Updated August 30, 2016

How to Invest in Stocks: Beginner's Guide

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Want to invest in the stock market but you have no idea where to begin, or even what any of it means? Start with this beginner's guide to stocks.

How to Invest in Stocks
How to Invest in Stocks © CreditDonkey

"Investing is simple, but not easy" - Warren Buffett

Warren Buffett, pretty much considered the smartest investor ever, hit the nail right on the head.

It's really not that hard to get started. All you need is some money and a platform to invest (as simple as a smartphone app). And chances are, you are already automatically investing in the stock market through your 401(K) at work.

But how to pick smart investments is the hard part. As well as mastering your investment strategy.

In this guide, we'll be showing you step-by-step how to invest in stocks. Note that we're talking about investing in individual stocks (i.e. not mutual funds, ETFs, etc). You'll learn:

  1. Why Invest in Stocks
  2. Investing is Not Gambling
  3. What Are Stocks
  4. How Much Money Do You Need to Buy Stocks
  5. Assess Your Risk Comfort Level
  6. Learn about Market Trends
  7. Choose a Brokerage
  8. Do Your Homework Before Deciding
  9. Analyze a Stock's Value
  10. Manage Your Portfolio

Tip: This article is about investing in stocks, but we always recommend that you diversify your investments. This means picking a mix of low-risk investments (such as mutual funds and ETFs) and high-risk investments (such as stocks).

WHY INVEST IN STOCKS ANYWAY?

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Here's a hard truth:

You can be smart about spending and you can be smart about saving. But unless you're a super-rich CEO with a huge income, you're not going to get very far. You can't expect to save everything you need for retirement.

To build long-term wealth, investing is necessary. Parking your money in a savings account or CD allows you to earn some interest, but it's not enough to make a true difference. Investing in stocks usually offers the largest returns over the long-term. Historically, this is the best way to generate growth to reach financial goals.

Just some of the goals may include:

  • You want to buy a house
  • You want to save for retirement
  • You want to save for your children's college education

Investing your money in the stock market certainly means taking on a higher degree of risk than stuffing dollars under your mattress. But it also paves the way towards bigger returns.

Historically, stocks offer an average return of around 10%, which is substantially more than the 1% to 2% you might be able to get with a money market or high-yield savings account. There's risk involved with stocks and that's why it's crucial to be educated (as you're doing now). And don't put all your extra money in one place.

Tip: Generally speaking, investing in bonds is safer than stocks. If you are more interested in preserving your wealth, you may want to consider investing in bonds. If you are young and want to build long-term wealth, you should focus on investing in stocks. As a long-term investment, stocks generally outperform bonds but also have more risk.

And Instead of investing in bank CDs, you may want to consider buying dividend paying stocks.

It's helpful to have a realistic idea now of how much you would need save/invest to reach your goals. Here are some handy calculators to help you out:

Investing is Not Gambling (But Watch Out!)

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More than a third of Americans surveyed say they are scared to invest in the stock market. Does this include you?

Some people feel like it's gambling. Because we can't 100% know that the stock we pick will grow. And it's true that sometimes stocks take a tumble and take people's hard-earned money with them.

But here's the difference:

It is gambling if you pick a random stock because it has an interesting sounding name and bet your dollars as if you would bet a running horse.

It's called investing when you do your homework and take the time to make smart selections. You study the trends and feel relatively confident in your choice. You're letting your wisdom - rather than chance - make your choices for you.

And in this guide, we're going to teach you how to do the latter.

Tip: Don't put all your eggs in one basket. Diversify your portfolio by investing in mutual funds and ETFs. A mutual fund pools money from many investors and typically invest in a range of companies. This helps to lower your risk if one company fails.

JUST WHAT ARE STOCKS ANYWAY?

Imagine a marketplace. Instead of artisans selling jewelry, clothing, etc., you've got companies selling little pieces of themselves. When you buy a share, you now own a little piece of that company. If the company increases in value, your piece will also go up in value.

Simply put, stock represents ownership in a particular company. The stocks we're talking about are for shares of publicly traded companies, and can be bought and sold on an exchange. Stocks can also be referred to as equities or securities; for our purposes, the terms are interchangeable.

