While your job is one way to earn an income, investing in stocks can earn you a source of future income with the right strategy. Investing is the act of putting money to work to earn income or capital appreciation. Investing is oriented toward future returns and thus entails some degree of risk. Learning how to invest wisely and with the right amount of patience over a lifetime can often yield significant returns. Warren Buffet defines investing as “The process of laying out money now, in order to receive more money in the future.”
To start investing in stocks, you must first understand how the stock market works, learn some stock market terminology, and comprehend some basic investment strategies.
What Are Stocks?
Stocks are units of ownership in a company, also known as shares of stock or equities. When you buy a stock share, you become a partial owner in a company, entitling you to certain benefits, including financial gains.
Companies issue stocks to raise money. There are two main types of stocks: common and preferred stock.
There are many differences between these two types of stocks. The main difference is that preferred stock usually does not give shareholders voting rights, while common stock does. Usually, you get one vote per share owned. Holders of common stock elect the board of directors and vote on corporate policies. Common stock often yields higher long-term rates of return. However, if a company goes bankrupt, common shareholders have rights to a company’s assets only after holders of preferred stock and other debt holders are paid in full.
Making Money Investing in Stocks
There are two main ways to make money in stock investing—an increase in the share price of the stock you own or from dividend payments.
Making money as a beginning stock investor doesn’t necessarily mean buying or selling stock often or constantly checking stock prices. The stock market is very unpredictable, and to try to outsmart the market by a quick stock trade is very risky and seldomly makes money in the long term. Instead, you are more likely to be successful if you choose reputable valuable stock and hold onto them for years.
A new investor can generally make money when investing in stocks by following these guidelines:
- Owning and holding securities
- Receiving interest and dividends
- Benefitting from the long term increase in the value of stocks
This investment strategy of ‘buying and holding,’ made popular by Benjamin Graham, can be very successful. Benjamin Graham was known as the father of value investing, and his investment strategies have been used by many high-profile successful investors such as Warren Buffett.
Why Stock Prices Fluctuate
Stock prices fluctuate wildly from one day to the next, and there is no clear-cut equation that will indicate how prices will behave. The prices are influenced by the market, consisting of buyers and sellers who are either individuals, corporations, or governments.
Several factors drive prices, but ultimately, the market’s supply and demand will determine the stock price.
Stock prices can, however, also be influenced by three other forces:
- Fundamental factors that drive stock prices are factors such as the company’s earnings and profitability, the company’s expected growth, and the perceived risk of the company’s stock.
- Technical factors are a mix of external conditions that can either increase or decrease the demand for a stock, such as inflation, the stock’s market segment’s economic strength, or the demand for other asset classes such as bonds.
- Market sentiment refers to market participants’ psychology, individually and collectively, and is often subjective, biased, and obstinate.
Stock Market Capitalization
A stock’s market capitalization, commonly known as market cap, is the sum of the total shares outstanding multiplied by the shares’ current market price. The market cap has more meaning than the share price, as it allows you to evaluate and compare similar-sized companies within the same industry. Companies are generally grouped by the following market caps:
- Small-cap: Between $300 million to $2 billion
- Mid-cap: Between $2 billion and $10 billion
- Large-cap: $10 billion or more
What Are Stock Splits
A stock split is an action in which a company divides its existing shares into multiple shares. While the number of shares outstanding increases by a specific multiple, the shares’ total value remains the same when compared to the pre-split amount. The most common split ratios are 2-for-1 or 3-for-1, in which the stockholder will have two or three shares, respectively, for every share held previously.
Stock splits usually take place when increasing share prices keep smaller investors from being able to buy them. Companies choose to split their shares to lower their stock price to a price level that will be more comfortable to most investors and keep the trading volume up by creating a larger buying pool.
Stock Value (Intrinsic Value) vs. Stock Price
A stock’s price is not the same as stock value. The stock’s price only tells you the company’s current market value of that stock. It says nothing about what the stock price expectations are and whether it is a risky stock to own or not. The price represents how much the stock trades at.
Stock Value also is called the Intrinsic Value of a stock. The Intrinsic Value can be higher or lower than the stock price. It is based on an investor’s perception of the inherent value of the stock. This includes both tangible and intangible factors and requires analyses of the company’s public financial statements. Often, different analysts will come up with different market value estimates for the same company.
