1. What’s the difference between a primary market for common stock and a secondary market?
The sale of new securities to raise funds is a primary market transaction. The proceeds of the sale of these securities represent new capital for the firm. New issues are typically underwritten by investment banking firms, which acquire the total issue from the company. They resell those securities in smaller units to individuals and institutional investors.
After the new issue of securities is sold in the primary market, subsequent trades of these securities take place in the secondary market. The secondary market is vital because it provides liquidity to investors who acquire securities in the primary market
2. What’s the relationship between NASDAQ and the OTC market?
The OTC market is the largest segment of the secondary market in terms of the numbers of securities (nearly 40,000). Although OTC stocks represent many small and unseasoned companies, the range of securities traded is very broad. This is a negotiated market where investors directly negotiate purchases and sales through dealers.
The NASDAQ system is a computerized system that provides current bid and ask prices on more than 5,000 of the most widely traded OTC securities. Trough a dealer, a broker can instantly discover the bid and asked quotations offered by all dealers making a market in a stock. The broker can then contact the dealer offering the best price and negotiate a trade directly.
3. Why should an investor hold a diversified portfolio? What’s the simplest way to diversify?
Diversification can substantially reduce the risk associated with investments. Diversity is simply not putting all your eggs in one basket. An effectively diversified portfolio reduces risk without cutting long-term average returns. In selecting blue chip stocks, investors should choose stocks whose risks are related to different economic, political, and social factors.
A diversified portfolio is very difficult to achieve when funds are limited. If you have limited funds, a mutual fund offers the opportunity to participate in an investment pool that can contain hundreds of different securities.
4. What is a growth stock?
A growth stock is a company whose earnings have significantly outstripped the earnings of other companies in the past and are expected to do so in the future. These companies tend to reinvest a large portion of their earnings and thus pay a relatively low (or no) dividend to shareholders. Investors who purchase these shares are more concerned with the appreciation in the market price of the stock than they are with the receipt of a cash dividend.
Because growth stocks provide little income, they depend on high growth rates to sustain a high stock price. If these growth rates fail to materialize, the stock price can fall dramatically. Consequently, investors in growth stocks should be aware of the greater risks that come with the possibility of earning the superior returns.
5. What’s the difference between a bull market and a bear market? What are the implications of each to the investor?
A bull market is a prolonged rise in the price of stocks; a bear market is a prolonged decline in the price of stocks. Stock market movements are extremely important to investors. Historical studies indicate that 60% of stock price movements are directly related to movements in the overall market; 30% to 35% are related to sector or group movements; and only 5% are related to individual stock movements.
Because stock prices have generally risen over time, bull markets are predominant over bear markets. In fact, the market typically rises two out of every three years. Although bear markets tend to be substantially shorter than bull markets, the decline can be steep. Even including the crash of 1929, when stock prices plunged 89%, the average bear market loss has been about 36% from peak to trough.
6. Does a balance sheet disclose the current market value of assets?
Generally, no. Items reflected under property, plant, and equipment are shown at their original cost less total depreciation recognized on the asset (called accumulated depreciation). The current market value of these assets is not reflected in the financial statements. For many corporations, the amount shown for property, plant, and equipment on the balance sheet is but a small percentage of the current market value of the assets.
The balance sheet also fails to disclose certain assets of vital importance to the corporation. For example, the value of a corporation’s human resources is not reflected in the balance sheet. Additionally, the value of brand names often is not disclosed, or if it is, it is shown at an unamortized cost, which has no relationship to its current market value. In recent years, the target of many takeovers has been to acquire valuable brand names.
7. How does the Securities and Exchange Commission serve the investor?
The Securities and Exchange Commission (SEC) was established by Congress to administer federal laws that seek to provide protection for investors. The overriding purpose of these laws is to ensure the integrity of the securities markets by requiring full disclosure of material facts related to securities offered for sale to the public.
The SEC does not insure investors. Nor does it prevent the sale of securities in risky, poorly managed, or unprofitable companies. Rather, registration with the SEC is designed to provide adequate and accurate disclosure of required material facts about the company and the securities it proposes to sell. A portion of the information included in the registration statement is included in a prospectus prepared for public distribution.
The SEC requires the continual disclosure of company activities through annual, quarterly, and special reports. Form 10-K is the annual report; it contains a myriad of financial data and non-financial information, such as the names of corporate officers and directors and the extent of their ownership. Form 10-Q is the quarterly report; it contains abbreviated financial and non-financial information. Form 8-K is a report of material events or corporate changes deemed important to shareholders or the SEC. All of these reports can be obtained from the company or from the SEC.