Last week, a friend asked me about investing in stocks and I realized many people ask the same questions over and over again.
This friend wanted to know what stocks were, why should you buy them, how to buy them and which stocks are the best to invest in.
Instead of repeat the same things again, I decided to write this article sharing 15 things you need to know before investing in stocks.
This article is written for complete beginners so check out some of my more advanced investing articles if you already know about the stock market.
1. Investing in stocks is one of many different investment options available
With the stock market at records highs, people are talking about stocks non stop on social media, the radio, news and financial blogs. Many people experience the “fear of missing out” and get interest in the stock market after seeing people make a lot of money.
It's important to realize that investing in stocks is just 1 of many ways to grow your wealth. The reason the stock market is attrative is because you don't earn a lot of money putting your money in a traditional savings account. Negative interest rates around the world leave people with no choice but to place their money somewhere else to receive a return.
You can invest in education, real estate, precious metals, p2p lending, bonds, and other lots of other things.
Don't feel like you must buy stocks. The world is abundant with investing options but I think investing in stocks is easy enough for anybody to do.
2. Investing in stocks allows you to own a porion of a real life business.
Investing in stocks isn't a game or scheme. You become a shareholder in a real life business when you purchases shares. As a shareholder, you are allowed to vote on matters like future acquisitions, who gets to sit on the board of directions, and get invited to the annual shareholder's meeting.
Owning a stock is like owning a portion of a small business or farm. You take ownership of the equipment, employees, assets, etc. If you plan to invest in stocks then take some time to learn more about the company and exactly who the management are.
A company with strong products/services and stellar managements tends to perform well in the stock market.
You can learn more about a company on their investor relations website or by listening to quarterly earnings conference calls (or read the quarterly earnings press releases).
3. Investing in Stocks comes with more risk than more conserative investments
Stocks are substantially more risky than money market accounts or high yield savings accounts. Check out any newspaper or website and you'l probably notice widgets tracking the S&P 500, NASDAQ, or Dow 30. These indexes track the biggest companies in America and it's not unusual for prices to change a lot in the very short period of time.
Some stock rise extremely fast while others can crash and lose over 50% within a day. There is a lot of risk in owning stocks but you can reduce that risk by buying outstanding companies at affordable prices and thinking long term.
Many people remember the 2008 stock market crash with the S&P 500 lost over 40% in 1 year.
However, many of these stocks recovered their losses and went on to increase 5x, 10 or even 40x their initial value just 12 years ago.
Thinking long term with a 2 to 10+ year investment horizon helps you get through emotional times when your stocks are falling.
Take a look at a stock's 1 year, 5 year, 10 year and 15 year annualized returns to see if the stock has performed well in the past. I use Morningstar to find “Trailing returns” of any stock by entering the stock's ticker symbol and clicking “Trailing Returns”.
While the past doesn't guarantee the future, it does show us what the company has returned to investors in the past.
Great companies usually maintain their excellence over the long run while mediocre companies can struggle no matter who is the CEO.
4. Most people invest in stocks by opening a brokerage account online
When I was growing up in the 90's, people used to call their stock broker to place a trade. A movie called Wolf of Wall Street deoes a great job of showing how people used to buy stocks in the past.
In 2020, the rise of the internet and smartphones makes investing in stocks a lot easier than before.
Most people open a brokerage account online with an SEC registered brokerage firm. The brokerage firm acts as a middleman and makes it easy for you to create an account and own stocks.
When you want to buy a stock, they take the order from you, place it on the stock exchange electronically and buy or sell stock according to your specific instructions.
When you open your brokarage account, you must complete an application and enter your personal information. Some brokerages will ask you a few personal questions to learn more about your financial background, work history and income.
Once you submit your application, you will be asked to link your checking/savings account to your brokerage account to make a deposit. Your deposit clears within 1 to 2 businessday days and then you can start investing in stocks.
Once the money is available for trading, you can buy stock by entering a ticker symbol, dollar amount and your specific order type.
Here's an example of the order process on Fidelity (my favorite retirement brokerage account)
You can hold these shares for as long as you like or resell them to get your cash back. There are many different order types you can use to customize your order even further. I'll explain those in a future article but for starters you only need to know about market & limit orders.
