5 Stock Market Basics

Analyzing funds requires knowledge about the underlying assets. It is not necessary to delve deep into their details, but you do need to know their essentials, so as to judge the level of diversification and risk of the funds that they compose. So lets discuss shares, bonds and some other assets.

What are shares of stock?

Shares of company stock are basically participation in the ownership of a company. For small to medium investors this doesn't usually imply getting involved in decisions that concern the way the company is run. There are a few times when we do take part with our vote, if we want, but what interests us most is that we participate in the distribution of the company's earnings.

Every company regularly decides what to do with the earnings it has achieved, if any. A part is transferred to the stockholders in the form of dividends and the rest is retained to invest in the growth of the company or to pay debt. The latter are termed retained earnings, as you may have expected. A company may retain all earnings if they think growth opportunities are big, which happens frequently with high-tech startups, or they may distribute most of them if they consider they have reached their full potential, which is a trend in tobacco companies for example. In the first case, investors make money through capital gains (this is, price increase) while in the latter they make it through dividends. Most cases stand in between these two extremes.

Why are the basics of stock analysis useful for analyzing funds?

Retained earnings (RE) are frequently expressed as a percentage of total earnings. A fund that lists companies with diverse RE ratios will be better diversified than one that only contains shares with a particularly high or low RE. There are other criteria to evaluate if a list of companies is well diversified or not. Do they belong to a particular sector? Is their price rather high or low in relation to their earnings and net assets? Is their debt high in relation to their assets? And so on.

At first sight, for passive investing, we prefer well-diversified funds, although less diversified ones can be useful in certain cases. For example, if the rest of our holdings has a bias, we may prefer to use a fund with the opposite bias, to compensate. Moreover, there is no indisputable definition for well-diversified, which is another reason for the usefulness of analyzing and classifying the underlying stock. If you want to attain only the basic knowledge required for diversified investing, then purchase funds that represent huge market sectors (which is the case with most of the so-called index funds) and forget about this more detailed analysis. But if you want to invest with more sophistication, you can make use of a more complete study of this topic.

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