Stock Investing FAQs
Stock investing can occasionally be perplexing. Often when a specific stock or investment question comes to mind, no obvious source for an answer is apparent.
Here is a list of practical answers to frequently asked stock investing questions. This quick reference guide is designed to be a "go to source" for answers to your stock investing needs.
AAII's Stocks area is your key to successful investing.
Stock Investing: Splits
Stock Investing: Dividends
Stock Investing: Broker Complaints
Stock Investing: When to Sell
Stock Investing: Technical Signals
Stock Investing: Earnings Estimate
Stock Investing: Company Information
Where can I find good, consistent information on companies?
The U.S. Securities and Exchange Commission's EDGAR database of filings for all U.S. public companies is your best bet for detailed financial statements. For the best commercial Web sites that offer stock information for free or a minimal fee, see AAII's Guide to the Top Investment Web Sites.
Stock Investing: Splits
What is a stock split and how does it affect my shares' value?
A stock split is an increase in a corporation's number of outstanding shares of stock without any change in the shareholder's equity or the aggregate market value at the time of the split. The share price and dividends per share are adjusted proportionately.
But what does that mean to you? After all, theoretically a split is a "non-event." This means that, unlike most other firm-specific "events," there is no change in the cash flows of the firm or in the relative strengths of the various interested parties of the firm. Since no real change has occurred within the firm, you would think that the stock market would show little reaction to a stock split announcement. Yet research shows that the market does indeed react directly to a split.
It is obvious that, unless the splits or dividends make the shares more desirable, they represent nothing but paper shuffling for which the corporation must pay. The usual argument for splits is that investors prefer stocks of companies that trade within some common range, such as $20 to $100. With the company's price in a more accessible range, the theory goes, more investors should flock to the stock, bidding up its price. Furthermore, many companies would argue that by allowing more shareholders to purchase and sell shares in round lots, stock trading costs would go down.
Research studies indicate, however, that transaction costs increase after splits. These costs include both commissions and the bid-ask spread, which is the difference between the price you have to pay to buy the stock and the price you can receive when selling the stock. Commissions per share of stock would typically decrease after a split, but not enough to compensate for the additional shares that need to be sold or purchased to meet the previous dollar amount of the complete transaction. On the other hand, one would expect the spread, when measured as a percentage of price, to remain the same before and after a split. In reality, the spread usually widens, increasing transaction costs. This is mainly attributed to a proportionate decrease in trading volume after most splits.
Most investors would settle for somewhat higher transaction costs if they lead to even greater returns, but most studies indicate that extra returns do not materialize after announcements or actual execution of stock splits or dividends. Most stock dividends or splits come after periods of high return, and the split is a reaction by the board of directors after the fact. A stock dividend or split in and of itself is no reason to buy a stock, unless you can do it some time before the company makes the announcement.
In instances where the dividend was increased and a split or stock dividend was announced, research does indicate that investors received extra returns, but this is probably more a reaction to the increase in dividend than to the stock split.
What are reverse splits?
A reverse split is a decrease in a corporation's number of outstanding shares of stock without any change in the shareholder's equity or the aggregate market value at the time of the split. The share price and dividends per share are adjusted proportionately.
A reverse split will decrease the number of outstanding shares. A 1-for-5 split would leave an investor with one share of a company stock for every five owned, boosting the share price by a factor of five. Stock distributions in the form of dividends or splits would be used for stocks priced too high, while reverse splits would be used for low-priced stocks.
Reverse splits have interesting consequences for the stock price. In these instances, studies have found substantial negative price performance when the announcement is made, approved and executed. In a large number of cases, the stock price continued to decline even in the long run. Reverse splits often occur when a company trading over-the-counter with a low-priced stock is trying to meet the listing requirements of exchanges, which typically carry minimum price requirements.
Stock Investing: Dividends
What is the impact on the stock market of cash dividends?
A cash dividend is cash payment to a corporation's shareholders, distributed from current earnings or accumulated profits.
An announcement of cash dividends would intuitively seem to have some impact on a stock's return. To move a stock's price, however, the amount of the dividend or the nature of the dividend must be a surprise.
