The Complete Beginner’s Guide to Investing in Stock
Investment in stocks is one of the best and easiest ways to accumulate passive income for individuals or families.
However, there is a stigma around stock investment. The average person feels stocks are too complex to understand and too risky to be involved with.
Especially since the recent financial-economic crisis, people are quite honestly scared of manipulations leading to fluctuations on the stock market. They consider it unreliable.
This article aims to give you the basic information so as to alleviate that stigma a little – enough so that you consider learning more, and, eventually, invest.
WHAT ARE STOCKS?
Stock ownership is the physical representation of ownership over part of a business – ownership of business shares.
Stocks are also called securities, because they give you financial security. Equities is another word for it, because of the equity they give you in the business ownership.
Two types are fairly popular – common stocks and preferred stocks.
This is how common stock works
This is the most popular type of stock for investment. If you own common stock, you are a stockholder, or a business shareholder, who shares the profits or losses of that business. The Board of Directors will be responsible to take the decision how many of the profits to retain back into the company and how much to send out to the stockholders, under the form of dividends.
This is how preferred stock works
Preferred stock works a lot like common stock, with several important differences. Once again, the owner of the stock is a shareholder. This time, however, the dividends are paid out at predetermined times. Preferred stock owners have priority over common stock. If a bankruptcy takes place preferred stock holders will have the priority for the chance to recoup their investments from sales or other forms of recoveries.
This is why stocks are issued
A company may open their business to stock investment, in order to gather funds. It is a good business model for startup companies with innovative ideas and leaders with strong entrepreneurial background.
On the other hand, stocks are attractive to investors, because they can participate in the economy without participating in business management.
Additionally, if the investor is well informed and intentioned, stocks can create far higher returns than other forms of investment.
This is how stocks are issued:
When you incorporate a company, you need your accumulated capital. Your organization may decide to divide that capital into shares. Let’s say your capital is USD 100 000. If you divide that into 100 shares, the price of each share will be USD 1000.
You may choose to come up with most of that capital yourself, hence remaining the main shareholder, and invite friends, family and other investors to become shareholders in your company.
Let’s say your first year you earn USD 2000 in profits. You have to decide how much out of those 2000 you reinvest back in your company. If you choose to reinvest none, you will owe 20 USD earnings per share (EPS) to each of your shareholders.
This is how stocks are bought and sold:
The initial price of each share might have cost each buyer USD 1000 in the beginning (from the example above). However, that price will not be permanent on the stock market.
Say you keep paying out 20 USD earnings per share (EPS) to each of your shareholders. This is not a worth investment. And they will try to sell out their shares for less than their value. If your profit is greater, the price will also be proportionately higher on the stock market.
The stock market is nothing more than a system of actors – buyers and sellers – where said actors are nothing more than individuals representing themselves or other buyers and sellers, that are looking for matching interests to obtain or dispose of stocks at a certain price.
It is nothing more than a marketplace. And the price depends on the supply-and-demand rules. Manipulating the supply-and-demand rules is often the underlying source behind financial crises.
HOW TO MAKE MONEY FROM THE STOCK MARKET?
Earning from stock is not as complicated as it sounds. Profiting, however, is another matter. Here are several factors you need to consider:
Dividend yield on cost
The dividend yield is a simple financial calculation. It is the ratio between the amount of money you would earn per today’s rate in dividends, and the current market price of the stock. It is expressed in a percentage.
The dividend yield is an interesting concept for future investors because it allows them to compare investing in stock to investing in other financial products that offer a return in an annual percentage rate – products such as bonds.
However, if you have invested in a successful company, the dividend rate will increase over time, unlike with bonds, where the return is fixed.
That is why, the dividend on cost is actually a more important variable, when you consider the subject of your investment.
The divined yield tells you how much you would profit today from dividends if you bought stock today. The dividend yield on cost is the ratio between the amount of money you earn per today’s rate in dividends and the price you paid originally instead of the price today.
Watch out for dividend traps though. Some stock investments may look great based on dividend yield on cost only.
Dividend yield on cost can be manipulated. If you see too-good-to-be-true dividend rates, that could mean a hefty law suit or bankrupt lurking around the corner.
To save yourself from dividend traps compare the rates to other years or other companies in the industry. You will notice the rates vary within some limits. If the difference from the average is too high, there is almost certainly something fishy.
Price to earnings ratio
The price earnings ratio is a convenient metric for assessing the prospect value of a company’s stock price compared to the current financial status of a company. (You will also come across it being spelled as the p/e ratio.)
