After the Facebook (Nasdaq: FB) public debacle and the August trading glitches that nearly tanked Knight Capital Group (NYSE: KCG), the Securities and Exchange 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 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.
After surveying several financial experts, we compiled a list of 10 things you didn't know about the stock market (but should):
- 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.
- 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 price should have been a red flag for investors. The social media giant lacked strong earnings or , 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, or housing may return less 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, at Modulus Inc.
- Online traders don't have a direct connection to the market. You might expect that when you push send or investor.gov. 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
- 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 the while sellers receive the , 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.