Stock Value determines if a stock is overvalued or undervalued, and it is the stock investor’s job to identify stocks that are currently undervalued by the market. Investors will buy the undervalued stock for a low price and expect to sell it later at a higher price.
The stock price should never be the only reason to buy a stock. Additional analyses are necessary to determine if the stock is worth buying.
What Are Dividends?
Dividends are the distribution of a part of the company’s earnings to its shareholders. They are a way for companies to reward their shareholder’s loyalty and a way for shareholders to earn a return on their investment.
Most companies don’t pay dividends. If they do, they can cancel them when times are bad and increase them when times are good.
Startups and high-growth companies in certain sectors like biotech usually don’t pay dividends. They put their profits back into the company so they can grow faster. Other companies don’t pay dividends because they want to increase their company’s value by reinvesting their profits by acquiring another company or buying other assets.
Companies that are more likely to pay dividends are usually well-established companies in the finance, healthcare, and oil sectors. Historically, these companies have had very high dividend distributions.
The company’s board of directors determines dividends. They decide the dividend amount, when the dividend will be paid, and the ex-dividend date. Eligible shareholders must own stock by the ex-dividend date to receive the dividend. Investors who purchase the stock after the ex-dividend date will not be qualified to receive the dividend.
Companies usually pay dividends quarterly, but some companies will pay monthly or semi-annually dividends. A dividend is paid per share of stock. So, if you own 50 shares and that company pays $3 in annual dividends, you will receive $150 in dividends per year.
Dividends are usually paid out in cash. Other types of dividend payments can be in shares of stocks or property.
Investing in stocks that receive dividends can be a great investing strategy. However, never judge a stock by its dividend distributions only. Always analyze the company’s overall performance, value, and growth expectations, as well.
What Are Blue-Chip Stocks?
A blue-chip stock is a share of a well-known, established company with an excellent reputation. These companies usually have a large market capitalization. This means they have a market valuation of over $10 Billion, have a solid growth history, are usually a component of a market index such as the S&P 500 or the Dow Jones, and often pay dividends to investors, regardless of the economic conditions.
Blue-Chip stocks make for great investments, as their dividend rates grow faster than the rate of inflation.
What Are Penny Stocks?
A penny stock is a share in a small company that typically trades for less than $5 per share. Most penny stocks trade via Over The Counter (OTC) transactions through the electronic Bulletin Board(OTCBB) or Pink Sheets. With a low price, penny stocks have the opportunity for quick and significant appreciation.
On the other hand, penny stocks are considered risky, and investors can lose the money invested in Penny stocks real easily. Penny stocks are often difficult to sell since there may not be any buyers for small company stocks. This is called low liquidity. Another reason why penny stocks are considered risky is that there is often limited or no information available regarding the company’s financial stability and history. This will often lead to fraud, which in turn makes investing in these stocks even riskier.
Investment Goals and The Type of Investor You Want to Be
As a beginner investor, the most important thing to do before you start investing in stocks is to prioritize your investment goals, what your risk tolerance is, and how much money you can and want to invest. With these priorities in mind, your ideas and strategies for investing can come from many sources. Family and friends are usually good places to start learning about investing in stocks. Online you will find an unlimited wealth of information on investing in stocks, stock trading, brokerage accounts, mutual funds, and the best stocks to buy. You can even look up how to emulate investment strategies followed by successful investors.
Once you have decided on your goals and risks, you have to chose what type of investor you want to be. Do you want to take the “active DIY” approach or the “passive approach” when investing in stocks?
If you are the DIY type and have the time and desire to research and evaluate stocks regularly thoroughly, you have chosen the more “active” approach to invest in stocks, and you can invest in individual stocks and/or index funds. An index fund is a type of mutual fund or Exchange Traded Fund (ETF) with a portfolio that mimics or tracks the components of a financial market index, such as the Standard & Poor’s 500 Index (S&P 500).
If you don’t have much time nor the desire to evaluate stocks and you are more of the “let someone else do the work for me” type, you should follow the more “passive” approach and let a Robo-advisor do the work. This is a service that offers low-cost investment management based on your goals. Most of the major brokerage firms offer these services today.
What Type of Investment Account to Open?
When investing in stocks, you need an investment account. What type of account you need depends on what type of investor you are.