There are two basic ways to make money by investing in stocks:

  • If you can sell stock for more than you purchased it
  • If the stock you own pays out dividends to shareholders

For example, let's say you buy 100 shares of a company's stock at $20 each. That's an initial investment of $2,000. After 5 years, the price per share has increased to $25. If you decide to sell all your shares, you'd sell for $2,500. You'd be making $500 in gains (not including any fees and commissions).

The company sets how many shares of stock it issues. And the price per share operates on a supply-and-demand model. If the company is hot and there's a lot of people wanting to buy its stock, the price will increase. If a company has more supply than demand, than the price will fall.

Related:

HOW MUCH MONEY DO YOU NEED TO BUY STOCK?

You can invest in the stock market with little money. Many investors start small.

Fortunately, some brokers don't have a minimum requirement to start trading. And some will expect you to invest at least $500 or even thousands before they'll let you do anything. On top of the account minimum, each trade can usually set you back between $4.95 (with a broker like Ally Invest and OptionsHouse) to $6.95 (with a broker like E*TRADE and TD Ameritrade).

And then there's the price of stocks themselves. While prices can fluctuate wildly from one minute to the next, the average per share price for an individual stock hovers around $70, according to The Wall Street Journal. If that seems a bit pricey, keep in mind that there are stocks currently being traded at well over $500 a share.

Look at it this way: Nothing you'll be doing is guaranteed, so limit your investment to an amount that you'll be comfortable losing if the stocks you choose turn out to be duds.

ASSESS YOUR RISK COMFORT LEVEL

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To figure out how much you'd be comfortable losing, evaluate your risk tolerance. Here are some factors to consider:

  • Your age: If you're relatively young and you have years ahead of you to invest, you may be more comfortable with an aggressive approach (remember, higher risk can result in higher returns). You have time on your side. You can reinvest and survive the ups and downs of the stock market.

    On the other hand, if you're nearing retirement or you're generally uncomfortable with taking risks when it comes to your hard-earned dollars, playing it safe might make more sense. For retirees and those near retirement, preservation of capital is important.

  • Your short-term goals: Are you trying to save up for a house? Think of your short term goals and when you want to reach them. Is it smarter to just save up for that in a savings account? You can't be sure that your stock will give you growth in just a short period. It may even go down. And if you need that money soon, you want to make sure it's within reach.

    Tip: Also be sure you have enough emergency reserve in your savings account first. A good reserve is usually 3-6 months of living expenses in case you lose your job. If you don't have that yet, don't invest that money in stocks.

    For emergency money and funds for short-term goals (such as a vacation), you want to make sure you can access them quickly. You don't want them tied up in investments. It is smart to store this money into online savings accounts so you can get to them whenever needed.

  • Your job: If you've got a stable career, then you can afford to take more risk with stocks. After all, you'll have your steady paychecks in case anything goes wrong. But if your income is more unpredictable (such as if you're self-employed), you may not want the high risk of stocks. In this case, it may be better if more of your portfolio is allocated to mutual funds and bonds.

Tip: Build an investment portfolio that matches your financial situation and tolerance for risk. Be mindful of your age, what your goals are, and your investment horizon. Revisit your portfolio on a regular basis.

Next is knowing when to invest. You want to have the proper investing strategy for the current state of the market. Learn about when stocks tend to rise and what type of stocks are currently performing well.

Here are some general things to know:

  • Stock prices rise when interest rates are low. When interest rates are low, people are able to borrow more money, and thus have more to spend. This in turn means that companies get more revenue and can grow. Stock prices will usually increase due to the growth.

    On the other hand, high interest rates mean that it's harder for people to borrow money, and thus they spend less. This will usually lead to a fall in stock prices.

  • Understand bear and bull markets. You may have heard the terms "bear" and "bull" markets. Bull market is when the market is performing well. Stocks on are the rise and people are confident about the economy.

    Bear market is when the economy is bad (such as in a recession). This leads to drops in stock prices. You'll want to adjust your portfolio to ride out this period or to take advantage of the opportunity. This may be a scary time and cause people to panic, but remember that historically, the market always has a positive return in the long run.