Originally popularized by Benjamin Graham, this ratio is thought to be one of the fastest and easiest ways to determine whether a stock is safe for investment or its value is being manipulated – which means it is being used for speculation on the market.
So what is the price-to-earnings ratio? The p/e ratio is the price an investor is paying for one dollar of a company’s earnings.
Let’s say you have stock in a company called STOK. STOK reported to earnings per share amounting to 3.5 USD. If the stock is selling for 28 USD per share then you divide 28 USD price per share to 3.5 USD profits per share and your ratio is 8.
For your calculation you will need to figure out the basic or diluted earnings per share, where the diluted earnings per share is preferred. That could be tricky for beginners. The good news is most financial portals will automatically calculate and show you the price-to-earnings ratio for the stock you are interested in.
This ratio will be helpful to you to sift through the companies selling at a high price because they have caught the trendy wave, but actually have no real worth to support those numbers.
Have in mind that in the various industries the p/e ratio ranges considered to be acceptable will differ from each other. Tech companies will usually have an average price-to-earnings of about 20, whereas textile manufacturers usually sell at a ratio of about 8. To a large extend that depends on the expectation of growth.
What does that mean in terms of designing your investment portfolio? You need to A) Compare the prices within the industry, B) Compare the history of prices within the same industry, C) eliminate outliers, D) ultimately go for the lowest p/e ratio.
Have in mind price-to-earnings can never be the only variable on which you base your decisions. Some accounting rules and incorrect estimates of future growth can affect the price-to-earnings ratio significantly.
HOW TO INVEST?
The first step towards beginning your stock investment career is to open a brokerage account. It is just an account that have with a stock brokerage firm. You deposit money with them – you can make a direct payment or hook a bank account to them.
When the money is available at their disposal, you can use it to invest different amount and variety of stocks. You will order your broker to sell or buy for you and they will do it for a fee or a percentage of the transaction.
You can choose between a cash brokerage account and a margin account. With a cash account you to deposit cash in advance and with a margin account, you could also borrow from your broker against certain assets at a low-interest rate. As a beginner, it is safer to opt for a cash brokerage account.
The next step would be to learn more about the types of deals you can order from your broker.
Limit orders for example give you the option to impose a limit on the maximum price you will owe or the minimum price you would accept when you are trading with stocks. Meaning you can use limit orders to purchase stock only when its price falls under a certain threshold.
Another type of order you should know about are the all-or-none orders. Most times, when you order an acquisition of a large amount of common stock, of the same company your broker will fulfil your order over the course of days or weeks. This will prevent you from distorting the market – if you leave a large order open that might increase the demand and, with that, raise the price.
However, if you want to place an order that should be executed at the same price, the solution is to make it an all-or-none trade. For your broker that would mean he would have to do it as a single transaction, or not perform on the order at all.
Another factor you have to consider is the expiration day of your order. When you place an order, have to give a deadline to when it can be executed. The first type are the ‘day orders’ – those are valid until the end of the day for the stock market. Afterwards those are canceled and no more attempts will be done to execute them. Market orders are usually done as day orders.
The second type you should consider are the GTC orders. It is an acronym for Good-till-Canceled. Those are valid until you end the order, until they are completed in full, or until 60 day from the order pass.
GTC orders have their risks. First, you need to be conscious of your placed order – especially during a volatile market events may occur that will require you to end your order before it was executed. Second, if you place a large order as GTC, you will pay a fee to your broker every time they act on it. For example, if you place an order to purchase 1000 shares from a company, and they do it in 10 equal steps, a commission will go out to them with each purchase. However, if multiple steps are performed in the same day, you should actually be charged once only.
Remember, all market orders will be executed by your broker unless you manage to cancel them before they become possible. That means you are not in control of the price. If you want to stay in control of the price you should consider placing limit orders or stop orders, which will turn into market orders under certain conditions.
Always consider revenue over cost. The entire cost. Never forget to factor in the amounts your broker charges as a commission. Have in mind the capital gains tax as well, since that will become greater each year.
But how to decide where to invest? The answer is simple and at the same time, it is complex. Long story short, you need to do some comparison and then some research.
Look for deals that look lucrative based on the dividend yield on cost and the price to earnings ratio. Do a historic and inter-industry comparison.
