The beginner stock market investor could be forgiven for thinking that the end of the world is nigh. With share prices having fallen dramatically the world over and the economies of most developed nations entering or already in recession things certainly do look grim. That's why I thought it was time to put together another "how to buy stocks for beginners" type of post.
So lets get back to basics. When you purchase shares in a publicly traded company, what does it mean? Well the first point I'd make is that your investment is more than just a number next to a stock symbol on the Yahoo Finance website (or whatever financial website you prefer). Your investment represents ownership of a portion of a real business. That ownership entitles you to a share of that business's future profits.
This is a very important concept to grasp. Don't be taken in by the daily fluctuations of share prices. These prices are driven by investor sentiment, by a bunch of people trying to guess what the future may hold. The rate at which these prices change belies the stability of the underlying value of your investment. The value of the business - your business - doesn't change that quickly. Sure there are times when a company makes an announcement about a fundamental change in their operations which may cause the price to plummet. But more often than not, it's just the general mood of investors pushing prices up and down.
Don't get me wrong - I'm not suggesting that we can ignore the current economic problems. But by the same token, don't let the current gloom and doom terrify you to the extent that you're willing to ignore quality companies trading at bargain basement prices just because you don't know if the stock market has bottomed yet.
That brings me nicely to my next point. I'm a firm believer in buying stock for the long term. One of the advantages of this approach is that it frees up your mind from worrying about the day to day gyrations of the stock market. By fixing your eyes firmly on a point 3 to 5 years (or even longer) down the track, you can afford not to worry about what your shares will be selling at next week or next month. You'll be able to focus on what really matters - watching the business, making sure it continues to perform as you expected when you bought it.
However, in order to do this you'll first have to put some effort into learning how to understand stock market concepts. Learn how to read a company's financial statements. Compare profitability ratios with those of it's competitors. Consider the financial strength of the company - does it have excessive debt and will it be able to make the interest payments on that debt?
There are a number of very good books available on investing in the stock market. I wrote a post some time ago about what I thought were some of the best investment books for beginners. The books mentioned in that post are all very good and well worth readying.
When To Buy Stocks
This is the essence of being a long term investor and is what I was alluding to before. If you're willing to take a long term view, you can afford to think more about the best stocks to buy rather than the best time to buy stocks. Accept that you wont pick the bottom. There's every chance that prices may go lower. However, if you're happy that you've bought stock in a good quality business who's earnings are going to grow over the long term, you'll be able to ignore the short term price movements. If it's any consolation, you probably wont pick the top either.
I think if you can remove this focus on short term results, you will remove one of the biggest impediments to beginners buying stock.
Friday, March 20, 2009
Monday, May 26, 2008
Is dollar cost averaging a suitable stock market investing strategy for beginners?
In this article I will describe what dollar cost averaging is and how beginner investors can put it to good use. From my recollection, Benjamin Graham (the father of value investing) proposed that the use of "formulas" like this was a good way to protect investors from themselves by reducing the risk of investors trying to time the market.
What Is Dollar Cost Averaging?
As I've already said, dollar cost averaging is a stock market investment strategy (or a form of formula investing). The basic idea is that an investor buys stocks at regular intervals thereby 'averaging' their purchase price. The advantage of this method is that investors avoid putting all of their their money into the stock market right at the top or just before a fall. By buying stocks in smaller amounts on a regular basis, you will be buying right through the stock market cycle - both the ups and downs.
Is Dollar Cost Averaging For You?
I have to admit to being a little cynical when it comes to dollar cost averaging. Sometimes it seems to be more of a marketing gimmick employed by mutual funds and other purveyors of investment products. They seem to use it to promote products whereby you buy shares or units in their mutual fund on a monthly basis. And you can understand why - they put a lot of effort into convincing you to part with your money, so rather than getting you to buy once they get you onto a regular plan. They will even take the money out of your pay to make it easier.
However, I think there are some scenarios where dollar cost averaging may be worthy of consideration.