5. Different Brokerages have different strengths and weaknesses. Choose Wisely
Different brokerages have differnt strengths and weaknesses.
Some brokerages offer free stock trades but lack good customer support.
Some brokerages charge a fee to buy and sell stocks.
Some brokerages offer retirement account while others only let you buy stocks in a traditional brokerage account.
It's important to know the pros and cons of a brokerage before you sign up. I typically use multiple brokerages for different purposes.
My favorite all-around brokerage is Fidelity. I've been using them since 2009 and they offer zero commission stock trades and fractional share investing. They are a great place to invest for your retirement.
My 2nd favorite brokerage is Robinhood. Their app is simple and easy to use. Robinhood is extremely popular with millenials although they lack 24/7 customer service and you can't do other stuff like automatically reinvest dividends.
6. Investing all of your money in 1 stock is risky: You can lose everything but you can also reap massive gains
Many people wished they invested all of their money in Apple's IPO (initial public offering) because you would have made A TON of money.
However, the opposite is true where people lost everything like the whole Enron stock debacle.
Putting all of your money in a single stock carries an enormous amount of risk and could be a disaster if you are near retirement.
A good strategy to reduce risk is to own a portfolio of stocks – that way you won't lose everything if one stock crashes to zero.
For beginners, I recommend no more than 5 to 10 stocks. You don't want to spread yourself too thin because you will have some winners and losers. Cut the losers and ride the winners.
If you want to build a dividend growth portfolio for retirement, add more stocks to reduce your portfolio volatility. Your goal is passive income and steady growth.
7. A smart way to own a large collection of stocks and reduce risk is to buy index funds
Many people are scared to buy individual stocks because the change in price causes too many negative emotions. That's why brokerage firms created index funds as a more conserative way for people to buy stocks.
Index funds are a large collection of stocks that seek to match the overall stock market. For example, the Fidelity Zero Free Total Stock Market Fund (FZROX) lets you own the entire U.S. stock market, not just a few randon stocks. This index fund holds stocks like Apple, Amazon & Google as its top holdings.
Index funds are a very easy way to own stocks with a lot less risk. Your only concern is if the entire U.S. stock market crashes.
8. Some stocks pay dividends, which becomes a nice source of income to buy more shares or cover your expenses in retirement
While many people are interested in stocks that are going up (capital appreciation), some people are also focused on dividend paying stocks.
Dividends are cash payouts to shareholder from a company based on a per share basis. Most companies pay dividends quarterly (every 3 months) while other pay either monthly or bi-annually.
If you own a dividend paying stock, you will receive a dividend automatically in your brokerage account on the dividend payout date. In order to receive the upcoming dividend, you must own the stock before the ex-divdend date.
For example, Apple pays a $3.08 divdend per share annually so you will receive 77 cents every 3 months per share of Apple stock you own.
If you own 100 shares of Apple stock then you get paid $77 every 3 months.
Dividend are important because it shows the company's management is focused on returning value to shareholders. Dividend paying stocks are usually older, more stablished companies with plenty of earnings left over after expenses are paid.
Some investors own enough stock that they can live off the dividends and retire early. This strategy known as a yield shield was made popular by the FIRE (financial independence, retire early) movement.
For example, if you own a $1,000,000 stock portfolio with a dividend yield of 4% then you can earn $40,000 in passive income just from dividends. That's enough money for a family of 4 to live off of almost anywhere in the world.
Best of all, this money comes in every 3 months without having to sell any of the stock. Apple and other great companies rise their dividends each year, which means your stock pays out more money in dividends even though you didn't invest more money!
Rising dividends are a sign that a company is stable and profitable. Check out the Dividend Aristocrats list for a collection of stocks that increased their dividends for at least 25 years in a row.
Of course, companies can also cut their dividend to preserve cashflow in tough times. Dividends are never guaranteed so be sure to double check the dividend & yield before buying a stock. Not every stock pays a dividend.
The dividend payment is deposited into your brokerage's cash balance but some brokerages have DRIP (dividend reinvestment plans) where you can automatically use the dividend to buy more shares of the same stock.