Dividends are the only cash payments that are regularly distributed by corporations to their shareholders. The board of directors decides upon the dividend, which is declared and distributed quarterly. The dividend can be of almost any amount and shareholders have no guarantee of dividend payments. However, dividend policies tend to be one of the more stable and predictable elements of a company. Decreasing or eliminating a dividend is tantamount to an announcement that the firm is financially distressed. Directors weigh dividend policies very carefully, rarely lowering dividends unless they have to, and not raising dividends unless they are confident that they can be sustained. When a company announces a larger than expected dividend or unexpectedly announces a dividend cut or omission, the market reaction is dramatic and sudden. Studies indicate that stock prices typically change to reflect dividend policy changes within the trading day of the announcement. With stock market reaction this quick, it is difficult, if not impossible for investors to make extra money after the announcement has been made. The only way for an individual to take advantage of a positive or negative surprise dividend announcement is to be positioned prior to the announcement.
What is meant by a stock's ex-dividend date?
In order to receive a declared dividend, a shareholder must be on the company's shareholder list on the holder-of-record date. The ex-dividend date is four days prior to the record date. Therefore, any shares purchased prior to the ex-dividend date are entitled to the dividend, while any shares purchased on or after the ex-dividend date are not.
On the ex-dividend date, you would expect the price of the stock to fall by the amount of the dividend. Several research reports reveal, however, that on the ex-dividend date prices tend to fall slightly less than the dividend payment would dictate. While stock trading costs and taxes would wipe out this excess return for most individual investors pursuing just this dividend capture strategy, if you are planning to trade a stock and it is very near the ex-dividend date, then you might consider selling on the ex-date or buying it just prior to the ex-date. Stock dividends are distributions of additional shares of stock to shareholders instead of cash. For an investor holding 100 shares of stock, a 5% stock dividend would entitle the investor to another five shares of stock. If the stock were selling at $100, after the stock dividend it will open at about 95 1/4, making the market value (price times number of shares) the same before and after the stock dividend.
How does a stock dividend differ from a cash dividend?
A stock dividend is the payment of a corporate dividend in the form of stock rather than cash. It is usually expressed as a percentage of the shares held by a shareholder, and is 25% or less than the total number of shares outstanding. The share price and dividends per share are adjusted proportionately.
When stock dividends are over 25%, they are typically called splits. If the same stock had a 2-for-1 stock split instead of a stock dividend, the investor would have 200 shares of stock but they would be trading at $50—half their previous price.
Prices will typically rise prior to a stock dividend announcement; after the announcement there will be little or no further increase in price. Generally, stock dividends create a positive impact on prices in cases where there is an increase in the cash dividend along with stock dividend.
Stock Investing: Broker Complaints
Where do I file a complaint against a broker?
Investors who wish to file a complaint against a broker should first turn to the brokerage's in-house compliance department or legal counsel.
When further action is warranted, the next place to turn is the exchange involved. Investors should also file their complaint with their state securities regulator. This department licenses brokerage firms and investigates charges against brokers.
Whenever contemplating filing charges against a broker, be prepared to detail the specifics, including dates and times of securities transactions. Some offices require you to explain the complaint in detail in a letter, others provide forms to fill out and notarize.
To contact the resources mentioned above, see AAII's Guide to Investment Information.
Stock Investing: When to Sell
Should I sell my stock when it makes up more than 10% of my portfolio?
A price increase in and of itself is no reason to dump a stock. On the other hand, you should also be analyzing your individual holdings in the context of your total portfolio. Your portfolio should always be diversified; if you own more than 10 stocks in equal weights that are in various industries, or you have holdings in diversified mutual funds, you can consider yourself diversified. If a stock holding has become a large percentage of your total portfolio holdings due to good price performance, causing an over-concentration in a sector or industry, you may want to consider paring back the position, taking some profits and redistributing the wealth. But don't unload a stock just because you have already made money on it. Always consider the future merits of a stock before you sell due to a price movement—use the same analysis that led you to buy the stock originally, and reassess based on current stock market conditions and price levels. If the outlook still looks good, keep the stock, but pare it back.