Consider using a robo-advisor. Once you have set your eyes on a company, do some follow-up research. Could there be bankruptcy on the line? Are any big scandals happening? Are any important customers leaving?
Now that you know the most important rules, you must be curious to know when you could have been now if you had joined the stock market years ago.
Here are the financial results you could have benefited from if you had invested in one of three famous brands a decade ago:
CEO Elon Musk is a public personality, not unfamiliar to. Tesla’s stock, however, seems to be on an upswing. Shares were going up 2% following the news that Consumer Reports were recommending the Tesla 3, now with a better performance.
If you had invested in Tesla back in 2010, when the company became public and made its initial public offering, a thousand-dollar investment in the company would give you about 12 times the return as of mid 2018, when you factor in price appreciation and dividends reinvested.
Another company famous for the questionable behavior of their CEO, Apple, has often been both complimented for the vision of Steve Jobs and reprimanded for the faults of his behavior.
If you had invested a thousand dollars in Apple back in 2008, that would have put more than $7,200 in your wallet ten years later, in 2018, when you factor in price appreciation and dividends reinvested.
Netflix is, on the contrary, considered to be quite scandal-free. A company that revolutionized the way people access movies, series and shows was thought to have a shaky future in the beginning, but it has managed to establish itself and is pretty stable on the stock market.
If you had invested a thousand dollars in Netflix back in 2007, that would have earned you more than a hundred thousand dollars years later, in 2018, when you factor in price appreciation and dividends reinvested. That means a return of more than a 100 times the investment.
The greatest reason for Netflix’s success on the stock market is the unexpected growth of its subscriber’s base.
THE WORST INVESTMENT MISTAKES
You must be impatient now to begin your stock investment journey. But holt, please make sure you don’t do any of the four worst mistakes you could fall victim to while planning your investments in the stock market:
Don’t fall victim to the TV
Once you get interested in the stock market, you will discover an entire new world. Sources, articles, papers, and even entire TV shows dedicated to the projections and analysis of the marketplace.
Use your common-sense before you consider the advice of TV personality on the small screen. The opinions of those ‘experts’ may make sense to a newbie, but a real investor will know better than to trust anything they say blindly.
TV ‘experts’ may mislead you with or without intention to take action in the wrong direction. More often than not they will be commenting on rather obvious trends rather than actually providing you with valuable information. Additionally, depending on the size of the audience, their preaching might distort the market and lead to different than expected results.
Don’t fall victim to ratios
Formulas and calculations can seem the perfect safety system against bad decisions. It is not just numbers and indexes. Get out of the mathematics and think about the real world when you take your decisions. Talk to your friends. Discuss your projections with advisors.
Do you know anyone with a good investment sense? A friend with an impeccable profit record can always confirm or reject your wildest intentions.
Advice by investment robots can put you on the right track, but real life experts are so far the best intelligence to predict how the market will behave.
Don’t get too comfortable
Don’t get too set in your ways. It is in the nature of every market to change. Make sure you always ask yourself several questions before you take any important decision about your investment portfolio. Most importantly – ‘Do I really have a reason to believe my expectations will not mislead me.’
Since 2008, the stock market has been watched over through a magnifying glass. It is not a rare view to see large loses followed by profits and then suddenly more losses. Accurate predictions of the market behavior is a but you can always take some common sense steps to make sure your investments are supported by some positive-trend data.
Don’t ever rush into a deal
Last but not least, if you’re planning on getting into stock investments, always make sure you keep yourself level-headed. You can never act on a hunch. Especially when the market is experiencing heavy volatility, all variables will be off track and you might be tempted to act irrationally. Always keep the long-term trend in sight and consider how all your actions will affect your investments in the future.
There is never one plan of action you can adopt to always make sure you take the right decision. Sometimes what seems right will betray your hopes, while an obvious mistake may make you a fortune, out of pure luck.
However, you cannot afford to count on chance. If you do, you are little better than a gambler.
A well-balanced portfolio where you have included a mix of stocks, bonds and other securities is perhaps your best bet against potential bad surprises and loss.
While it takes some of the fun away, you are way better-off if you play your cards carefully.
Investing in the stock market, to a beginner, looks like a parallel universe. It is the same brands and companies you know from the news, or from the logos on products you use in your everyday life.
However, there are new rules to learn. You need to teach yourself to look at the same news and same companies from an entirely new perspective.
Just as any other field, investments of time and money can look intimidating, but once you learn how to behave on the market, you might find yourself a very lucrative and fascinating hobby.