9. Stock Prices are driven by two
9. ETFs are a collection of stocks that resemble mutual funds
Some people want to own all the stocks in a specfici sector because they think it;s going to do well in the future.
For example, you may think Cannabis stocks are going to perform well once the U.S. legalizes medical & recreational use in all 50 states. However, you aren't exactly sure which Cannabis stock will do well.
Instead of guessing which stock, you can own all the Cannabis stocks by purchasing an ETF (exchange traded fund). ETFMG Alternative Harvest (MJ) is an ETF that holds many different Cannabis stocks.
ETFs have lower fees than mutual funds and you can buy them easily without worrying about fund minimums.
10. Index Funds is the best way to invest in stocks if you don't have time to do research
For most people, buying an index fund is the smartest way to invest in stocks. As I mentioned earlier, index funds are less risky than owning individual stocks yet tend to perform extremely well in the long run.
Index funds hold dozens (sometimes hundreds) of different stocks so your risk is lower even if one of the stocks goes to zero (which is very unlinkely).
Fidelity index funds are the best ones out there because they have 4 zero fee funds for Fidelity customers. These 4 funds have zero minimums so you can start investing with as little as $1.
11. Don't Invest in Stocks With Money You Cannot Afford to Lose
Many people are interested in buy stocks but don't have much money to invest. Take your time and build up some money before you invest in stocks.
Never invest in stocks with money you can't afford to lose. Stocks perform best when held over the long term and you should be able to sit the money aside for at least a few years.
12. Start Investing in Stocks with at least $100
A common complaint is I hear is: “I don't have any money leftover after paying bills to invest in stocks.”
People think you need thousands of dollars to invest in stocks. That's false. Many brokerages have zero account minimums and you can start investing with just $5.
The problem with $5 is you are limited to a small number of stocks whose share price in below $5 aka penny stocks. Penny stocks are highly spectulative and I don't recommend them as good long term investments.
Start with $100.
If you're short on cash then set a goal to save up $100. There are many different ways to invest $100 in the stock market. Starting with a cool benjamin is enough capital to get started. Continue adding to your account with every paycheck.
13: Pay Attention to EPS (Earnings Per Share)
Stock prices are driven by earnings over the long run even though emotions such as fear and greed move stock prices in the short run.
EPS is a calculation of a company's total earnings divided by the number of shares outstanding.
Great companies increase the EPS over time, thus returning more money to shareholders.
If a company's EPS rises, usually the stock price will follow this trend. On the other hand, a company with falling EPS will usually experience a decrease in stock price.
14. Think about the best Tax Strategy for your stock portfolio
Taxes are an important aspect of investing that often get overlooked. If your stock rises in value and you sell it, you pay capital gains taxes. Same goes for your dividends if they are qualified.
Capital gains are taxed on your profits, not the entire amount. Same goes for dividends.
When you pay taxes depends a lot of the type of investment account you have. Generally, there are 2 different types of accounts: tax-deferred and tax-free.
SEP IRAs and 401ks are tax-deferred, meaning you pay taxes on your withdrawls .
Roth IRAs are tax-free, meaning you pay taxes on the contributions but the earnings grow tax-free.
A Roth IRA is the best retirement account if you're an employee while SEP IRAs are good for self-employed people or freelancers.
15. Don't Marry a Stock
Last but not least, there's an old saying on Wall Street that goes: Don't marry a stock.
Stocks are portions of a real business. The stock doesn't know you own it so don't create an emotional bond if the company's fundamentals turn sour.
Always be willing to sell a position and don't be afraid to raise cash if you are uncertain about a stock's future.
So What's Your Next Step?
Here's some recommendations based on your investment goals:
- Investing for retirement? Use your 401(k) at work or open a Roth IRA. If you're self-employed like me, open a SEP IRA.
- Investing for wealth building? Open a traditional investment account.
- Investing for your kids or grandkids? Open a 529 Savings plan (for college) or Custodial UTMA account (to be transferred to the minor after age 18 for general expenses)
What stocks or investments should you buy? Use target retirement funds if you're saving for retirement. Index funds are a good choice as well.
For capital appreciation and wealth building? Invest in stocks whose products & services transform the world.
Check out my top stocks for 2020 if you need more ideas.
Hope this helps! Good Luck!