Basics of Investing: How to Invest in Stocks

by Sep 12, 2020Personal Finance

Even before you start investing, you have to learn the very basics of investing. Why it is so important?

Investment carry risk. When you invest your hard earned money, especially in stock market without understanding basics of investing, you could lose some or all your money invested.

In such an event, lost is not only your invested capital but also your confidence to invest further in the stock market.

When you burn your fingers in stock market as a beginner, the timid you become about investing. You may hesitate or never return to investing in stock market.

That’s why it is important to learn the basics of investing even before you start to invest.

When you read this whole article, you will have a basic understanding of investing to help you get started.

What is an Investment?

Investment is a process of buy an asset in exchange of money. Your investment may grow the value of money in the future as returns or profit.

For example, you buy physical gold as an investment, the intent may not only to consume it but also use it for wealth creation. Here, gold is an asset that appreciates its value in the future over the time.

Investing we talk about mainly evolves around shares and stock market. However, there are also other ways of investments for creating wealth such as investing in property or other assets.

Why You Need to Invest?

Why invest when you can save your money in the bank account for interest as return?

Short answer is Inflation. The value of money depreciates over the years due to inflation.

Interest rates in savings bank account is diminishing over the time and this yield low return from savings interest rate. As a result, the value of your money kept in bank account grows at a very lower rate of return which fails to beat the inflation.

Below is an illustration of capital gain when £1000 is held in savings account as compared to investing in stock market over 30 years.

You will get a return of 3996% from investing in stock market as compared to keep the same money in savings account over a long term.

Basics of Investing

However, in real investment carry risk. Past performance is no guarantee of future. These risk can be reduced by understanding the basics of investing.

Types of Investment: Basics of Investing

Stock market is the first thing people think about when we hear the word investing. There are several more investments.

Basic types of Investments in stock market

  • Bonds
  • Stocks
  • Mutual Funds
  • ETFs

Other types of investments (not an exhaustive list)

  • Gold
  • Real Estate
  • REITs
  • Wine
  • Farmlands
  • Arts & sculptures
  • Peer-to-peer (P2P) lending
  • Angle investing
  • Venture Capital

This article cover the investment in stock market a more in detail.

Basics of Investing: Bonds

It is a type of investment product. In simple terms, you are giving your money to institutions (Governments and Corporate Companies) by buying the bonds issued by them for a given period of time. You earn regular interest in return, usually know as coupons.

In terms of risk and returns, Bonds stands between savings account and investment in stock. Because, it is less risky and yield less return than investing in stock.

Since, investing in bonds is considered safer than investing in stock market, most people include bonds in their portfolio as a way to reduce the risk. However, it is not completely risk free.

Basics of Investing: Stocks

Stock is an investment in an individual company. When you buy a stock, you are buying a small piece i.e. a share of that company.

Why would a company sell their share of stocks? Companies sell shares to raise cash to improve or expand their business. Investors buy and sells those shares between themselves.

Stocks can you earn you higher return but that comes with higher risk compared to other investment.

Basics of Investing: How Does Stock Market Works?

To keep it simple, think of stock market as a virtual market place (as it is happening online in today’s world) where buyers and sellers meet to buy and sells stock.

Companies who wants to sell their shares public have to be listed in a stock exchanges e.g. London Stock Exchange.

When you buy a stock of company for a price, however, tiny your investment is, you become a ‘shareholder’ of that company.

That slice of that company share can be traded in stock exchanged with any other investor who wants to buy it.

Basics of Investing: Mutual Funds

For a beginner, buying an individual stock can be risky. Because, when the company performs poorly, the stock price of that company will go down than the price you originally bought. As a result, you might end up losing some or all of your capital if you sell the stock.

Since, picking individual stock to buy can be intimidating process for beginner, you have an alternative which is Mutual fund.

Mutual fund is a pool of fund i.e. money collected from various investors to invest in securities such as Bonds and Stocks. This allow a small or individual investors to buy a large number of shares of many companies in one single transaction.

In simple terms, rather than investing in one individual stock, mutual fund allows you to invest in a collective number of companies (or other securities). As a result, poor performance of one company may not largely affect the value of fund.

Hence, it is reducing risk by diversifying the portfolio of the fund.