I think the principle of regular investment is sound. It can help prevent a new investor putting all of their money in at the top of the market. Also, in uncertain and volatile times (such as we're experiencing at the moment) it can help prevent investor procrastination. By that I mean an investor who sits on his (or her) hands waiting for the market to bottom out only to wait too long and miss the start of the recovery. Or they might try to pick the bottom and invest once they see a recovery under way, only to find the recovery short lived and the subsequent downturn takes the market to new lows.
In this situation, a regular investment program can help the investor psychologically. By committing a portion of their capital this month, then another portion the following month, they can cover both cases. If the market does recover, they can take solace in the fact that they bought in at lower prices. And if the market continues its downward trend they still have the funds available to make purchases at lower levels.
Another potential positive of dollar cost averaging as a stock market investing strategy is in its use as a regular savings plan. In my opinion a regular savings plan is a great idea regardless of what shape or form it takes. If by drip feed investing a portion of your pay or salary into a financial market you are able to accumulate and growth your wealth then I'm all for it.
In the past, I've used a form of dollar cost averaging at times of market uncertainty - including the most recent downturn. Rather than trying to indulge in market timing by picking the bottom of the market, I would buy the stock which provided the greatest value at the time I was buying. With financial markets plummeting, I was concerned about the risk of investing all of my money only to see the market drop by another 10% or more. Regardless of how objective I try to be, the idea of purchasing stock, even for the long term, only to see it keep falling is an unpleasant one. But by keeping funds in reserve, I'm able to purchase that or other stocks at the lower prices. Please note that this is where I'm confident of the long term prospects of the company in which I'm buying stock.
So, as you can see that even though I have my concerns about dollar cost averaging, there are times when it may be useful. But as with the application of any stock market strategy, it should revolve around the purchase of quality stocks.
Monday, March 17, 2008
Stock market investing beginners need to understand the difference between price and value.
In my last post Stock Market For Beginners I discussed the basics of what the stock market is and how it works in simple terms. Hopefully those wanting to get started investing in shares will have got a good grounding buy reading the post. If you haven't read it yet, I suggest you go and read it now.
In the article I briefly discussed price and value - two very important investment concepts. I didn't go into the difference in any great detail, except to say that the price of a stock may differ greatly from what the underlying value in the company. Today I want to discuss this concept in greater detail.
The price at which a stock trades is a function of normal market forces - that is supply and demand. Regardless of the underlying value (or lack thereof) in the corporation whose shares are being traded, the price will only be what someone is willing to pay. Human emotions, both fear and greed frequently seem to have a large bearing on the price at which a company's stock changes hands.
We've seen it again and again through the history of stock market investing. The market booms and then it crashes. Think the dot com boom, the crash of 1987 and so on. For those that aren't familiar with these events, the prices of shares increased by a large amount in a relatively short period of time to reach unsustainable levels. As the prices increased, more and more investors (or perhaps more accurately speculators) bought in hoping to make a quick buck. This caused prices to keep rising which in turn led to more buying.
Eventually investor sentiment changed and nobody wanted to buy the shares anymore. Even worse, everyone panicked and tried to sell at the same time. If you'll recall earlier, I said that the price of a share will be whatever someone is willing to pay for it. When nobody wanted the buy the shares, sellers had to drop their price a great deal before anyone was willing to buy.
This brings me the the value of a share as distinct from the price. The value of a stock is dependent on the underlying value of the company which issued it. How much cash can it generate? What are it's assets and liabilities? And so on...
During many past stock market booms, the underlying value of companies didn't increase by very much, yet the price of the stock increased by a great deal. Similarly, when the stock prices of some companies dropped by more than 50% in a matter of days, the value of the companies themselves hadn't changed by anywhere near that much (if at all).
Typically, while the value of a company changes relatively slowly over time, hopefully for the better (but sometimes for the worse), the price of a company's stock changes much more quickly. The stock price of some companies can differ greatly from the underlying value, both on the upside and the downside. This a very important investment concept - the price and value of a stock are not necessarily the same.
This is where value investors like Benjamin Graham used things like Dividend Investing and Price To Earnings Ratios to try to exploit these differences between price and value. Graham believed that if he could buy shares which were at a steep enough discount to their underlying value, he would profit when the share price increased and the gap between price and value closed.