Should I sell my stock when management changes?
It depends on the company: Does one person rule or can the company thrive under management changes?
Management changes may signal the need for another analysis of the company and should not automatically trigger a sell unless the company is ruled by one personality or it is so small that the only pool of talent is the individual who has left. This one-person show is often the case in start-up ventures and the smallest companies that started out as entrepreneur ventures. Rarely does the management of a multi-national company stand alone, without capable underlings who can step in and continue or expand the present businesses. As part of any stock investing analysis, you should familiarize yourself with the pool of management talent and their tenure at a company. This information is available in the company's 10-K proxy and statement.
My brokerage firm downgraded the stock. What should I do?
While the downgrade of a stock may cause a price drop temporarily, you need to analyze why the analysts changed their mind. Wall Street brokerage firms employ thousands of analysts and research personnel to issue "expert" opinions on the stocks that they are following. Become your own analyst and examine what caused the change. Did they meet with management? Conversations with management by an analyst may have merely resulted in a changed impression rather than any real change in financial data. Were new earnings released? This is public information that you can analyze by examining the company's 10-Q statement. Are sales and earnings declining? Are margins shrinking? Is competition increasing along with inventories? Only after you have examined these and other factors yourself should you decide to sell a stock. Don't simply take a broker's recommendation; your own analysis will mean more in the long run.
What types of news announcements should warrant a sale of the stock?
News that affects the long-term prospects or the composition of your portfolio may warrant a sale—for example, a change in corporate strategy.
Other news could affect short-term prospects for stock gains but won't affect long-term operations. Product delays, natural disasters, and litigation are all examples of occurrences that may drag the stock price down temporarily, but rarely limit long-term growth for large companies. In these instances, you should consider all the products and income potential of a company when determining the net effect of a news event, not just the item tied to the event.
The loss of a major customer is another example of an event that may result in a temporary price drop. Your initial analysis of a firm should include its customers and their stability as customers. Many small firms may have one or two major customers that would dramatically affect cash flow if they were to leave. Examining the remaining customers and other sources of income is necessary to adequately decide whether or not to sell.
Another news event that often affects the short-term stock price is the release of consensus earnings estimates. Companies with earnings that come out below levels expected by analysts (a negative earnings surprise) tend to underperform the market. Most of the loss occurs within the first two trading days of the announcement, but the effect of the surprise can be seen as long as two months later. Many institutional investors have short-term investment horizons, which means that if a stock doesn't meet their earnings goals, they will sell the stock immediately. But the rest of the stock market will take some time to digest the information and act on an announcement.
Earnings surprises also rarely occur just once. Most negative earnings surprises tend to be followed by negative surprises the following quarter. Since most individual investors have longer-term horizons and goals, they are willing to sit by with one or two quarters of disappointing earnings. As long as the dissappointment can be explained adequately by short-term events rather than any fundamental long-term shift in the company, this holding strategy normally pays off with improved returns over the long term.
Stock Investing: Technical Signals
Should I sell my stock when the price declines past its 200-day moving average?
This is a classic "sell signal" for technical analysts. Technical analysis analyzes stocks based on past price movements, rather than looking at the underlying fundamental merits of the company.
The 200-day moving average signal assumes that the trend or the overall direction of the stock price is the real driving force behind the price movement: "The trend is your friend." A 200-day moving average is the sum of the closing stock prices over the past 200 trading days divided by 200, which smoothes the daily price fluctuations to provide a longer-term indication of price movement. The signal assumes that if the current price crosses under the 200-day moving average, a change in the trend of the stock price has occurred, and warrants a sale of the stock. Many investors swear by this basic rule. However, research does not support the use of moving averages.
Should I sell my stock when it breaks through lines of support?
This is another "sell signal" for technical analysts.
"Support" is a physical trendline drawn on a chart that plots a stock's historical prices; the line is drawn at the level that has seemingly held up the stock's price—in other words, the stock's price repeatedly has touched this level but has not dipped below it.