Mutual fund are managed by professional managers and it is priced daily as Net Asset Value (NAV) per share or unit. When you buy a mutual fund, you are ideally buying some units of the fund at an NAV priced on the day you buy.

Professional managers who manages the fund (i.e. a pool of money from investors) makes the investment in stocks and bonds (or other securities). For this service, you are charged a nominal fee to pay the fund manager and the company.

Active Funds

Active funds as the name suggest, it involves active buying and selling of stocks, trying to yield higher returns to the investors.

Instead of you picking the stocks, the fund manager, a group of analyst and researchers, actively buy and sell stocks with an aim to outperform or beat the benchmark or stock market index.

The cost of investing in an Active funds are high. Investors are charged a service fee such as commission, administrative fee and more.

The cost ranges from 0.5% to 3% or even higher in some cases. This mean if you looking for a 10% return on your money, the active fund has to yield more than 13% (assuming fee is 3%) to earn you the desired return.

A lot of fund managers are increasingly failed to beat the benchmark or stock market index. Even, some active funds yield less returns than a stock market index.

What is a Stock Market Index?

It is an index that measures the performance of a stock market. Meaning, it helps to compare the past price with the current price to measure the stock market performance.

For example, FSTE 100 Index is a collective of top 100 companies listed in the London Stock Exchange.

Passive Funds

Passive funds are index funds, typically track or mimic the performance of index. FSTE 100 and S&P 500 are examples of indexes.

The aim here is simply provide the returns same as the stock market index by replicating the movement of the stock market.

This is otherwise tracker funds simply because it tracks a particular stock market. The most popular stock market is S&P 500 which is the top 500 companies listed in the U.S. stock exchange.

A tracker fund purchases stocks in the same proposition as the market.

For example, an S&P 500 tracker fund, purchases the same proposition of all 500 companies in line with the market value. The value of such tracker fund will therefore moves in line with the value of the market.

It eliminates the need for a fund manager to actively buy, hold and sell stocks. For this reason, the cost of investing in passive is merely low (e.g. Vanguard tracker fund cost is as low as $0.05) compared to active funds cost.

Having said that, the value of a tracker entirely depends on the performance of an entire market.

In other words, if you invest in FSTE 100 tracker fund, your returns from the fund is depends on the performance of all the 100 companies in the FSTE 100 index fund.

Not all the companies will performance well in reality, some do well and perform poorly. Due to this, the value of some stocks in an index goes up and other goes down. As a result, generally you get an average return from a tracker fund.

Basics of Investing: EFTs

Exchange Traded Funds (ETFs) are similar to a mutual fund. The difference is that ETF are traded in stock exchange as oppose to mutual fund which is traded once per day and priced only after the market is closed.

This means the price of EFTs changes throughout the day in the stock market and you can buy or sell on the same day. Whereas, the price of a mutual fund (i.e. NAV) is determined by a fund manager after the market is closed.

Mutual fund is less liquid than ETF. This means when you sell a mutual fund on a particular day, you may not get the cash on the same day as the selling price of the fund is only determined after the market is closed.

Most ETFs tracks an index fund and the expense ratio, that is, the cost of managing the fund is low. But, since, it is traded in the stock exchange, the transaction cost of EFTs are higher.

Not all ETFs tracks an Index, there also some actively managed ETFs which as higher expense ratios.

How to Invest in Stock Market: Basics of Investing

Below are step by step guide to invest with confidence in the stock market.

Step 1: Start with a Goal

Even before you start to invest, ask yourself the below questions. Answering these question basically defines your investment plan.

  1. What are these investments for? This is your goal for your investment. E.g. You want to invest for your retirement or your child’s education or travel around the world.
  2. How much money would need to achieve your financial goal? You are setting yourself a target. Be as accurate as possible. If you are investing for your retirement, then you need to calculate your annual expenses and your retirement number. Read more to learn about retirement number.
  3. How long will you invest your money? This is your time in market. It helps you choose your investments assets (i.e. stocks, bonds or other assets).
  4. How much rate of return you expect from your investment? Determine average rate of expected returns.
  5. How much risk can you live with? This is your tolerance to exposure of risk on your investment capital.

Step 2: Find Money

Save money to invest. Best practice to save money for investing is to pay yourself first even before you start to spend.

