A Beginner's Guide to the Stock Market - critical summary review

According to Matthew Kratter, the founder of the educational platform Trader University, the stock market is both “a complex emergent system” and “the greatest opportunity machine ever created.” Unfortunately, most people stop at the former and never even bother to learn how it works. 

That’s where “A Beginner’s Guide to the Stock Market” comes in. Written for people who know little to nothing about the stock market - but have “the intellectual curiosity and hunger to learn” - Kratter’s book should help you harness the energy of the stock market to give yourself a huge advantage in life.

So, get ready to discover what stocks are and how the stock market works, while learning how to avoid the five mistakes beginners usually make and pick stocks like Warren Buffett!

A brief glossary of basic stock market terms

To kick things off, let’s break down several basic terms all beginning investors should know:

• Stock. A stock is a share of ownership in a company. Whenever you buy a stock, you become a shareholder, that is to say, a partial owner of the company that owns that stock. If you had enough cash, you could simply buy every share of a company and then you would own that company in its entirety.
• Market capitalization. Often referred to simply as “market cap,” this is the total value of a company’s shares. It is calculated by multiplying the price of an individual stock by the total number of shares outstanding (that is, shares that have been issued, purchased and held by investors). For example, McDonald’s currently has 765,317,332 such shares, each of them valued at $187.62 by the market. Multiply the two and you get $143.58 billion - McDonalds’ current market cap.
• Investors and traders. An investor is a person who buys stocks and holds them for many years. On the other hand, a trader is a person who buys and sells stocks quickly, holding them for an hour, a day, a week or maybe even a month.
• Stock exchange. A stock exchange is a place where stocks are bought and sold. It’s something like “an eBay for stocks.” The most well-known stock exchanges in the United States are the New York Stock Exchange (NYSE) and the Nasdaq. Nasdaq is best known for its tech stocks such as Apple and Netflix, and NYSE for its blue chip (high-quality) stocks such as Coca-Cola and McDonald’s. NYSE stocks are usually identified by a two-letter unique ticker (KO for Coca-Cola) while Nasdaq’s stocks commonly have four-letter tickers (AAPL for Apple).
• Broker. You cannot trade directly on a stock exchange as an individual. That’s where brokers come in. Brokers are simply middlemen who give people access to a stock exchange. When you register with a broker, like Charles Schwab, for example, you get a brokerage account in return. Once you put some money in it, you’re ready to buy your first stock.

How the stock market works

A company's stock price – and, hence, its market cap – moves around a lot over time. This is because the stock market constantly adjusts to new information. 

For example, in 1996, Apple was valued at less than $3 billion. But then the company brought back Steve Jobs, who introduced the iPhone and the iPod. Traders, investors and supercomputers everywhere took note of these events and the price of Apple’s stock started going up. In August 2018, Apple became the first U.S. company with a market cap of over $1 trillion, and just two years later it became the first $2 trillion U.S. company in history. 

Of course, sometimes the market can be wrong as well - at least temporarily. For example, in February 2000, the dot-com enterprise Pets.com raised more than $80 million from investors in its IPO. On a side note, an IPO, or an initial public offering, is when a formerly private company becomes investable by offering its shares to the general public for purchase for the first time. The shares of Pets.com went as high as $14. However, by the following November, they were valued at $0.19, as investors realized that the company’s business model was unsustainable.

Now, if you had bought Apple stock back in 1996, you would be a very rich person today just from holding that stock over time. However, if you had bought a hundred shares of Pets.com in February 2000 during its IPO, you would have been $1,000 poorer by the end of that year. 

But that’s how the stock market works. It is “a forward-looking mechanism,” meaning, “it tries to figure out what is most likely to happen over the next 3-6 months, and then prices stocks accordingly.” Hockey great Wayne Gretzky said once that he skates not to where the puck has been, but to where it is going to be. Well, all good traders and investors try to do the same.