    You can't predict market trends with absolute certainty. But have a general idea of the current state of the market to influence your investing strategy.

  • Industries that do well in strong economies: When the economy is doing well, people tend to spend more money. Industries such as airlines, retail, and automobiles do well during these times.

  • Industries that do well in falling economies: On the other hand, other industries aren't so impacted when the economy isn't doing well. This includes industries such as utilities and discount retails.

CHOOSE A BROKERAGE

Before you can actually begin buying stocks, you'll need a platform to invest. The easiest way is through a brokerage. This is an account that holds your investments.

  • A full-service firm means you'll have expert advice on tap at all times. This may be the better option if you're not sure how to pick stocks, or you don't have the time to research and keep up with the market. But you'll pay a premium for the service.

  • A discount brokerage has low fees since you'll be doing all the investing yourself. This is the better option if you are confident about selecting stocks. This ensures that more of your investment seed money is going towards the purchase of your stocks.

  • Robo-advisors have recently come onto the scene. These are computers that use an algorithm to automatically make investments for you based on your goals and risk tolerance. Because there is no real person behind this, the fees are kept low.

How to Make Your Choice:
There are a number of online brokers to choose from. You'll need to take a look at their features, fees and convenience. Will you want to set up a retirement account like an IRA (you can get tax advantages with such an account) or a general brokerage account (which will result in you having to pay taxes on your earnings if you sell)?

Also be sure to pay attention to how much it will cost you to buy and sell stocks. Fees can run $5 to $10 per trade, depending on which brokerage you choose. If your strategy is to hold on to your investments over the long-term, paying the higher fee may not make much of a difference, but you'll want to look into cheaper options if you plan to trade stocks on a regular basis.

Learn which stockbroker is right for you. In some cases, paying a lower commission for trades means sacrificing some of the variety you'd get with a more expensive brokerage.

Tip: You also want to choose a broker that's beginner friendly with a lot of educational resources. Some brokers such as Ameritrade and OptionsHouse allows you to dip your toe in the water first before taking that plunge with a virtual trading platform. Using a virtual trading platform, you can do paper trades to practice strategies and ideas. That way, you can ease into this new world by making mock trades before doing the real thing with your hard-earn dollars

DO YOUR HOMEWORK BEFORE DECIDING ON AN INVESTMENT

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Remember, investing is not gambling. So you'll need to put in the time researching before settling on your choices.

You'll want to know who the rising stars in an industry are and where they seem to be headed. Established brands (or blue chip stocks) are usually safer bets, but you'll pay more for them. The value of a mature enterprise will tend to grow at a slower pace than a rising (i.e., riskier) newly public company.

Learn which companies to invest in. When researching individual companies, you need to understand the company's goals and how likely it is to make a profit based on its structure and operations. If you buy stock in a startup, for example, but the people running it don't have a solid plan for turning a profit, odds are you're not going to make any money either.

Some things to look for include:

  • The annual report: This is a report detailing the company's activities, financial performance, and future insights. Most companies will have this for free on their website to download.
  • The balance sheet: This snapshot tells the company's assets (what they own) and liabilities (what they owe).
  • The income statement: This statement tells investors the company's total earnings over a period of time.
  • The cash flow statement: This is a breakdown of cash coming in and leaving the company. It's broken down into business operations, investing, and financing.
  • The profit margin (in %): This shows much profit the company gains for every dollar in sales. The higher number the better.
  • The return on equity (in %): This shows how much profit the company generates with each $1 of the shareholders' money. The higher number the better.
  • The company's debt: Look at how much debt the company is carrying. The more that a company borrows, the more it has to pay back with interest, which can affect the stability of its per-share stock prices.

Tip: If you don't have time to focus on any one company, you could put your money toward a mutual fund or ETF (exchange-traded fund). Index ETFs are very popular choices. Whatever you do, do not put all your money in one place. Diversifying where you park your money will help you avoid losing your shirt if one industry falters suddenly.

