It is no coincidence that most wealthy people invest in the stock market. While fortunes can be both made and lost, investing in stocks is one of the best ways to create financial security, independence, and generational wealth. Whether you are just beginning to save or already have a nest egg for retirement, your money should be working as efficiently and diligently for you as you did to earn it. To succeed in this, however, it is important to start with a solid understanding of how stock market investment works. This article will guide you through the process of making investment decisions and put you on the right path to becoming a successful investor.
Establishing Your Goals and Expectations
Make a list of things you want
To set your goals, you’ll need to have an idea of what things or experiences you want to have in your life that require money. For example, what lifestyle do you want to have once you retire? Do you enjoy traveling, nice cars, or fine dining? Do you have only modest needs? Use this list to help you set your goals in the next step.
Making a list will also help if you are saving for your children’s future. For example, do you want to send your children to a private school or college? Do you want to buy them cars? Would you prefer public schools and using the extra money for something else? Having a clear idea of what you value will help you establish goals for savings and investment.
Set your financial goals
In order to structure an investment plan, you must first understand why you are investing. In other words, where would you like to be financially, and how much do you have to invest to get there? Your goals should be as specific as possible, so that you have the best idea of what you’ll need to do to achieve them.
Determine your risk tolerance
Acting against your need for returns is the risk required to earn them. Your risk tolerance is a function of two variables: your ability to take risks and your willingness to do so.
Learn about the market
Spend as much time as you can reading about the stock market and the larger economy. Listen to the insights and predictions of experts to develop a sense of the state of the economy and what types of stocks are performing well.
Formulate your expectations for the stock market
Whether you are a professional or a novice, this step is difficult, because it is both art and science. It requires that you develop the ability to assemble a tremendous amount of financial data about market performance. You also must develop "a feel" for what these data do and do not signify.
Determine your asset allocations
In other words, determine how much of your money you will put in which types of investments.
- Decide how much money will be invested in stocks, how much in bonds, how much in more aggressive alternatives and how much you will hold as cash and cash equivalents (certificates of deposit, Treasury bills, etc.).
- The goal here is to determine a starting point based on your market expectations and risk tolerance.
Select your investments
Your "risk and return" objectives will eliminate some of the vast number of options. As an investor, you can choose to purchase stock from individual companies, such as Apple or McDonalds. This is the most basic type of investing. A bottom-up approach occurs when you buy and sell each stock independently based on your projections of their future prices and dividends. Investing directly in stocks avoids fees charged by mutual funds but requires more effort to ensure adequate diversification.
- Select stocks that best meet your investment needs. If you are in a high income tax bracket, have minimal short- or intermediate-term income needs, and have high risk tolerance, select mostly growth stocks that pay little or no dividends but have above-average expected growth rates.
- Low-cost index funds usually charge less in fees than actively-managed funds. They offer more security because they model their investments on established, well respected indexes. For example, an index fund might select a performance benchmark consisting of the stocks inside the S&P 500 index. The fund would purchase most or all of the same assets, allowing it to equal the performance of the index, less fees. This would be considered a relatively safe but not terribly exciting investment. Advocates of active stock picking turn their noses up at such investments. Index funds can actually be very good "starters" for new investors. Buying and holding "no-load," low-expense index funds and using a dollar-cost-averaging strategy has been shown to outperform many more-active mutual funds over the long term. Choose index funds with the lowest expense ratio and annual turnover. For investors with less than $100,000 to invest, index funds are hard to beat when viewed within a long time period.
- An exchange-traded fund (ETF) is a type of index fund that trades like a stock. ETFs are unmanaged portfolios (where stocks are not continuously bought and sold as with actively managed funds) and can often be traded without commission. You can buy ETFs that are based on a specific index, or based on a specific industry or commodity, such as gold. ETFs are another good choice for beginners.
- You can also invest in actively managed mutual funds. These funds pool money from many investors and put it primarily into stocks and bonds. Individual investors buy shares of the portfolio. Fund managers usually create portfolios with particular goals in mind, such as long-term growth. However, because these funds are actively managed (meaning managers are constantly buying and selling stocks to achieve the fund’s goal), their fees can be higher. Mutual fund expense ratios can end up hurting your rate of return and impeding your financial progress.
Purchase your stock
Once you've decided which stocks to buy, it is time to purchase your stocks.
