In this quick guide to stock market investing for beginners, I have compiled 15 tips that every new investor should know before getting into the stock market. These tips will help you invest wisely in individual stocks that are likely to have a higher return than investing through an advisor or through a mutual fund.
1. Do Not Invest Money You Need
The first rule every beginner should know about the stock market is that there is no guarantee in the market. An investment that looks great on paper does not always pan out in real life. Before investing a dime into the stock market, consider that losing all of your money is a real scenario, however unlikely.
You can minimize the risk of major losses by making sure you do not need to withdrawal investing money in the near future. Consider Chipotle (CMG). Just two years ago, this stock was priced in the $400 range. It then was attacked by short sellers and crashed to as low as $250. Fast forward to today, and CMG is over $500 a share. The company did not change at all throughout that time – it just steadily grew as it has been doing for years. However, if you needed to withdraw money from your stock account to pay bills or living expenses, and you had to cash out at $250, you would have lost a massive amount of money.
2. Buying Stock is Easier Than You Think
Getting started in the stock market is very easy; the ease at which one can purchase stock often surprises beginner investors. All that is required is signing up for a discount brokerage account on a site like TradeKing or E-Trade. You can sync these investing accounts to your bank accounts and transfer money at no cost.
Buying and selling stock however is not free. Discount brokerages do not buy and sell stocks for you for charity. With that said, it is not very expensive either if you use a discount brokerage; typical fees for a buy or sell order are in the $8-$10 range. I recommend TradeKing as they have the lowest trading fees around at just $4.95 per trade.
Once you have money available for use in your account, you can just click “buy stock”, search for the company you want, and put in an order. Which leads me to my next beginner investing tip…
3. Use Limit Orders to Buy and Sell Stock
When purchasing stocks, you have the option of buying via a “market” order or a “limit” order. A Market Order means that you will pay whatever the current going rate is for a stock. A Limit Order allows you to set the highest price you are willing to pay for a stock (or the lowest price at which you are willing to sell a stock).
When you buy or sell via a Market Order, you leave yourself open to the whims of the market. Stocks often go up and down a few percentage points on a daily basis. If you put in Market Order, you just might get caught on the high end of the average value of the stock. If you sell via a Market Order, you might end up on the low end of the day’s variance.
Protect yourself from these fluctuations by using a Limit Order. A Limit Order allows you to set the maximum price you would be willing to pay for a stock (when executed as a buy) as well as the lowest price you would be willing to sell a stock (when executed as a sell). By setting a Limit Order for a buy at .5%-1% under current price and as a sell at .5%-1% over current market price, you can eek out extra profits.
4. Avoid Mutual Funds and Indexes
One of the biggest mistakes beginning investors make is investing in the stock market by buying into a mutual fund or an index fund (i.e. a fund that tracks the S&P 500, the Dow Jones, etc). Here is my tip to you: avoid these funds and indexes entirely.
Despite the fact that mutual funds tend to deliver inferior returns, many people put their entire stock holdings into these funds. Mutual funds suffer from two problems: fees and rules. The fee part is easy to understand: mutual funds have management fees that crush the total profits. In order for a mutual fund to pay its typically hefty management fee (compared to an index fund that tracks the Dow or S&P 500), the fund must significantly outperform the overall market. This rarely happens.
In addition to the fee problem, even if a mutual fund is being run by a very capable manager capable of beating the market average, these funds are often constrained by their “charter” – a set of governing rules that the manager must follow. For example, imagine a fund specifically tracks small cap stocks. If one of the companies the fund invested in did very well, eventually this company’s market cap would go beyond the limits set for what is acceptable for the fund (as the fund only is allowed to invest in small cap stocks). At this point, even if the stock continues to remain a stellar investment, the fund manager must sell its shares of the growing company to remain within the rules for the fund.
Index funds represent a problem for investors because they track the entire market rather than specific stocks. Sometimes companies are clear losers and you would want nothing to do with them. For example, imagine an index fund that tracked the New York Stock Exchange (NYSE). If you put money into such a fund, you would in effect be taking a tiny share of every company on the exchange. This includes both the winners and losers. If you have read this blog before, you know I think Best Buy (NYSE: BBY) is tremendously overvalued, yet if you had money in a NYSE fund, you would be stuck with shares of BBY since BBY is on the NYSE.
5. Invest in the Individual Stocks of Great Companies
Now that you know how to buy stocks and that individual stocks generate higher returns than funds, the next focus for beginners is to pick the stocks they want to buy. The best way to invest in individual stocks is to invest in the stock of great companies that are not only likely to be around in 5 or 10 years, but still be thriving at that time. I have covered in great detail how I pick these sorts of companies in my stock investing manifesto.
6. Plan for the Long Haul
Once you determine what stocks you want to invest in and purchased shares, my next beginner tip is to plan for the long haul. Stock prices move up in spurts. Companies may lose 10%, 20%, or even 40% of their market cap due to negative sentiments. This can even happen to great companies (see: AAPL, CMG).
Great companies tend to be priced at a premium. Sometimes investors get spooked by the high relative cost of the stock, causing prices to dip. However, if you picked a great company, eventually earnings growth will catch up to share price and the stock price will go up. Just as a single company can quickly lose 10%+ of its market cap, such stocks can also gain over 10% in a day. Even companies with huge market caps can be subject to these sorts of jumps: Google (GOOG) moved up over 10% in one day recently after having a good quarter (an increase in market cap of well over $25B).