The main thing stock market beginners need to remember is that the price a company's share trades at is based on market forces - the perception that people collectively have of a company. And while this consensus view is mostly correct, there are times when the market get it wrong - but on an individual stock level, but also with regard the stock market as a whole.
You have a choice as to whether to buy or sell at a particular price. Don't take the stock market at face value. Make sure a high-priced stock is worth what is being asked - look at its fundamentals. Exercise some skepticism. Similarly, don't pass over the market pariah until you're sure there is no value there. If the market isn't interested in a particular company and marked its price down, this is a good place to start looking for value. But again, be sure of the fundamentals.
If stock market beginners keep this difference between price and value in mind, they will be well on the way to a successful investing career.
Friday, March 14, 2008
An introduction to investing in the stock market for beginners.
In this article I will explain the basics of the stock market. Those first starting out in investing need to grasp the basics of what it is and how it works. Who are the participants and how does an ordinary investor fit into the picture? The first thing we need to do is understand some of the basic concepts.
What Is A Stock?
A stock or share represents part ownership in a company or corporation. When you buy a stock you become part owner of a business - it may only be a small fraction of the business, but it's still important to consider yourself an owner. Ownership of the stock entitles you to all of the rights and responsibilities a business owner normally enjoys. You're entitled to share in any profits the company makes. You'll receive the benefits of any success the company has. This could be through share price appreciation, stock dividends, capital returns and so on.
When you buy stock, it's important to understand that you are buying a piece of the business, not just lending the company some money. If you lend a company money (by buying a bond or debenture) you're entitled to receive regular interest payments and a specified rate. Anything the company earns in excess of that amount becomes the property of shareholders. This means that as an owner you can receive potentially unlimited benefits if the company does well.
However, if the company does poorly and doesn't make much money, the creditors (people who decided to lend money to the company) will normally be paid their interest payments before shareholders receive any dividends. And in the worst case, where a company goes out of business and gets wound up, the shareholders stand last in line. Everybody else must be paid in full before shareholders receive a cent. This means employees, other secured and unsecured creditors, the government - everybody gets paid before stock holders. Only if there are excess funds after paying all of these other people and institutions do the owners of the company's stock receive anything.
What Is The Stock Market?
The stock market is an institution which facilitates the buying and selling of shares. It provides a mechanism for owners of listed companies to sell their stock to those interested in buying. The price of a stock at any given time is a basically what someone is willing to pay for it. This is an important concept to grasp and I will explain it more fully in a future post. But for now you just need to understand that price and value are 2 different things. The underlying value of a stock may be vastly different to the price at which it trades.
Where was I? That's right, the stock market is a place where people can buy and sell shares. When (and if) you decide to invest in shares, the stock market is the institution which will facilitate this. Whether you're investing on the NYSE, the NASDAQ, the LSE (London Stock Exchange) or the Bombay Stock Exchange (Indian market), the principles are the same.
What About The Dow, S&P 500 and the FTSE?
When you hear commentators saying things like "...the market was up by 25 points today..." what are they talking about? Normally they're talking about stock market indices. A stock market index is kind of like an average representation of a particular market (or segment). The stock prices of a group of companies is averaged out (it's actually more complex than a simple average but that will do for now) and presented as a single number. That number is then used to give an indication of the direction the market moved on a particular day - ie. up or down - and its relative level over time.
The most well known market index is probably the DJIA (Dow Jones Industrial Average) often just called The Dow. The DJIA is comprised of the 30 largest and most widely held companies in the United States. The index is currently comprised of companies like IBM, Microsoft and General Electric. I say currently because the composition of the index changes from time to time. As companies grow and shrink, or merge with other companies, the top 30 companies can change so the index is altered to reflect this.
Other stock market indices include the following:
- S&P 500 - The S&P 500 is made up up 500 large capitalization corporations in the US. It's maintained by Standard and Poors and is a broader based index than The Dow. This means it should give a better indication of the broader activity of the market.
- FTSE 100 - The FTSE 100 idex is comprised of the largest 100 companies listed on the London Stock Exchange.
- SENSEX - The top 30 on the Bombay Stock Exchange.
- Hang Seng - 40 largest companies listed on the Hong Kong Stock Exchange.
- DAX - 30 large cap companies listed on the Frankfurt Stock Exchange.