Read more to learn about how I saved 70% of my income.

It is advisable to not to invest in stocks if you need your money back in less than 5 years. Because, it is a high risk to invest for short-term in stock market. You may lose your invested capital in a downturn. Investing in stock is a golden goose but only for long term investors.

Be a long term investor. Invest only the money you do not require in the near future.

Step 3: Start Investing

Start investing even with little money. Once you have the savings (even if little savings), you have to get started as soon as you can to invest. You can meet your financial goals even with smaller money by investing regularly for a long-term.

Remember, keeping money in your savings accounts, lose its value over the time due to inflation. That’s why you will have to start investing now than later.

Open a Brokerage Account: Basics of Investing

You will need a brokerage account/investment platform to invest in stocks and bonds.

Investment account such as Shares and stocks ISA, provides savings on the tax on your capital. The allowed investment amount on this account, which is eligible for tax-free returns is £20,000 per annum per person.

You can open Shares and stocks ISA accounts in any of the below online investment platforms.

These company charges a platform fees as below.

PlatformPlatform ChargeMin ISA Deposit
Vanguard0.15% Annually£500 or £100 per month
if regular savings
FidelityLess than £7,500: Annually 0.35%
if you have a regular savings plan
or £45 Annually if you don’t
£7,500 to £250K: 0.35% Annually
£250K to £1 million: 0.20% Annually
£25

Robo-advisors

You don’t have an understanding of basics of investing or you do not want to DIY your investment as beginner, then Robo-advisors would be an ideal choice for you.

You need little or no knowledge about investment to invest using Robo-advisor. Because, it uses algorithms to create an investment portfolio based on your needs and tolerance to risk exposure. It usually invests in ETFs.

You do not have to worry about picking the stocks or funds. Because, the Robo-advisor does it all for you.

  • Nutmeg
  • Scalable.Capital
  • Moneyfarm
  • Munnypot

Step 4: Define Asset Allocation

Asset Allocation is a strategy of an investment plan which primarily focus on balancing the risk and returns of your portfolio.

A portfolio is an asset or mix of assets you own.

A portfolio of assets for your investment is constructed based on your investment goals, risk tolerance and your time in the market (investment time horizon).

Three main assets are stocks, bonds or fixed-income and cash. Some other assets can be your property, gold, pension funds and so on.

Basics of investing
An illustration of a Portfolio’s Assets

Based on your financial goals, time horizon, and risk tolerance, you can build your portfolio with mix of assets.

For example, if your goal is to save to buy a car in an year. You build your portfolio with less risky investment assets such as fixed-deposits, short-term bonds, etc.

However, if you are investing for retirement, then it has longer time horizon (based on your current age). You can build your portfolio with a high risk assets such as individual stocks, mutual funds or long-term bonds.

Even if you are investing for long-term and you risk tolerance is less, you may have to build your portfolio with right mix of securities – stocks, bonds, or other assets.

As thumb of rule, the right percentage of stocks to hold is determined by subtracting your age from 100.

For example, if you are 25 years old, subtracting 25 from 100 is 75. This mean you can invest 75% of capital in stocks and remaining 25% in bonds.

However, it is only thumb of rule, not necessarily, one has to follow as it. Based on your risk tolerance and time horizon (time in the market), you can increase or reduce your investments in stock and bonds.

It is however important to diversify your portfolio to effectively manage the risk and reward.

Step 5: Start with Mutual fund or EFTs

For a beginner, it is better to start investing in mutual funds or EFTs rather than picking individual stocks yourself.

It is even more better to invest in passive mutual funds or EFTs. It minimise the cost of investments and avoid the risk of reduced returns from an active funds managed by a fund manager.

Example of passive funds (index or tracker funds)

Step 6: Keep Investing

Do not try to time the market. It means do not wait for the market to crash to buy at low and sell at high. You will never need succeed with this approach.

Far more money has been lost by investors preparing for corrections, or trying to anticipate corrections, than has been lost in corrections themselves.

Peter Lynch

Keep invest in the stock market (tracker funds) at all times i.e. irrespective of whether the market is low or high.

By doing this, you benefit with Dollar-cost averaging. This mean you avoid buying at the highs or lows of the market.

Continuously investing in the same investment vehicle at all different times reduces the risk and provide an average return.

