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What to Know Before You Invest in Stocks

To most people, financial markets are pretty daunting and investing seems like an incredibly complex undertaking. It can be, of course, but the basic idea is pretty simple: buy things that will increase in value over time. That isn’t all you need to know, however. Before you part with any of your hard-earned money, there are a few basic things about the logistics of investing you should know, as well as some simple rules and techniques that make finding winners more likely and protect you against disaster should you make a mistake.

Finding A Broker

In 2019, everything changed for new investors, particularly those with limited funds to kick start an account. Previously, trade commissions and account fees made it difficult to get in the market. Not only was the cost prohibitive, but they also forced new investors to do extensive research into fee structures before they started. Now, though, most brokerage companies offer commission-free, no minimum accounts, so cost is no longer an issue.

Choosing a broker now comes down to personal preference when it comes to the information and analysis offered and which order entry system you are comfortable with. It is easier than you might think to find out which suits you. Most firms offer a paper or practice trading account, in which you can trade with virtual funds. That enables you to try looking up a stock and placing an order on different platforms and to find the one that best suits you. Use that opportunity before you start.

The first rule of investing is not to buy anything that you don’t understand, so...

Know What You Are Buying

There are lots of ways to invest, but initially, it is best to stick to just stocks and ETFs.

ETFs

ETF stands for Exchange Traded Fund. Not that long ago there was no such thing, and investors who wanted to get exposure to multiple stocks in order to spread risk had a choice. They could buy each stock individually, which was expensive given the high commissions charged at that time, or they could buy shares in a mutual fund. That option was also expensive, as sales charges and ongoing management fees ate into returns.

ETFs are different.

They normally track an index, such as the Dow or Nasdaq. Maybe they follow an index that tracks one particular area of the market such as an industry (like technology or healthcare) or big or small companies. Why are fees associated with ETFs so low? Because for the most part, no highly paid analysts and decision makers are required. They are, as their name suggests, traded on exchanges just like stocks, and are usually subject to the same commissions, which are currently zero. They can be a good way of investing in the market overall, or of buying into industries and sectors that you think will do well without having to research individual stocks. For example, if you're attracted to the idea of buying into biotechnology, but don't really know any of the companies involved, you can sidestep that by simply buying into an ETF that tracks the biotechnology sector.

Stocks

Stocks are what most people are familiar with and represent an ownership share in a company. As an owner, you have a right to a share of the company’s profits, but that doesn’t mean that you get a check at the end of every year. Some companies do pay out some of their profit in the form of a quarterly dividend, but it is not compulsory. Dividends, however, aren’t the reason most people buy stocks. The average annual dividend yield for the S&P 500, a broad, representative collection of stocks, is just below 1.8%, so returns from dividends alone are not enticing.

What attracts people to stocks is the prospect of price appreciation, and that comes when you buy the right thing at the right time. For example, if you bought one share of Apple stock in January of 2015, it would have cost you about $110. By January 10, 2020, that share would be worth almost $310. That's $200 in 5 years. Imagine owning 100 shares of Apple stock, then, or 1,000. That is price appreciation in a nutshell.

Picking and Researching A Stock

For new investors, there are two common ways that ideas are generated. The first starts with an individual stock that you heard or read about, or maybe a company whose product you like, and think others would too. These ideas start with a single stock. The second is when you have a view on the market overall or a particular sector, and then look for a way to play that idea. These often end up as ETF plays but can sometimes be drilled down to one company.

Either way, before you part with any money, you should do your own research. This can be as simple as googling the stock's ticker symbol (a letter code used to identify it on exchanges), then reading articles written by others, or you can look up the information yourself. The best approach is probably a combination of the two, which you can get from somewhere like Nasdaq.com.

Simply type the ticker symbol into the search box and you will be redirected to a page that has everything you need: charts showing recent price activity and moves, data such as the market cap (size) of the company, any dividend yield, and its P/E ratio, as well as links to stories that feature or mention your stock.

When you do this, don’t go in looking for confirmation of your idea. If you do, you will no doubt find it. Instead, look for reasons not to do the trade. Is the P/E too high (see below for more on P/E)? Is growth slowing significantly? Does the company have negative cash flow and a lot of debt? No trade is perfect, so there will be reasons not to, but if all the objections seem answerable go ahead and buy. At least you will be aware of the possible risks.

How Do I Tell if A Stock is "Cheap"?

Let’s get one thing out of the way straight away. Just because a stock has a low price in dollar, or even penny terms, doesn’t mean that it is "cheap," nor is the opposite true of a stock whose price is measured in the thousands of dollars. The value of a stock is always a function of how many shares there are and how much money the company makes or is projected to make as well as the price.

For example, take two hypothetical companies in the same industry with about the same profits and rate of growth. Company A has issued a million shares and their shares are around $50. Company B’s stock, on the other hand, is only $5, but they have issued 100 million shares. Simple math tells you that while B looks cheaper, you would have to buy 100 shares at a cost of $500 to have the same ownership as you would from one $50 share of A. B is actually ten times more expensive in relative terms!

As you can see, value in a stock is about more than price. The most common metric used to assess value is the Price to Earnings (P/E) ratio. That expresses the price of a stock as a multiple of the last year’s earnings attributable to each share. Using Company A in the above example, if they had profit of $2.5 million, that would be $2.50 for each of the million shares issued. At a price of $5 that equates to a P/E of 2 (5/2.5). For reference, the average P/E of the S&P 500 since the 1870s has been around 16.8, so in theory, stock in company A would be good value.

If you're a little confused by the math I'm using, I go into much more detail about P/E ratios here.

There are other factors to consider such as the rate of profit growth and the liquidity of the company, and P/E should be considered on a relative basis, as compared to the market as a whole or others in the industry, but understanding P/E is a good start to understanding value.

Not Everything Will Work Out

This is something that every trader and investor realizes at some point, and the sooner you realize it, the less it will cost you. When investing, time is your friend, but that doesn’t mean that you have to hold onto everything forever.

When you initially decide to buy a stock, it’s because you can foresee something in particular happening that will cause the price to rise. If it drops, you got it wrong and there is no sense hanging on, waiting for that to change. Your thesis didn’t pan out -- move on.

Cutting losers is the hardest thing for most people to get used to when they start investing in stocks, but it is important. If you don’t, you will simply end up with your account being full of underperformers. As soon as you buy, set a level at which it would be obvious that your idea wasn’t working and if the stock gets there, sell it. This is known as a stop-loss.

With zero commissions you can always buy back in, but more often than not you will find a better use for that money if you start the process again.

Conclusions

Starting out as a stock investor is daunting. It is a business full of jargon, there are thousands of stocks to choose from, and seemingly thousands of differing opinions about each one. At its heart though, it is simple enough.

There is no twenty-year rolling period in the history of the market when investing in it would have lost you money, so the odds are in your favor. Find a broker that you like, find a stock that you like, and set limits should things not go your way, and you will be fine.