- Nikkei - An index of stocks on the Tokyo Stock Exchange.
- CAC 40 - 40 of the top 100 stocks on the French Stock Exchange.
So why would you want to invest in stocks? The fundamental reason is to generate wealth (or put more bluntly, to make money). But this can be accomplished in two main ways.
The first method could be called stock market trading (others may call it speculation). This normally entails buying a stock to take advantage of short term price movements. The underlying value of a company is sometimes of secondary importance. The buyer is normally more interested in whether the price of a company's stock will go up in the short term. People engaged in this sort of activity may only hold the stock for a matter of days (sometimes even hours).
The second method can more properly be called investing. It entails buying stock in a company because you believe in the long term prospects of the company and because the stock can be bought at a reasonable price. Determining a fair price to pay is another article (or articles) in itself, but you can do worse than starting with fundamentals like price to earnings ratios and dividend yield for investing. Having bought the stock you would normally hold onto to it, bank the dividends when they arrive and only sell it when it becomes overvalued or a better opportunity arises.
How To Buy Shares On The Stock Market.
An ordinary investor normally can't participate directly in the stock market. You will need to engage a stockbroker to do your buying or selling for you, for which you will be charged a fee or commission. The stockbroker holds a license to buy and sell shares on your behalf. I wont go into the mechanics of it here, but you basically call your broker and ask him to buy or sell stock on your behalf. Most stockbrokers now have only share trading facilities which allow you to buy and sell over the internet, normally for much lower fees.
There is obviously a lot more to investing than I've been able to cover in one article. However, in a nutshell, this is the stock market for beginners.
Sunday, February 24, 2008
Am I well suited to stock market investing?
Before embarking on a career as a stock market investor, beginners should be asking this question you should be asking yourself. I mention in my last article (How To Start Investing In The Stock Market) that before you get started, you need to be sure this is something you want to take on. In this article I will discuss some of the things you'll need to consider before deciding you're ready.
Are you emotionally ready for stock market investing?
Participating in the world's financial markets can be an emotional roller coaster ride. Anyone who's had any experience will know that prices can fluctuate wildly. And with this volatility, you need to make sure you will be able keep your head.
Imagine buying a stock, only to see it drop by 5% or even 10% the next day. What will you do? Will you panic and sell straight away? Or will you hold on secure in the knowledge that you've done your research and that over the long term the value of your shareholding will be realized?
It happens to all of us eventually. If you don't think you'll be able to sleep at night with all of this going on, direct investment may not be for you. You may be better off letting a professional manage your money. Stick with a mutual fund or something similar.
Do you have a long term investment time horizon?
Maybe I should clarify something here. I consider investment be be the act of buying stocks in quality companies at reasonable prices and holding for the long term. Short-term trading and speculation are fine - but you need to be aware of the risks. I don't consider these activities to be investment. It can be exciting but I would only employ a small amount of my capital in such endeavors.
Having got that out of the way, what I wanted to say was that you need to ask yourself how long you plan to be in the market. Are you planning to invest the money you've saved up to go on vacation at the end of the year? Or the deposit you've been saving to buy a house? If this is the case, the stock market probably isn't the right place for you. Consider cash or fixed interest investments.
You should be looking at a 3 to 5 year time frame - preferably longer. This will give you time to ride out any volatility associated with market cycles. Stock prices tend to oscillate around the intrinsic value of a company. If you invest in a company whose intrinsic value is rising over time, the stock price should eventually follow. The problem is that over the short term prices may fall short of this intrinsic value sometimes. And at other times it may even trade at a premium. You will need to give yourself sufficient time to ride out these periods of under-valuation. The last thing you want to have to do is sell out at one of the low points - especially if you think the intrinsic value of the company has increased over the period you've held it.
What is intrinsic value? This is a complex topic - beyond the scope of this article. I will write about this in more detail in a future article. But for now, let's just say that it's the true value of a company, rather than the value at which it is currently selling.
Do you have sufficient funds to invest in the stock market?
The reality is that you will need a certain amount of money before starting your stock market investment career. How much is enough? It depends. I would think about $5,000 to $10,000. But this could vary depending on how much additional money you can spare each month to add to your portfolio.