7. Try and Ignore the News
Every day, commentators will try to spin stories about stocks just so that they have something to talk about on their TV show or website. I try to stay away from that sort of talk on this blog. Generally, day to day news has little influence on the overall prospects of the company, particularly negative news. Negative news tends to get a lot of press coverage though since people cannot help but read it.
As an example of this, consider the recent announcement that there were delays in the Apple and China Mobile deal. While many news reports were objective, there were still some talking heads that suggested that this delay meant that Apple was suddenly a definitive sell. In reality, while the deal would have been nice for Apple, even without the deal, Apple is still very profitable and hitting record sales with their latest product refresh.
Try to ignore these negative stories to the best of your ability and instead focus on the long haul. If you read every single negative news story about your stock, you might end up “panic selling” and lose out on a lot of money.
8. Stay Away from Financial Advisors
For the average investor, most financial advisors are a rip off. The problem with financial advisors is the same problem with mutual funds: the management fee kills any added value. In order for someone managing your money to be worth their while, they have to be able to routinely beat the market average by multiple percentage points. By definition, there can only be a few people in any given year that are able to beat the average by a significant basis. Anyone who can do this reliably is not going to be managing small accounts.
Instead, it is a far better practice to simply learn how to invest and take control of your own holdings. Stick around, read posts on this blog, then reap the rewards of bigger returns for yourself.
9. Do Not Purchase Stock All At Once
Another good stock market tip for beginners is to split up your investment over several purchases. This helps protect you from significant price drops due to a bad earnings report or another catalyst that significantly hurts share price.
Ideally, split up your initial investment target into three amounts and purchase shares 30 days apart.
10. Enroll in Dividend Reinvestment Programs (DRIPs)
A dividend reinvestment program (also known as a DRIP) will automatically take dividends issued by a company and use it to purchase additional shares of stock. If left to run over a long period of time, a DRIP will accrue enough new shares that the dividends generated on those new shares will become significant. Learn more about DRIPs in my guide to dividend reinvestment programs.
Note that TradeKing, E-Trade, and many financial institutions will enroll your stocks into a DRIP at no cost. However, Scottrade does not offer DRIPs. As a result, I strongly recommend avoiding Scottrade, and will continue to hold this view until they start offering DRIPs for free like everyone else.
11. Add to Positions Over Time
If you want to generate significant wealth through stock market investing, you do not want to buy stock one time and never invest again. Instead, you should continuously try and use your savings to purchase additional shares.
Once you get a feel for how the companies you own tend to be priced, you can start allotting your new purchases to whatever stock is cheapest relative to historic values. If you get good at investing in your relatively cheapest holding, you can significantly improve your total return.
12. Learn the Balance Sheet Basics
While you do not need to be a financials wizard to successfully invest in stocks, it can be very beneficial to understand the basics of a balance sheet and other key metrics reported on sites like Google Finance. Learn more about technical stock market in my section on stock investing guides.
13. Readjust Your Portfolio As Necessary, But Not Too Often
No matter how well you pick your companies, inevitably one company will perform better than another. Imagine if you initially owned 5 stocks earlier this year with an even 20% of total value invested each stock. Further, imagine one of those stocks happened to be TSLA, which you purchased at $34. Imagine your other stocks made a healthy 15% run on average while your TSLA holdings increased nearly 5 times in value.
Following such a run, at the end of the year, your stock in TSLA would be worth about 50% of your portfolio’s total value. This is not an ideal scenario as any drop in TSLA’s share price could more than wipe out any gains produced by the rest of your portfolio.
The solution to this “high quality problem” is to redistribute your holdings every 18 months. You only need to redistribute your holdings if one stock begins to be worth more than 33% of your total value. Redistribution involves selling whatever stocks have gone up significantly in value (relative to your portfolio) and then using the proceeds to buy shares of stocks you hold that are lagging.
You do not want to do this too frequently as you can miss out on a big run. Imagine if you did this as soon as TSLA hit 33% of your total worth – you would have missed out on half of the return. Additionally, by holding more than a year, you will pay less income tax on any of your profits.
14. Own Stocks You Understand
If you still need help picking winning stocks, another great beginner tip is to pick stocks that you understand. If you know nothing about oil refining, it is difficult to pick the “best in class” refining company. Stick to investing in businesses you understand so that you can objectively evaluate company quality.
Remember not to confuse your personal opinion with the public’s opinion. You may not think Chipotle is different than Qdoba (or another burrito chain), but clearly the public at large strongly prefers Chipotle to these other restaurants.
15. Remember to Take Profits
As my last beginner stock tip, remember that at some point you will want to take profits. While holding great companies over a long period can make you very wealthy, you will not realize any of that wealth until you sell the stock and take profits.
Be particularly mindful of the fact that many companies do not stay on top forever. McDonald’s and Wal-Mart have made many investors rich over the last 40 years, but these two companies are getting respectively hammered by fast casual restaurants and eCommerce. When a company’s time has come and gone, sell the stock and move on to greener pastures.
Looking for new opportunities presents an excellent opportunity to make outsized gains. Just as old companies often falter in time, other companies rise to take their place. Apple is the largest company by market cap today, yet it was not even in the top 100 companies just 15 years ago.