Popular places to keep tabs on stock news:

Tip: Investment magazines are a great way to keep up to date with the latest market news and trends. Kiplinger wins our title of Best All Around Magazine; each issue contains a lot of tips and recommendations for making wise investments, as well as for basic personal finance. Our other top picks include Bloomberg BusinessWeek, which is a must-read for staying on top of breaking financial news, and Barron's, which is entirely focused on financial markets analysis.

HOW TO ANALYZE A STOCK'S VALUE

There's a lot more to a stock than its price.

Tip: There are two common approaches to selecting stocks. Growth investors want stocks that offer earnings growth potential. Growth stocks are generally more expensive. While value investors want stocks that are undervalued. Both growth investing and value investing have their pros and cons. You may want to consider having both growth and value stocks in your portfolio.

Another way to look at a stock is to analyze its value. The most widely used way to do this is to look at the price to earnings (P/E) ratio. This is a quick way to gauge a stock's worth without having to sift through tedious accounting reports.

The P/E ratio is the ratio of the company stock's current share price to the company's average earnings per share (EPS) over the past year. Simply put, it's how much investors are currently paying for $1 of the company's profit.

  • The EPS is the total earnings divided by the number of shares held by all investors. So for example, let's say a particular company in the past year has a profit of $1,000,000, and there are 500,000 shares out there held by the public. This would mean that the earnings per share is $2.
  • Now, let's say the current price per share of the stock is $40. The P/E ratio would be $40/$2, or 20. This means investors are paying $20 for $1 of the company's profit.

So why do you care about the P/E ratio? It gives you an idea of how the company is performing compared to other companies in the same sector.

Tip: It's helpful to look at the national average P/E ratio (which is usually 15-20), but you want to make sure you're comparing to companies within the same industry. The technology section usually has high P/E ratios, while automotive and utilities companies typically trade at low P/E.

A high P/E ratio means that investors are paying more for the stock compared to earnings. This generally means they're expecting more future growth. But if the ratio is way above average, this could mean that the company is overvalued, and the stock can drop big if the growth stops.

A lot of value investors swear by only investing in companies with low P/E ratios. It's more of a bargain buy. But you'll need to look more into why the ratio is low. It could be because the company has done really well in the past year (the "E" part), and the public just hasn't caught up yet. This would be a smart buy. Or it could be that investors predict problems in the future and aren't buying. In that case, you may want to follow suit.

The P/E ratio is a quick way to gauge value and compare against other companies. It's a great tool to use, but it shouldn't be your only factor.

MANAGING YOUR PORTFOLIO

Great, maybe you've bought some stocks - Congrats! But your work is not done yet. You have to actively manage your portfolio too.

Here are some tips for your portfolio:

  • Diversify your stocks across a variety of industries and companies (established brands as well as young, fast growing companies). Choose a mix of value and growth stocks.

  • Assess each stock to see if it is performing as your expected. If a stock is growing a lot slower than others in the same industry, you may want to sell it and invest the money elsewhere. If a stock is too erratic and makes you uncomfortable, you may also want to make a change.

  • If your stocks aren't growing as much as you'd like, try not to be too impatient. If the stock market has a bad day (or week or month), try not to panic. You want to hold a stock for the long-term (think 5+ years, even 10 or 20!). Some people like to buy and sell quickly to make a quick buck, but we want to help you build wealth for the long term.

  • Every year, review the companies to see how they're performing. This will allow you to evaluate whether keeping the company's stock is a worthwhile investment.

FINAL WORD

There's a fine art to buying stock and making smart decisions. It's absolutely crucial that you understand how the market works and the current trends. Take your time to learn about the companies and analyze their financial histories before making your selections.

Hopefully, we've given you a basic understanding so you can feel confident to take that first step. Just remember to take it slow and do your research, and you'll be setting the tone for success.

Rebecca Lake is a journalist at CreditDonkey, a stock broker comparison and financial education website. Write to Rebecca Lake at rebecca@creditdonkey.com. Our data-driven analysis has been recognized by major news outlets across the country and has helped investors make savvy financial and lifestyle decisions. (read more)

Disclaimer: Opinions expressed here are those of the author's alone. Please support CreditDonkey on our mission to help you make savvy financial decisions. Our free online service is made possible through financial relationships with some of the products and services mentioned on this site. We may receive compensation if you shop through links in our content.

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