If a stock's price eventually breaks through this support line, it is a sell signal to technical analysts. For example, assume you purchased a stock at $72 and the price then increased to over $100 and continued to trade in a range of prices that never dipped below $100—thus, support for the stock is $100. Suddenly, the price moves below $100 in a downswing. If you are following trends, this may signal a new trend of the stock and you would sell the stock.
If you are not a technical analyst, you would probably not take this as a signal to sell. However, you should take it as a signal that the stock market may know something about the company that you don't. You should look into the events that caused the dip in the stock's price and determine if they are only temporary, or if they may affect the company's future earnings. Your decision to sell or hang onto the stock should be based on this analysis and not on the price drop alone.
What is the significance of analysts' consensus earnings estimates?
For an investor in common stock, knowledge of expected earnings, changes in expected earnings, and actual earnings is crucial for understanding stock price behavior. Earnings surprise is the key. Positive earnings surprises occur when actual reported earnings are significantly above earnings per share forecasts; negative earnings surprises occur when reported earnings are significantly below earnings per share forecasts. Both have lingering long-term effects.
Consequently, a very rewarding stock market strategy is one that avoids stocks you believe will have negative earnings surprises or that have had negative earnings surprises. Selecting positive earnings surprise stocks before and even after the earnings come in may be similarly profitable. Even a strategy of simply selling after negative earnings surprises and buying after positive earnings surprises probably has some merit.
Three factors are important in looking at earnings estimates:
- The earnings per share forecast;
- The level of agreement among analysts following the company on expected earnings; and
- Any significant revisions in estimates.
All of these earnings estimate factors are embedded in current stock prices, and revisions in earnings forecasts will affect stock prices immediately, as will any significant surprise in actual versus expected earnings. As would be expected, more distant forecasts have greater variability, less consensus, and have fewer analysts making estimates.
There are potential rewards for disagreeing with the consensus and being correct. The trap that investors often fall into is that, upon hearing robust forecasts of earnings sung by a choir of analysts, they purchase the stock and are disappointed as the stock fails to soar when the consensus proves correct. Why did the stock fail to soar? Because its price already reflected the consensus viewpoint.
A few points on earnings estimates worth keeping in mind:
- Know the earnings forecast consensus of a stock you own or are interested in.
- Realize that the stock price already reflects the general consensus about future earnings.
- Be aware that if a stock is highly touted, the basis for the recommendation should be an earnings forecast significantly above the prevailing opinion.
- Ask for and carefully evaluate the foundation of an earnings forecast that deviates substantially from the consensus before investing.
- Be sensitive to revisions in forecasts and monitor actual quarterly earnings relative to forecasted earnings.
- Significant earnings surprises, positive or negative, probably have a fairly long-term effect on a stock's price as analysts revise long-term earnings forecasts accordingly.
- Don't expect extraordinary gains (gains beyond stock market returns) if you agree with the earnings consensus.
- Stocks that are followed by fewer analysts and with fewer estimates will provide more opportunity for you to benefit from your research efforts.
Where can you find earnings estimates? Many investing Web sites report earnings estimates and earnings surprises; see AAII's Guide to the Top Investment Web Sites for information on these.
What causes revisions to earnings estimates?
Earnings are announced for quarters based on the firm's fiscal year. As the fiscal year-end approaches, fiscal-year consensus estimates converge toward the actual fiscal-year earnings and there is less divergence. However, the focus does not abruptly shift to the next fiscal year as the previous one ends. Instead, stock prices probably, but not precisely, incorporate a rolling four-quarter earnings forecast perspective. Earnings forecasts are a moving target.
Also, analysts change their forecasts in reaction to a changing firm, industry, and economic environment. New information drives analysts' expectations and stock prices. Following the trend of changes in analysts' earnings forecasts for a firm and determining the root causes of those changes should prove valuable.
If you are unsure of why earnings forecasts are changing, it is not a bad idea to simply call the firm itself and ask for the investor relations department. They will tell you about all the information the company has released or any public information they are aware of that has been published.