Build a portfolio containing between five and 20 different stocks for diversification
Diversify across different sectors, industries, countries, company size, and style ("growth" vs. "value").
Hold for the long term, five to ten years or preferably longer
Avoid the temptation to sell when the market has a bad day, month or year. The long-range direction of the stock market is always up. On the other hand, avoid the temptation to take profit (sell) even if your stocks have gone up 50 percent or more. As long as the fundamental conditions of the company are still sound, do not sell (unless you desperately need the money. It does make sense to sell, however, if the stock price appreciates well above its value (see Step 3 of this Section), or if the fundamentals have drastically changed since you bought the stock so that the company is unlikely to be profitable anymore.
Invest regularly and systematically
Dollar cost averaging forces you to buy low and sell high and is a simple, sound strategy. Set aside a percentage of each paycheck to buy stocks.
- Remember that bear markets are for buying. If the stock market drops by at least 20%, move more cash into stocks. Should the market drop by 50%, move all available discretionary cash and bonds into stocks. That may sound scary, but the market has always bounced back, even from the crash that occurred between 1929 and 1932. The most successful investors have bought stocks when they were "on sale."
Tips
- During your wealth accumulation stage, consider over-weighing stocks that pay low or no dividends. Lower yielding stocks tend to be safer, have greater growth potential, eventually leading to bigger dividends later, and save you on taxes (by allowing you to defer tax on unrealized capital gains rather than paying tax on dividend, a form of forced distribution).
- Before buying stocks, you might want to try "paper trading" for a while. This is simulated stock trading. Keep track of stock prices, and make records of the buying and selling decisions you would make if you were actually trading. Check to see if your investment decisions would have paid off. Once you have a system worked out that seems to be succeeding, and you've gotten comfortable with how the market functions, then try trading stocks for real.
- Information is the lifeblood of successful investment in the stock and fixed-income markets. The key is to stay disciplined in implementing your research and in assessing its performance by monitoring and adjusting.
- Look for chances to buy high-quality stocks at temporarily low valuations. That is the essence of value investing.
- Remember that you are not trading pieces of paper that go up and down in value. You are buying shares of a business. The health and profitability of the business and the price you will pay are the only two factors that should influence your decision.
- Don't look at the value of your portfolio more than once a month. If you get caught up in the emotions of Wall Street, it will only tempt you to sell what could be an excellent long-term investment. Before you buy a stock, ask yourself, "if this goes down, am I going to want to sell or am I going to want to buy more of it?" Don't buy it if your answer is the former.
- Buy companies that have little or no competition. Airlines, retailers and auto manufacturers are generally considered bad long-term investments, because they are in fiercely competitive industries. This is reflected by low profit margins in their income statements. In general, stay away from seasonal or trendy industries like retail and regulated industries like utilities and airlines, unless they have shown consistent earnings and revenue growth over a long period of time. Few have.
- Wall Street focuses on the short-term. This is because it is difficult to make predictions about future earnings, especially far into the future. Most analysts project earnings for up to ten years and use discounted cash flow analysis to set target prices. You can beat the market only if you hold a stock for many years.
- The goal of your financial adviser/broker is to keep you as a client so that they can continue to make money off of you. They tell you to diversify so that your portfolio follows the Dow and the S&P 500. That way, they will always have an excuse when it goes down in value. The average broker/adviser has very little knowledge of the underlying economics of business. Warren Buffett is famous for saying, "Risk is for people who don't know what they're doing."
- Be mindful of your biases and do not let emotion dictate your decisions. Trust in yourself and the process, and you will be well on your way to becoming a successful investor.
- Companies with strong brand names are a good choice. Coca-Cola, Johnson & Johnson, Procter & Gamble, 3M, and Exxon are all good examples.
- Invest in companies that are shareholder-oriented. Most businesses would rather spend their profits on a new private jet for the CEO than pay out a dividend. Long-term-focused executive compensation, stock-option expensing, prudent capital investments, a sound dividend policy, and growing EPS and book-value-per-share are all evidence of shareholder-oriented companies.
- Understand why blue chips are good investments: their quality is based on a history of consistent revenue and earnings growth. Identifying such companies before the crowd does will permit you to reap larger rewards. Learn to be a 'bottom up' investor.
- Invest in tax sheltered accounts such as Roth IRA or 401k and max them out each year before putting money into taxable accounts. You can save a great deal in taxes over the long run.