The idea is that you will need to diversify your holdings. You will need to buy stock in a number of companies to reduce the risk that a single company will under perform. If you're unlucky enough the own the next Enron, you want to make sure it's no more than about 10% to 15% of your total holdings. But there are costs associated with buying each of these holdings. You'll need to buy enough to make it worthwhile.
If you only have a small amount to invest, you may want consider fixed interest or a mutual fund until you have saved enough to take the plunge.
Are you willing to put in the time and effort to succeed in the stock market?
In order to be successful, you'll need spend a fair amount of time on your investments. You will need to spend some time getting educated before you begin. You'll need to spend the time researching the companies you intend to buy. You'll need to spent time monitoring you're holdings. This doesn't mean checking the prices everyday, but rather satisfying yourself that the fundamentals of each of your holdings remains sound from one period to the next.
While not an exhaustive list, the above questions should start beginners thinking about whether they are suited to stock market investment.
Tuesday, January 29, 2008
Learn how to start investing in the stock market.
Beginning investors tend to approach the stock market with great trepidation. It seems so complex. There is so much to learn. So much new terminology - dividend yield, price earnings ratio, net tangible asset backing, short selling, bull market, bear market and the list goes on.
But you want to get started. The guy next door doubled his money in a couple of months. A colleague at work doubled her money in less than a week. Everybody's making money and you feel like you're being left behind.
So where do you start? Well, first I would suggest you make sure that direct stock market investing is for you. Some people just aren't suited to it. There's nothing wrong with that. There are plenty of other options which will give you exposure. Find a good mutual fund for example.
How do you know if you're well suited? I plan on writing a more thorough article on this in the near future (see Stock Market Investing - Is It For You?) but you could start by asking yourself some of these questions. Are you willing to put in the time? Are you comfortable with the volatility you will undoubtedly experience? What is your time-frame (the longer the better)?
Once you've answered these questions and assuming you still want to proceed here are the steps I suggest you follow.
Get Educated In Investment Fundamentals:
If you're going to manage your own portfolio, even with the assistance of a professional, you will need to understand what you are doing. Read some books. Read the financial press - but don't worry too much about what the market is doing from day to day. There are some great resources available on the internet as well. Start noticing the companies around you. Where do you shop? What are you buying for Christmas? Peter Lynch (a very successful fund manager and author of a number of investment books) is a great advocate of this. Apparently a number of his best investing ideas came from observing consumer trends at the grass roots level.
Don't get me wrong - there is no substitute for actually getting in there and doing it. But the more background information you have the better prepared you will be. And this education should be ongoing. There is always more to learn.
Find A Stock Market Mentor:
Find someone you trust who has some investing experience. This could be a friend or a relative or anyone else you feel comfortable with. A mentor can be a great resource. You can get a second opinion for some of your ideas. You may get confirmation that your reasoning is sound or you may get some feedback about things you hadn't considered. It will be a great benefit if you don't have to make your investment decisions in isolation.
Take A Long Term View:
Once you feel comfortable enough to make your first investment, start small and take a long term view. Don't bet the farm your first time out. Even if you've saved up a lump sum to invest, buy stocks a little at a time. This has a couple of advantages.
Firstly, you wont be putting all of your money into the market at the top. What does this mean? Over time the stock market will go up and go down. There are many reasons for this. Investor sentiment, the state of the economy and lots of other external factors all play their part. It's notoriously difficult to predict the direction that prices will take. Very few professionals get it right even the majority of the time so amateurs like us have no chance. But over time if we assume that the market will rise over the long term, which it has historically, then these short term gyrations shouldn't matter to us - provided we didn't put all of our money in at the top.
The other advantage to investing a little at a time is that we will make mistakes. And we will learn a lot from them. But we need to make sure that if we completely mess up our first foray into the market, we'll still have some capital in reserve so we can regroup and try again. Then over time we should build up a solid portfolio diversified not only by company and industry but also by the point in the market cycle at which we made our purchase.
I know this article hasn't covered yet any of the specifics of choosing a stock to invest in - I will cover that in upcoming articles - but hopefully it has given you some things to think about.
How to start investing in the stock market...
