A new investing era
The stock market is more accessible than ever, thanks largely to the rise of digital trading apps, competitive trading fees and a host of low cost ETFs and index funds that simplify your investment options. In today’s highly digitized society, you can effortlessly download a trading application on your smartphone, create an account, upload funds, and start buying stocks with very little hassle. Within minutes, you can make your first purchase and begin building your portfolio.
While the barrier to entry is low and purchasing stocks may be easier than ever before, the stock market itself is still an incredibly complex place with many potential pitfalls. As such, it is important that you get to know the lay of the land before you start investing your hard-earned cash.
With that in mind, here is everything you need to know before you start investing.
What Is a Stock?
Although the words ‘stocks’ and ‘shares’ are often used interchangeably, a stock is a security that one can buy and which represents ownership of a fraction of a corporation, for example Google or Apple. Corporations like these issue smaller pieces or units of stock, which are known as shares. In other words, when you purchase shares of a stock, you are buying a ownership stake in a business and become a shareholder. Being a shareholder typically gives you voting rights or eligibility to receive a share of profits, known as a dividend.
Each share has a monetary value known as the share price. This is the amount it will cost investors to buy the shares of the given stock before trading fees. The share price rises and falls based on factors such as:
- Investor sentiment
- Economic factors
- Industry performance
- Company performance
The exact number of shares that a company issues will vary based on its size and market capitalisation or value.
To generate revenue investors might choose to purchase shares, hold them for however long they choose before the value has risen sufficiently, and then sell them for a profit. Alternatively, they might choose to hold them longer term in order to accrue dividends. If the value of a stock drops below the original purchase price, investors will lose money if they choose to sell their shares at that point. The risk therefore is that you may lose the money you invest or end up with less money that you had initially invested. This is why it is often suggested that you should never invest money that you cannot afford to risk.
What Is the Stock Market?
The stock market is simply the place where shares of a publicly traded company are bought and sold. Selling shares allows a company to generate revenue and fund future projects, growth or expansion.
There are many different stock markets, or ‘stock exchanges’ as they are often called, in operation. Two that you might be familiar with are the NASDAQ and the New York Stock Exchange (NYSE).
Essential Trading Concepts Every Beginner Needs to Know
Before providing some practical tips on how to start your own investing journey, let’s explore four key concepts that you need to know, which include the following:
Income vs. Growth Investment Strategies
While there are many ways to participate in the stock market, almost all of these approaches fall into one of two broad categories: income or growth investing.
Income investing is exactly what it sounds like. This process involves purchasing shares to generate a recurring income. When using this strategy, you can invest in standard stocks that have a history of stability and pay competitive annual dividends. A dividend is a distribution of a company’s profits to shareholders.
A growth investment strategy focuses on the long term. When investing using growth-oriented principles, the goal is to purchase stocks and hold them for a period of multiple years so that, as the company grows, so too does the value of your shares.
Investment Time Horizon
Your investment time horizon is how long you intend to hold an investment. In this case, that investment is stocks, and your time horizon will vary based on your goals and strategy.
For instance, if you are focused on generating short-term income, your investment time horizon may be expressed in weeks or months. Conversely, if you are building wealth for retirement, your investment time horizon may be a number of years.
When investing in the stock market, you need to ensure your investment time horizon aligns with your investing goals. That said, you don’t have to set a clear deadline for when you will sell a stock. Instead, you may wish to classify your time horizon using more generalized terms like “long,” “moderate,” or “short.”
If you have a longer time horizon, your portfolio can usually withstand more risk, as you will have plenty of time to recoup any early losses or fluctuations in value. In contrast, if you are perhaps close to retirement and have a shorter time horizon, you might possibly be more risk-averse and take a more conservative approach in your investment decisions by choosing more stable investments.
The Compounding Effect
The compounding effect occurs when you hold shares of a stock long enough to generate returns on your original investment and on successive returns. For this to work, you must reinvest your returns back into the stock market.
For instance, suppose that you invested $1,000 in the stock market and achieved a return of 10%. You now have $1,100. If you pull the additional $100 out and don’t reinvest it, you will not benefit from the compounding effect.
However, if you do reinvest it and earn another 10% return, you now have $1,210. Those earnings are a result of the compounding effect.
As the value of your portfolio grows, the extra return derived from the compounding effect will become far more significant and may take on chracteristics know as the ‘snowball effect’ where the returns on the returns create the opportunity for exponential growth. If you are investing in stocks over a period of decades, this can translate to very siginificant sums of money.
Tax Efficiency
Tax efficiency is the process of paying as little in taxes as is legally allowed. When you invest in stocks, you will be using post-tax dollars because you would have already paid taxes on those earnings when you received your paycheck. However, you will also have to pay taxes on any returns on your stock investment when you sell/withdraw them.
For instance, if you invest $1,000 of post-tax income and earn a 10% return, you’re left with $1,100 total. When you sell those stocks, you will have to pay taxes on the $100 you earned. But if you reinvest the returns and the original revenue, you will not yet owe taxes as you will have not triggered a taxable event.
If you are interested in a more tax-efficient investment option, you should consider a 401(k) or Individual Retirement Account (IRA). With these investment options, your capital gains and/or dividend are automatically reinvested, which will accelerate the growth of your account. However, as with stocks, you will have to pay taxes once you ultimately withdraw your funds.