1. DIY APPROACH – online discount brokerage account:
Brokers are either full-service or discount. Full-service stockbrokers offer the full range of traditional brokerage services, including financial advice for retirement, healthcare, and everything else related to finances and wealth management. They usually charge high fees, require steep minimum investment amounts, and often only deal with high-net-worth clients.
Online discount brokers used to be the exception, but now they are widely used. Online discount brokers give you the tools to buy and sell stocks yourself. Many discount brokers also offer a Set-It-And-Forget-It Robo-advisory service and mobile apps. When opening a brokerage account, you should know that some brokerages will charge fees for extra services.
2. PASSIVE APPROACH – ROBO-advisor account
Robo-advisors are a great way for the beginning investor because they often have low fees, and they do most of the work for you. These companies will ask you about the size of your investing budget, risk tolerance and, expected returns and then build a portfolio designed to achieve those goals. Robo advisors manage your investments for you using computer algorithms. Their fees are meager due to low overhead costs. The typical cost of a Robo advisor account is only between 0.25% to 0.50% of your account balance per year.
These days, some Robo advisor accounts also offer educational blogs and tools and might even allow you to customize your portfolio somewhat. This way, you can learn all about investing in stocks and become a more “active” investor in the future.
Although Robo advisors do most of the work for you, you should always check your account regularly to ensure your investment goals are still on track.
3. Invest in your employer’s retirement plan
Investing in stocks through your retirement account might be another option. If your employer offers a 401(k) or another retirement plan as part of your benefits package, you should definitely consider investing some of your money in that plan, especially if your company matches a portion of your contributions. The match is a guaranteed return on your investment and essentially free money. If possible, you should try to invest the necessary amount to get the maximum company match allowed.
For example, a common matching arrangement is 50% of the first 6% of your salary you contribute. This means if you contribute 6% of your salary, the company will match it with 3% of “free money.”
You can contribute up to $19,500 to a 401(k) in 2020 (or $26,000 if you’re 50 or older). The advantage of a 401(k) is that there usually is no investment minimum and you can invest any amount up to the maximum. Contributions to a 401(k) are made pre-tax and will go directly from your paycheck to your 401(k) account.
The main drawback is that the investment options are often limited to the investment choice provided by your plan provider.
What to Consider When Investing in Stocks Using the DIY Approach to Buying Stocks
1. What is your investment budget, and where to invest your money?
The stock market is no place for money that you might need within the next five years. Short-term market declines are pretty common. While the stock market usually shows great returns over the long run, there is too much risk in stock prices declining in the short term.
Deciding where to invest the money, you do not need in the next five years is called asset allocation. Several factors play a role here. Your age is a major consideration, and so are your risk tolerance and investment objectives.
When it comes to age, the general rule is, the younger you are, the more risk you can take in your portfolio as you have decades ahead of you to deal with ups and downs in the market. However, if you are retired, you do not have the time to recover from losses, so your investment portfolio should be less risky.
2. Understand the difference between mutual funds and individual stocks
Mutual funds let you purchase small pieces of many different stocks in a single transaction. They track an index such as the S&P 500 and replicate that index by buying the stocks of the companies in it. Index funds and ETFs are types of mutual funds. Buying different mutual funds is a great way to build a diversified portfolio.
When you invest in an individual stock, you are purchasing ownership in that one company. For example, when you buy Apple stock you are a part-owner of Apple.
3. Focus on the long term, and manage your portfolio
As a beginning investor, mutual funds are a less risky investment option as they are inherently diversified. For most investors, especially those who are investing for retirement, a predominantly mutual fund portfolio seems like a good choice. The downside of owning mostly mutual funds is that you might miss out on a huge return on some individual stocks. As discussed before, younger people might benefit from adding some individual stocks to their investment portfolio as they have a longer time available to recover from losses.
The best thing to do after you start investing in stocks for the long term may be the hardest. Don’t look at your investment account every day and don’t get distracted by the daily news from Wall Street.
Even though you are in it for the long run, every investor, regardless of their age, should check their portfolio a few times a year to make sure it’s still in line with their investment goals. For example, check if your risk tolerance is on par with your age. Furthermore, check if your portfolio is too heavily weighted in certain sectors, industries, or certain geographical areas.