Stock investments offer tremendous opportunities for making money as an investor. Overall investing in the stock market has historically paid off with great returns. If you are a long term investor and follow a few important rules (diversification, risk management, etc.), it is very likely that you will see a steady increase in the value of your stock market portfolio over the years. In this guide we’ll cover the basics of investing in stocks.
- What are stocks?
- Why invest in stocks
- How to make money investing in stocks
- Which stocks should you buy?
- Alternatives to direct investments in stocks
- Risks of investing in stocks
What are stocks?
First, what exactly is a stock? A corporation’s stock, which is also known as a share or its common stock, essentially represents part ownership in a company. When you are investing in stocks, you are buying part of a business. Of course, as a regular stock investor you will own only a very small portion of the particular company.
Say, you buy 100 shares in Apple Inc. That will cost you about $19,000 because Apple shares currently trade at a little over $188 each. But there are about 4.9 billion shares that have been issued by the company. So, your ownership represents only a very small fraction of Apple. The following chart shows that approximately 61.3% of Apple stock is held by various financial institutions:
But holding even a single share in Apple gives you all the rights that larger shareholders have. Of course, your voting rights will be based on the number of shares that you own. While making a stock market investment is similar to buying part of a business, there is one important difference. When you invest in stocks, you are not involved in the management of the company. That role is carried out by the board of directors and the managers that the company employs. However, you still do benefit in several ways which we’ll cover later in this stock investing guide.
Why invest in stocks
Stock investing has two major benefits. As a stockholder, you are entitled to the dividend that a company pays. These are the firm’s profits that are distributed to shareholders. The other major advantage of investing in stocks is that you may see a rise in the market value of your investment. In fact, the stock of a well-managed company that is performing well can rise steadily over the years providing investors with a significant level of returns.
How much can you expect to earn if you invest in the stock market? To get an idea of the returns that you can make, let’s examine how the Dow Jones Industrial Average index has performed over the years. The Dow Jones Industrial Average is a stock market index comprised of the 30 largest companies based in the U.S.
This stock market index includes firms like Coca-Cola, Wal-Mart, American Express, and Goldman Sachs. The biggest and most profitable American companies are included in the Dow. The components of the Dow are periodically changed to ensure that the index includes only the biggest and most profitable American companies. How has the Dow Jones index performed over the long term? The following chart illustrates its rise since 1896:
Over a shorter time frame of 10 years, the Dow Jones Industrial Average index has doubled in value. Here’s another illustration that shows the benefit of investing in stocks:
Investing in stocks is clearly more profitable than deploying your funds in bonds or other fixed-income securities. But how can individual investors profit from the stock market? Is it difficult to learn how to invest in stocks?
How to make money investing in stocks
Before you begin investing in stocks, you will need to open an account with a brokerage firm. These firms act as the middleman between the buyer / seller of stocks and the stock exchange. A brokerage firm is basically your access to a stock exchange where you can buy and sell shares. Initially, you will need to deposit funds into your brokerage account. This money will be used for investing in stocks on your behalf.
You need to choose the brokerage firm with care. A full-service broker that provides investment advice as well as executes your trades can be expensive. Online stock brokers charge lower fees, but the services that they offer can be limited. In most cases, they will simply act as the interface through which you place your orders on a stock exchange. Once you have established a brokerage account, you can start investing in stocks. Here are some points that you may like to bear in mind about how to invest in the stock market:
- When you are picking individual stocks, remember to do your homework
- High-priced stocks can often give you the greatest returns
- “Averaging down” is usually not a good idea
- Cut your losses short and let your winners run
When you are picking individual stocks, remember to do your homework
Some investors see a fall in the price of a stock as an opportunity to buy. However, there may be a very good reason for the decline in the stock’s market value. The low-priced share that you buy may see a further decline in its price. Consider the example of Sears Holdings, an American company that owns the Sears and Kmart retail stores. In May 2015, the company’s stock was trading at about $40. Now it is valued at less than $4.
An investor who purchased stock of Sears Holdings because it had exhibited a decline in its valuation would be staring at large losses. It’s important to keep in mind that usually there is a very good reason why stock prices rise or fall. Often stocks perform based on the overall market environment. However, the price movement of a stock can also be related to good or bad news about the particular company.
High-priced stocks can often give you the greatest returns
A stock that has risen sharply in the recent past, may still have plenty of steam left. In fact, high-priced shares often provide the greatest returns. Amazon’s stock quotes at a little over $1,600 on May 23, 2018. The price to earnings ratio is at a level of 206. But many analysts say that the price of Amazon stock is likely to rise even further.
Averaging down is usually not a good idea
“Averaging down” is an approach that some investors take. Say, they buy a share at a level of $30 and its price falls to $25. They buy additional shares at this value to bring down their average cost. While this can be a good strategy if you are very sure that prices will rise in the future, it can lead to additional losses if the stock’s value does not recover.
Cut your losses short and let your winners run
What this means is that you should quickly sell a stock that performs poorly. On the other hand, if a stock rises in value, you shouldn’t be in a hurry to sell because it may appreciate even more. Many investors do exactly the opposite. They are quick to cash in on their profits if their stock investment gains in value, but are reluctant to book a loss if a stock’s price falls. It’s important that you have a trading plan before you get involved in the stock market.