That said, IRAs and 401(k)s provide an additional tax benefit. Investments in these types of accounts can be deducted from the current year’s income total, which means that you will owe less in taxes for any years in which you contribute to your IRA or 401(k).
Benefits of Index Funds and ETFs
As you can imagine, researching, selecting and managing numerous individual stocks can be quite time-consuming. However, a diverse portfolio is necessary for mitigating risk and increasing your chances of earning strong, consistent returns over time.
Fortunately, there are several more simple ways to create a diverse portfolio and minimize the number of stocks you are managing. These securities are known as index funds and exchange-traded funds or ETFs.
While there are subtle differences between index funds and ETFs these are essentially a passively managed basket of all the stocks listed on a particular index. For example, an S&P 500 index fund will be a collection of the top 500 largest companies in the United States. When you buy a unit of such an index fund you are essentially buying a portion of all of these stocks. This is a great way of mitigating risk because your investment is spread across 500 companies, meaning that if the value of one company falls significantly this might be offset by the value of the remaining 499 companies.
Investors who wish to take a more conservative approach might choose index funds and ETFs because of their lower risk in comparison to other investment options. However, it is because of this lower risk that they also have a lower chance of earning significant returns in the short-term, which is something to be mindful of if short-term, outsized profits is part of your strategy.
To summarize, index funds and ETFs tend to be…
- Less risky than investing in individual stocks due to diversification
- Lower cost with fewer ongoing fees fees due to passive management
- Easy to invest in
10 Tips to Jumpstart Your Investing Journey
If you are ready to invest in the stock market, here are nine simple steps to help you get started:
1. Understand that nothing is guaranteed when you invest in the stock market.
Accepting this simple fact will mean you are mentally and emotionally well prepared for any eventuality.
2. Define Your Risk Tolerance
Your risk tolerance is the amount of risk you are willing to take on when making investments. Having a high risk tolerance means you are willing to invest in more volatile stocks that have the potential to plummet in value or yield a large return. If your risk tolerance is more modest, you might wish to focus on more stable stocks and well-established brands such as those known as dividend aristocrats.
As a beginner, think of your risk tolerance as the amount of money you are willing to lose. For instance, if you can withstand a loss of up to $1,000 without it negatively impacting your financial health, then it would be wise to set this amount as your maximum investment.
3. Identify Your Goals
Next, identify what your investing goals are. Do you want to experiment with trading, or are you looking to build wealth for retirement?
Your goals will dictate the following:
- Which stocks you invest in
- How much you invest
- How often you buy and sell or whether you hold your investments long term.
Setting clear goals from the start will help you build a balanced portfolio and effectively manage your assets.
4. Choose Your Investing Style
Your investing style refers to how active or passive you are in managing your assets. If you are an active investor, you will likely manage your stocks and build your portfolio independently.
If you prefer a more passive approach, you can enlist the services of a professional broker or robo-advisor. Robo-advisors are more cost-effective than brokers or traditional financial advisors, but they typically do not provide the same personalized level of support.
5. Select a Trading Platform
Your goals and investing style will heavily influence which trading platform you choose. If you want to directly manage your investments independent of any robo-advisor or broker, a simple platform may be a good choice.
However, if you want access to the latest analytics tools and need high-level support, a more dynamic platform will likely be the right fit for your investing goals. There are plenty of great platforms out there, but not all of them are free, so make sure to explore your options before signing up.
6. Try a Simulator Before Making Your First Trade
Using a simulator gives you a chance to practice trading before putting your hard-earned dollars at risk. While you don’t need to spend weeks training yourself on a simulator, you should run at least a few practice trades.
As with trading platforms, there are plenty of simulators available, many of which are free. That said, the paid options tend to offer more tools and educational resources to help support your investing journey.
7. Do Your Homework
Once you have picked a platform, created an account, and run a few practice trades, you are almost ready to buy your first stock. However, before you add a stock to your portfolio, do your research. This is especially important if you plan on buying a lot of shares or purchasing some high-value equities.
Make sure to:
- Analyze the stock’s performance over the past 12 months, perhaps within the context of global factors or the performance of the industry it is in
- Determine whether it is trending up or down and what the outlook for the stock might be
- Consider whether it aligns with your risk tolerance
If it does match up with your risk tolerance, consider whether it makes sense to invest given your time horizon.
8. Buy Your First Stock
After you have narrowed down your list to a few quality stocks, you may be ready to make your purchase. Thanks to modern digital trading platforms, you can make a purchase almost instantly — provided the market is open, of course.
All that is left to do is select how many shares you want to buy and hit the purchase button.
9. Diversify Your Portfolio
It is considered a good idea to diversify your portfolio. Diversifying mitigates risk in case one industry or company experiences a sharp drop in value. One idea for diversification might be to acquire stocks in at least 10 different businesses, each in different industries.
10. Be Disciplined
If you decide to actively manage your own investments, discipline is key. Consistently add funds to your portfolio, stick to your risk management plan, carefully monitor your shares, and watch trends so that you can adjust your strategy as needed.
Create a plan, follow through with it, and don’t hesitate to seek professional brokerage services if you need some help with achieving your financial goals.
Don’t Wait — Start Investing Now
Investing in the stock market can be a fun, exciting, and rewarding process regardless of whether you want to build long-term wealth or simply participate at a casual pace. No matter your goals, make sure to be disciplined, do plenty of research, and leverage the abundance of digital resources out there to propel you toward your goals.
