Investing in stocks for beginners is unnerving for some but does not have to be. An understanding of the process and the right outlook can minimize risk while increasing one’s net worth.
Why invest in stocks?
Although it is easy to forget when things are down, stocks do tend to do well over the long run. Most of the richest people in America earned the lion’s share of their wealth from the value of their stocks increasing over time. Most people cannot get ahead from only their salaries.
What is stock investing?
Basically, stocks are shares in a company. Companies issue stocks for various reasons, with raising money being the most important. Those who buy shares owe a part of the business the shares are in.
What determines stock prices?
Although beginners investing in stocks often are under the impression that the price of a stock is determined primarily by how the company is doing, it should more accurately be thought of as what the markets anticipate future returns to be. Since a company’s results will ride at least partially on how the economy as a whole is doing, economic conditions play a great role in this.
There are also the emotional factors that should not be forgotten. Often, markets are driven by emotions or bad information that drives a stock price higher or lower than what market forces alone would dictate.
The biggest mistakes
While nobody wants to buy high and sell low for any other kinds of purchases, that is what many do with stocks. Beginners and other less-experienced investors often buy stocks when they see prices rising and sell when they fall. It is important to look at shares with a more long-term outlook and not get too excited. Although it is best to buy when the markets are down, it is generally not advisable to be overly concerned about timing. Invest at regular intervals with money that can be put away for a long period.
The second major mistake is lack of diversity. It is never a good idea to put too many eggs in one basket. Spread investments as much as possible over different types of companies. An example of this is buying shares in large, medium and small capitalization companies. Since this may be difficult to do for the small investor, mutual funds and ETFs, which have diversified investments, may be the way to go.
Understanding share prices
Many beginners investing in stocks often automatically shy away from those stocks that are priced higher. However, the actual price of a share is not really a measure of its investment risk since companies sometimes do stock splits. For example, if a company does a split when the prices of their shares are at $50, an investor who held one share at $50 will now have two at $25.
What is much more important than the price is the Price-Earnings Ratio (P/E Ratio). Which is defined as: the valuation of a company’s share price compared to its earnings per share.
For example:
- Company A trading at $5 per share with earnings per share of $0.10 will have a P/E ratio of 50 (5/.1).
- Company B trading at $110 per share with earnings per share of $30 with have a P/E ratio of 3.66 (110/30).
In more practical terms, investors are paying $50 for every $1 in earnings for company A. However, they are only paying $3.66 for every $1 in earnings for company B. Therefore, company B offers a much better value than company A. Lower P/E ratios are more favorable for investors.
Basics of selecting stocks
Every stock investor first needs to sit down and consider the level of risk they are willing to take. For beginners, it is usually better to go with large capital stocks since they are generally more stable.
Some of the most important criteria to consider are:
- Earnings growth: This is the most important number for many investors. Companies that consistently meet or exceed earnings show the most promise.
- Cash flow: Large, positive and increasing cash flows are what to look for.
- Debt to equity ratio: This is the long-term debt divided by the equity of the shareholders. Not surprisingly, low to zero debt is the best.
- Return on net worth: This is a measure of profit after taxes divided by net worth, and a growing return is an important positive.
Sources for reliable information on companies
- Form 10-K, required every year by the SEC, summarizes the company’s performance and is perhaps the single best source of information on companies
- Annual reports, sometimes combined with the 10-K, give a comprehensive overview of the different activities of the company over the year as well as its financial performance.
- Statistical showings of company performance in five to ten-year periods, as well as other useful information, are provided by firms to include Morningstar, Moody’s, Value Line and S&P.
- Read business publications to include Fortune, Forbes and Business Week to gain good background knowledge and tips.
Those who do not want to research companies might want to consider no-load mutual funds or ETF investing strategies since these offer diversity and professional management in the case of mutual funds. The relative advantages and disadvantages of each can be found at ETFs vs. mutual funds.
Finding a broker
With a few exceptions, everyone must go through a broker to purchase stocks. There are several types to consider: full service, discount or online brokers. Many beginners investing in stocks go for full-service brokers, since they give them tips on stocks and other assistance. However, the drawback is that the fees for buying and selling stocks will be significantly higher.
Discount brokers and online brokers are similar and make it possible to do stock trades at much lower fees. However, services for an online broker must be accessed virtually entirely online. These brokers will not offer the kinds of personalized advice full-service brokers will but have extensive online resources their clients can utilize. Compare fees carefully and make sure any online broker offers an easy-to-use interface. Be sure to understand trading online before getting started.
Wherever orders are placed, keep in mind that the prices are always changing, and the price the order was placed at not be available by the time it is processed.
Other things to consider
The long-term outlook that is advisable for stocks should also be combined with a tax strategy. Any money for stocks should first go into retirement plans to include IRAs and 401Ks to take advantage of the significant tax advantages they offer (see 401K vs. IRA).
As with any investing, avoid anything that looks like a get-rich-quick scheme or is offering returns that are too good to be true. Margin investing should only be done by those with a lot of experience and never by beginners.
