put with cash.
I have to decide how to expand my portfolio and when to do it. The market has been going up for several years now but nothing goes up forever. Market pundits are talking about a stock market correction being long overdue. I agree with them. The Fed is expected to start raising interest rates from next year, which will negatively affect stock prices. Rising interest rates are also not good for investing in bonds. Because interest rates are at rock bottom right now, bond prices are very high. When interest rates start going up bond prices will fall so I’m going to stay away from bonds. For the time being, I could consider a stable stock with a very low beta such as a utility company but I don’t want to buy something for the short term. Because, I own a low-risk stock in the consumer sector, I am considering buying a riskier stock in a non-consumer sector. I have shortlisted a few stocks but I am not planning to buy right now. I will wait for the market to go down at least ten percent before I consider buying my second stock. A wise investor by the name of Warren Buffet advises to buy when everyone else is selling and sell when everyone else is buying.