Investing in the Stock Market: A Beginner’s Guide

How similar is investing in the stock market to gambling? Well that depends on how a person invests.

There are a variety of strategies to “play” the stock market, but unfortunately the vast majority of individuals traders invest with no clear plan. For example, when a person invests in a company because the company is at an all-time low, and they have a feeling it will tread upwards back to its original high, they are gambling.

An investment should be a calculated decision, especially considering how much is potentially at stake because of the miracle of compound interest. If you want to learn more about compound interest, look at the example from a previous article found here.

In essence, compound interest can fund a lavish retirement, a child’s college education, and provide financial security for a person’s mental well-being. However, investing in the stock market is not easy, and any investor should follow the tips below in order to create a well-crafted portfolio.

#1: Understand How Investing in the Stock Market Works

Purchasing a stock seems abstract in nature. At first, it seems like you are buying a stock with precious capital and in return all of you have is a number of shares on a screen.

This makes stocks unique in a sense. Buying a stock is not like buying a commodity like oil, where you have a tangible result in front of you.

However, a stock still has value. It represents partial ownership in a company! Therefore, when a stock price rises up or down, it is often indicative of how the company is doing.

Stocks are naturally risky because when a company loses value, the stock will too. On the flip side, stocks can also be quite lucrative depending on the company’s success.

The primary reason people invest in stocks is to grow their capital over time, but some traders take different strategies too. For example, day traders actively trade while the market is open in order to create a profit each day.

On the other hand, many investors trade with their long-term financial goals in mind. In this case, investors can hold onto stocks for years to maybe even decades, and much less active management is required.

A common term when choosing stocks is due diligence. To ensure an educated purchase of a stock, investors use quantitative and qualitative techniques to choose which stocks fit their portfolio.

For example, investors can perform a fundamental analysis of stocks by analyzing their balance sheet, or technical analysis by reviewing the graph of a stock price over time. However, performing due diligence on a stock is not easy, as it takes hours even for financial experts. The average retail investor should not be discouraged though because there are options to “piggyback” off of big firms through exchange-traded funds and mutual funds.

#2: Understand How Bonds Work

Contrary to stocks, bonds are typically considered a more stable investment because they tend to offer more predictable return streams. The Washington State Department of Financial institutions defines bonds as “an investment product where you agree to lend your money to a government or company at an agreed interest rate for a certain amount of time. In return, the government or company agrees to pay you interest for a certain amount of time in addition to the original face value of the bond.”

Essentially, the government or a company is borrowing money from you, and they promise to pay it back in a certain timeframe with some additional interest to make it worthwhile. Moreover, there are bond rating agencies which exist to rate bonds on the likelihood that they will fulfill their promise to you. Some bonds, such as those issued by the United States government, have a AAA rating, meaning you are very likely to have your bond fulfilled at the expiration date.

In summary, investors must realize that there is a risk when it comes to investing in the stock market, but that risk can potentially be offset by also investing in bonds. However, bonds also typically offer lower rates of return than stocks.

#3: Know Your Risk Tolerance and Choose an Allocation Accordingly

Naturally, everyone’s financial situation and tolerance for risk is different. One primary factor in determining this is age.

For example, a 22-year-old who just graduated college can generally afford to take more risks in the stock market than a 70-year-old who just retired. This is because the young college graduate has plenty of years for his money to compound, so a temporary market downturn won’t hurt him as much in the long run.

On the other hand, someone who just retired may be relying on their investments to live off and cover their fixed costs like insurance, groceries, and utilities. As such, they are much more sensitive to pullbacks in the stock market.

Based off this and other factors, investors must determine how much risk they can tolerate and allocate their money accordingly into stocks and bonds. A young investor, who is not currently relying on his investments to live, may be willing to accept more risk in the hopes of greater returns whereas an older investor may choose to forfeit risk in exchange for a more predictable return. Typically, as people near retirement age, they shift their portfolios more heavily toward bonds.

#4: Create a Diversified Portfolio

Diversifying an investment portfolio can offer a range of benefits–primarily, mitigating risk by spreading your investment dollars across asset classes, market caps, business sectors, and geographies.

Market cap is short for market capitalization, and it refers to the total market value of a company’s outstanding shares of stock. You have likely heard of different terms for stocks, such as “large-cap” or “small-cap.” While there is no universal definition for what constitutes a company as a “large-cap” or a “small-cap,” the following parameters generally apply:

  • Mega-cap: market value of $200 billion or more;
  • Large cap: market value between $10 billion and $200 billion;
  • Mid-cap: market value between $2 billion and $10 billion;
  • Small cap: market value between $250 million and $2 billion; and
  • Micro-cap: market value of less than $250 million.

Besides investing in companies in different sectors and of different market capitalizations, investors can further diversify their portfolio by investing in international markets and bonds.

#5: Select Your Investments

Investing in the stock market often requires an accessible avenue to achieve diversification while still ensuring thorough due diligence. Luckily, there are options like exchanged traded funds (ETFs) and mutual funds.

ETFs and mutual funds provide a straightforward way for investors to invest in a diversified basket of securities. These funds either track an index or are actively managed by a portfolio management team, enabling investors to access professional management and diversification. However, keep in mind ETFs and mutual funds often have management fees and other expenses, which can reduce your total earnings over time.

Develop a Plan for Investing in the Stock Market

Investing in the stock market can indeed be rewarding, but it’s important to be aware of the associated risks. Diversifying your assets and carefully researching investment opportunities can help to mitigate these risks. Finally, before you begin investing, it’s wise to have a concrete plan tailored to you as a plan can significantly improve your chances of success.