This also reduces stress of waiting to enter the market and avoid taking no actions for all long period of time waiting for the right time to enter.

Remember, the cash you hold on savings account earns very low interest rate and it fails to beat the inflation.

Making regular investment for a long-term always wins than timing the market.

It is best to automate your regular investments rather manually investing which will unconsciously lead you to time the market.

All the investment platform allows to set up automatic investment into the funds you choose.

Step 7: Continuous Learning

Once you become confident about investing in index fund. The nest step is to gradually learn more about investing to pick individual stocks.

Learn More about Investing – Books You should Read

  • One Up On Wall StreetBuy on Amazon.
  • Intelligent Investor: The Definitive Book on Value Investing. Buy on Amazon.
  • The Financial Times Guide to Investing:The Definitive Companion to Investment and the Financial Markets: The Definitive Companion to Investment and the Financial Markets. Buy on Amazon.
  • Overcoming Underearning: A Five-Step Plan to a Richer Life. Buy on Amazon.

Step 8: Buy Direct Stocks

Once you started to invest in the stock market with tracker funds and gain some understanding of investing, move to the next step to invest in individual stocks.

Make a slow and steady start to buy direct stock. Invest little money in one individual stock. Slowly build portfolio by investing in more individual stocks.

Avoid loading all your capital in one individual stock as it risk losing some or all your money if that one company performs badly. Diversify your portfolio with individual stocks from various sectors and regions.

Step 9: Invest and Forget It

Do not be short-term trader. Various studies shows that more than 90% of short-term or day traders lose money.

I have personally seen one of my friend who was a day trader lost £20000 just in one day. He turned timid about investing since then.

Think long-term, invest for the future rather than short-term gains. Longer your money in the market, the more the time it has to grow.

Step 10: Rebalance Your Portfolio

Rebalancing is the process of realigning the weightage of your assets in the portfolio. This mean you periodically realign your assets in line with your defined asset allocation (refer Step 4).

You asset allocation is constructed based your on financial goals, risk tolerance and time horizon. It is important to check at some interval to ensure your current assets are in line with your asset allocation.

When it is not, you will have to move your capital from one asset (higher percentage of holding) to another (lower percentage of holdings).

For example, let’s assume defined asset allocation is 60% stocks (mutual funds, ETF and individual stocks) and 40% bonds or fixed-income.

When your current assets (let’s say stocks) is grown over the time and it is not now 70% of your total investment. You other asset, bonds or fixed-income is only 30%, then you have to sells 10% of stocks and move that investment into bonds. This ensures your assets are in-line with your asset allocations.

For a long-term investor, it is advised to rebalance your portfolio atleast once an year.

Top 10 Tips to Succeed in Stock Market Investment

  1. Self-discipline is key to success in stock market. Always stick to your investment plan which is designed based on your goals.
  2. You do not need a financial advisor. Your are one who cares more about your money. Do your own research to invest.
  3. Do not panic sell your assets (stocks, mutual fund or ETF).
  4. Avoid the headlines (e.g. UK is in rescission or depression). Do not let the news mess up your investment.
  5. Stay in control of your emotions and keep investing.
  6. Do not keeping checking your stocks price. It leads you to either panic sell in downturn or profit booking in upward market. Remember, you are investing for long-term not for short-term gains.
  7. Do not be too greedy and invest all your capital in one stock. Wealth creation is a long-term process.
  8. Do not invest with gut feeling. Always do the research and make your own model to invest or simply invest index funds.
  9. Do not invest based only on recent past performance. Analyse the performance of the fund or stock for the last 10 years and their growth potential for next 10 years.
  10. Do not time the market. Keep investing at all times for long-term success.

Conclusion

A beginner can succeed with investing in stock market (especially in index fund or ETFs) even with an understanding basics of investing. You can start investing even with little money. Regular investment in stock market yield high return rather than waiting for the market to crash to invest a lump sum amount. Investing based on your goal for a long-term will make you succeed in stock market.

Happy investing:)

About Me

My name is Naresh Jayakumar. I am mastering personal finance to effectively manage, save and grow money. I’m on my happy jounery to financial indenpendence.

I blog to share the tricks and hacks of making, managing and saving money to help others achieve Financial Independence in their lives too.

 

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