A Stock Market How To For Novice Investors
A stock market how to guide--investing and building wealth with stocks and value investing.
Whether you're saving money for a house, college, retirement, or a rainy day, the stock market seems like an attractive place to put your money. After all, isn't the stock market made up of successful businesses which themselves know how to make money?
Sure, the way some people explain their investment strategies, it sounds like gambling. They speak of winners and losers and timing, but that's not how wise investors invest. We do our research. We make a plan. We're cautious. Above all, we avoid speculation and look for good businesses to own.
There's lots of jargon—lots of new technical terms—about investing, but you can get started with a little bit of knowledge and manage your money and your risks your own way. You can do it! This stock market how to guide will help, in just four simple steps (five for advanced investors). You can learn the basics of investing in the time it takes you to read a few paragraphs.
Step One: Set Your Investing Goals
Before you can invest, you have to know why you're investing. Are you looking for a safe place to put your money? Are you trying to get a better return than a money market account or a CD? How long do you plan to invest? Are you managing your 401k your self?
Everyone answers these questions differently, but all of their answers include some aspect of safety, growth, and risk tolerance.
An investor focused solely on safety will have to give up on risky investments and accept that the potential for enormous growth is small.
An investor focused solely on maximizing growth will have to accept that the risks are high.
An investor focused solely on avoiding risk will have to accept that safe investments are boring but don't return much.
Risk includes the possibility that you might lose all of your investment, but it also includes the worry you might feel if you check the performance of your investments every day (or every hour during the day). This is as much psychology as anything else.
Your goals should also match reality. If you have no appetite for risk at all, your investment options are few, and you shouldn't expect to earn more than 1% or 2% annual returns. If your risk appetite is modest, a 5% or 6% return is realistic. Any annual return of 8% of more will require you to accept higher risks.
Remember to factor in the anticipated holding period of your investment. If you're 25 and hope to retire at 65, your tolerance for risk over 40 years is very different from someone who's 60 and hopes to retire at 65.
Keep in mind that an investor looking for 401k investment options might approach tax planning very differently from an investor looking to build wealth to buy a house in the next five years. If one of your investing goals is to minimize or otherwise manage your tax liability, you need to consult a tax attorney or accountant. (In particular, be wary of the capital gains tax which applies to non-retirement accounts.)
Once you have figured out your investing goals....
Step Two: Decide How Much You Can Afford to Invest
Even if you've decided you have no appetite for risk and have come to accept that you're likely to make maybe 1% or 2% per year of returns, you have to face a truth about investing: you might lose it all.
That's probably not going to happen—the risk is very low if you invest in something very secure like US Government bonds or Treasury bills—but keep in mind that if you need to cash out an investment, you may have lost money on it. You may have to pay penalties. You may have to pay taxes. You may have a time window when you can sell. You may have to wait to find a buyer.
For investing to work, you must set a budget and stick to it. Only invest money you can afford to lose (not money you need to pay the rent or to buy food) and only invest money you can afford to have unavailable to you for the near future.
In other words, consider that every dollar you invest will be locked up for a minimum of five years. If you can afford that, great! If not, reconsider your budget.
Step Three: Find a Discount Broker
While some investors happily hand off the responsibility for their investments to advisors, you're better off managing your investments yourself. In the same way that only you can set up a household budget or a diet that meets your needs, only you can truly determine which investments meet your goals for income while not exceeding your tolerance for risk.
Getting good advice from other people is fine—great, even—but why hand over the responsibility to someone else who won't feel the pain of your choices or the joy of your successes? Besides that, you're going to pay for the privilege of letting someone else make decisions for you. You're going to pay a lot.
You're best off finding a discount Internet stock broker. Don't worry; all "discount" means is that you're not paying exorbitant broker fees. These are trustworthy institutions used by millions of happy investors.
A good discount broker will allow you to buy and sell stocks and funds over the Internet with low fees and low trouble. Advice and assistance are available if you desire, but you're in charge. This does two things for you. First, it lets you keep responsibility over your decisions. You do only what you want to do; you don't let anyone else pressure you into doing something you don't like or don't understand. Second, it's a lot cheaper. You could be paying 1% of your portfolio to a professional money manager every year even if his or her choices lose you money.
This classifies you as a self directed investor. In other words, you're responsible for your financial decisions. You get to choose your risk and tolerance and you reap the rewards. You can decide to plow all of your investment dollars into Moose Brand Canada Maple Syrup (if it makes sense) or pick low cost mutual funds. It's up to you!
Keep your money and understand your investments. Set up a discount brokerage account.
Step Four: Find an Index Fund
Buying a bond or a Treasury note from the US Government is a very safe investment. Over the long term, owning a share of a market index like the Dow Jones Industrial Average, S&P 500 index, or the NASDAQ provides a reasonably safe and reasonably good return of 6% to 8% annually, over the long term. That's very good and it's not much work.
Better yet, there are almost no fees involved for investing in this type of index fund. Low fees translates to high yield; there's a strong correlation. If you keep your costs low, you keep more of your money. (Compare the cost of index funds against the expense ratios of mutual funds, but you'll discover that index funds are almost always cheaper. There are plenty of free mutual fund ratings out there to compare—too many, in fact. Pick a few plausible possibilities and compare.)
If you're new to investing, you could do very well to sock most of your available money into a fund like the Vanguard 500 Index Fund (VFINX) which tracks the S&P 500 index. It's a diverse selection of 500 large American corporations, and it's the standard by which all other investments measure their performance. If you're careful about picking your own stocks, you can get better performance, but if you're the invest and forget it type, this is a great way to invest over the long term.
Other great index funds exist, but look for low fees and diversity and check their performance against the S&P 500 index.
Do note: even if you have a 401k through your employer and can't manage it on your own with a discount broker, sinking your money into a couple of good index funds is a great 401 k investment strategy. You can certainly find a good IRA discount broker, but rolling your money into a 401k self directed investment account might be more trouble than it's worth, unless you change jobs.
Optional Step 5: Find a Great Stock on Sale
You can safely stop at step 4. Many investors have met their goals doing so.
If your goals are greater and if your tolerance for risk is larger, it's time to move on to finding a great company and buying its stock when it's a great value. This is value investing, and it's a powerful technique for investors who are comfortable doing their own research and managing risk over a longer term.
If that's you, one good place to start is to read a good book on investing or two, then immerse yourself in important concepts like how to read stock market symbols, measuring real earnings and patient, buy and hold investing. The risks are higher, but the payoffs may be more—10% and 12% annual returns, if not more.
This is one way to invest in the stock market. There are as many approaches as there are investors, but learning how to invest in the stock market can be rewarding. It's less daunting than you might have thought. Here at Trendshare, our how to invest guide for new investors can help you navigate the sometimes confusing world of investing.
You can get more complicated if you want; certainly there's value in setting up a personal finance spreadsheet to track your investments (though you could use something like Google Finance or Yahoo Finance to track your own portfolio and get regular stock quotes). You can decide whether you want to stick solely with index funds (a fine choice!) or buy individual stocks. If the latter, you could look for stocks with low valuations or high dividend paying stocks—it's up to you.
You could also stand pat (again, that's a fine choice.) What's important is that you've made a plan. You've decided what's important to you and you've taken control of your own investments. You're well on your way to making your money work for you.
If you've found this short guide useful, please share it freely as our stock market how to lesson.