Which stocks should you buy?
If you are planning to invest in stocks, making the right choice can be difficult. There are thousands of different stocks available and choosing the best stocks to invest in can seem to be an impossible task. The first step can be to decide between stocks that provide a high dividend yield and those that could give you the benefit of capital appreciation.
If what you are looking for is a steady, dependable stream of passive income on a regular basis, you may want to opt for a Dividend Aristocrat. Dividend Aristocrats are stocks that:
- Have a track record of increasing dividends for at least 25 consecutive years.
- Are part of the S&P 500, which is an American stock market index based on the 500 largest companies that are listed on the New York Stock Exchange or the NASDAQ.
- Meet pre-defined size and liquidity requirements. It should be easy to buy and sell these shares on the market.
A recent article in Forbes lists five leading Dividend Aristocrats:
- Walgreens Boots Alliance – one of the world’s largest pharmacy and retail companies.
- ExxonMobil – the world’s largest publicly-traded energy company.
- Cardinal Health – a U.S. drug distribution company that sells to more than 24,000 American pharmacies and supplies drugs to 85% of the country’s hospitals.
- AT&T – the American telecommunications behemoth.
- Genuine Parts Company – a leading auto parts supplier.
A word of caution about Dividend Aristocrats. At times, a company may increase dividends to ensure that it stays on the Dividend Aristocrat list. It may pay dividends from the funds that it needs for its expansion or for its operational expenses. That would not be good for its long term health.
You are unlikely to receive a high dividend income from a growth stock. Growth stocks are shares in a company that is expected to increase its revenues and net income at a rate that is greater than the average. Companies that are expanding rapidly need all their financial resources to fund their expansion. Consequently, they pay a lower dividend. But they can make up for this by appreciating in value.
Consider the example of FAANG stocks. That’s an acronym for Facebook, Apple, Amazon, Netflix, and Alphabet’s Google. These popular tech stocks have seen sharp increases in value in the recent past:
|Company||Increase in share price in the last one year until May, 2018|
In fact, the rise of FAANG stocks has resulted in a situation where they now account for 27% of the NASDAQ.
Alternatives to direct investments in stocks
If investing in stocks seems too complicated and stock trading is an activity that you would not like to take up, there is another option. You can put your investible resources into mutual funds or exchange traded funds (ETFs).
A mutual fund is an investment vehicle that pools investors’ money and buys stocks, bonds, and other financial instruments on their behalf. The stock picking decisions are left to professional fund managers. If the shares that the fund manager buys perform well, the value of your investment will rise.
ETFs (exchange traded funds) are similar to mutual funds. However, instead of active fund management they usually track an index like the S&P 500 or the Dow. Due to this reason, the costs associated with an ETF usually are lower than the fees that you could expect to pay when investing in a mutual fund. That’s because mutual funds, especially those that are actively managed, can incur high expenses for company analysis. That way the fund managers of a mutual fund are able select those investments with the greatest potential based on their market analysis.
Performance of ETFs (exchange traded funds)
An investment in an ETF can be very rewarding on the long run. For example, an investment of $10,000 in the Vanguard S&P 500 ETF made five years ago would have grown to $18,370.
The Vanguard S&P 500 ETF has a very low expense ratio. Currently, it stands at only 0.04%. Mutual funds generally charge you about 1% to 2% of the assets under management (AUM) as expenses per year. While that seems low, it can add up to a significant amount over the years.
If you decide to invest in an ETF or a mutual fund, pay close attention to costs. Vanguard, which has over $5.1 trillion in assets under management, provides the above example to illustrate how costs can eat up your returns. Consider an investment of $100,000 that yields an annual return of 6% and which carries no costs. In 25 years, your initial investment would grow to $430,000. If you had to bear 2% in costs every year, you would have only $260,000 at the end of 25 years. The seemingly small annual cost of 2% would eat up $170,000 in the 25-year period.
Risks of investing in stocks
While investing in stocks can provide high returns, you also need to be aware of the risks that you are exposing yourself to. If the company that you have invested in fails to keep up with the competition or technological changes, it could quickly become unprofitable. This could lead to its stock market valuation falling very quickly.
Consider the impact that online retailer Amazon has had on its brick-and-mortar competitors. In the last three years, Sears Holdings, a large traditional retailer has seen its share price fall from $40 to a little over $3. In the same period, Amazon’s share price has risen from $425 to over $1,600.
Another factor that you should be aware of is that investing in stocks requires a long term commitment. If you want to invest your money only for six months or a year, you should not invest in the stock market. Your time horizon should be at least five years, preferably longer. If you want to maximize your returns, how long should you wait before you sell the stocks that you have bought? Legendary investor Warren Buffett says, “Our favorite holding period is forever”.
Conclusion: Investing in the stock market
A high-performance stock can continue to provide good returns for many years. Of course, you must be careful to monitor the company that you have invested in. Be prepared to sell your holdings if the company fails to keep up with the competition and reports poor financial results on a regular basis. If you don’t want to get involved in individual stock picking, you can instead invest in mutual funds or ETFs for long term returns.
We hope you like this guide about investing in the stock market. If you have any questions about investing in stocks, please let us know. What are your thoughts on buying stocks as long term investment? Have you invested in stocks already? We’ll be more than happy to read your feedback in the comments below.