Five huge mistakes that beginners make

Most inexperienced investors and traders make the same basic mistakes. In Kratter’s opinion, if you can avoid the following five at the beginning of your stock market career, you will save yourself a lot of losses and misery and get ahead of the pack from the get-go. Here are his “5 Commandments for Beginner Investors”:

1. Don’t buy stocks that are hitting 52-week lows. “In spite of what everyone will tell you,” Kratter suggests, “you are almost always much better off buying a stock that is hitting 52-week highs than one hitting 52-week lows.” But isn’t it counterintuitive and risky to buy a stock at all-time new highs and pass over one at an all-time low? Well, history says it isn’t.
2. Don’t trade penny stocks. A penny stock is any stock that trades under $5. There’s a reason why you are not allowed to trade with them on the NYSE or the Nasdaq: they belong to lower quality companies that may never make a profit. Moreover, since penny stocks are inexpensive, investors often buy large quantities of them. This makes the penny stock market more volatile than that of higher-priced stocks.
3. Don’t short stocks. Shorting a stock means betting that its price will fall. More specifically, it means borrowing shares from your broker at a certain price (say $10), then selling them on the open market with hope they will go down, and finally buying the stocks back later at a lower price (say $5) so that you can return them to the broker from whom you’ve borrowed them. However, if the stock goes up, you will be forced to buy back the shares at a higher price and end up losing a lot of money. Advanced traders earn a lot of money from shorting stocks. Beginners, however, almost never do.
4. Don’t trade on margin. A margin account is a type of brokerage account which allows you to borrow money from your broker. For example, if you desperately want to buy $20,000 worth of some company’s shares, but you only have $10,000 on your normal brokerage cash account, you won’t be able to. However, if you put this money on your margin account, your broker can lend you an additional $10,000 to buy more shares of your preferred stock. That way, if the stock goes up, you’ll earn twice as much as you would have with your own money. However, if it goes down, you’ll lose twice more than you would normally have. Add to that the “outrageous annual interest rate,” and you are quickly accumulating some potentially insurmountable financial problems. The best way to tackle them? Don’t ever exceed your cash buying power in a margin account. If you don’t trust yourself, don’t even open one!
5. Don’t trade other people’s ideas. Do not buy stocks from companies you are not familiar with. Even if you get a good and legitimate trading tip from someone (which you rarely will), if you don’t know what you’re investing in, you won’t have the conviction to hold on to the stock during the difficult times. And even if you do, you won’t know where your stop loss is, so you’re risking losing a lot of money. So, to quote Warren Buffett, “Never invest in a business you cannot understand.”

Warren Buffett and value investing

We just mentioned Warren Buffett. For a reason, of course: he is widely considered one of the greatest investors in history. Even so, his stock market strategy is fairly simple and can be summed up in a few rules: 1) invest only in what you know, 2) try to pick companies which you believe are going to be around two decades from now, and 3) (to quote one of his most memorable pieces of advice), “If you aren't willing to own a stock for ten years, don't even think about owning it for ten minutes.”

That all sounds pretty easy, but the question of how to guess the right company remains unanswered. According to Buffett: “The single most important decision in evaluating a business is pricing power. If you've got the power to raise prices without losing business to a competitor, you've got a very good business. And if you have to have a prayer session before raising the price by 10%, then you've got a terrible business.” To use Kratter’s example, if Coca-Cola decides to raise its prices by 10 cents per can, few would even notice; however, if a local gas station charges you 10 cents more than its nearby competitor, you would probably go to the competitor instead.

Buffett is famous for popularizing value investing, an investment strategy devised by his mentor Benjamin Graham which involves buying stocks that appear to be trading for less than their intrinsic worth. As we already mentioned, it takes time for the stock market to adjust to new information; even more, it is sometimes wrong. So, if you think that the stock market underestimates the value of some company at the moment, buy shares of its stock immediately. In time, the market will correct itself and the difference will be your earnings.

It is usually said that a must-have metric for value investors is the price to earnings ratio, or P/E for short. The P/E determines the market value of a stock (P) compared to the company’s earnings per share (EPS). For example, if a company’s stock trades for $200 (P) and it has EPS of $10 over the past 12 months, then the company has a trailing P/E ratio of 20 (which is what you get when you divide 200 by 10). Companies with a high P/E ratio are often considered to be growth stocks, and those with low P/E ratio are said to be value stocks. Even though it’s true that a low P/E ratio can mean that a stock’s price is undervalued, it can also mean that you’re just fishing in the wrong hole. So, until you become an advanced investor, don’t ever buy a stock with a P/E of 10 or less. Low P/E stocks made Buffett a lot of money in the past, but nowadays, in the words of Kratter, they are “almost always pricing in future bad news.”

Final notes

Succinct and simple, “A Beginner’s Guide to the Stock Market” stays true to its title from cover to cover. Kratter has a real knack for explaining the complex and sometimes confusing aspects of the stock market in a very easy-to-understand way. 

Moreover, his decades-long experience in investing and trading gives weight to each of his tips and suggestions. Follow them, and you should be just fine.

12min tip

To quote Kratter, trading is simple, but it’s not easy. So, don’t ever get greedy or overconfident. Always question your abilities and always do your own research.