Investing in Stocks for Beginners
Why is Investing Important
As the years go by most adults will end up purchasing a house or some other accommodation to live in and for a lot of adults this will be their only asset of significant value. It's an asset that generally appreciates in value over the years - so it's worth more and more as time goes on. However the family home is not considered an investment as it's not able to provide a future income.
Most adults spend their lives working - either for an employee or running their own business and most adults will try to enjoy life outside of work. For some this may involve eating out regularly while for others it may involve a leisurely sport like playing tennis or skiing. Whilst these recreational pastimes involve an expense - this is not an issue whilst they are still working. In other words the adult can afford to finance their chosen lifestyle.
But as humans, people have not evolved to the stage were they can continue to work as they age past a certain point - at some point they will either not be capable to work or younger people will be seen as being more desirable for an employer and replace the aging worker.
Now this creates an issue - if the adult stops working then they stop receiving their income which was used to finance their lifestyle. This means the adult can no longer finance their lifestyle
Sure there will be some token pension benefits but this will generally only be a fraction of the income they received whilst working.
So is there anything the aging worker can do to continue financing their lifestyle after they retire form work.
The answer is YES - it is to put some money aside regularly whilst they are working. A small amount of money regularly put away adds up to a considerable amount of money over the years. This is further compounded when invested.
Let's look at some figures to illustrate this:
Investing for the Future
Someone working puts away $1000 per month.
1. Investing in bonds earning around 2.5% p.a. amounts to a little over $300,000 in twenty-years time.
2. Investing in stocks earning around 10% p.a. including dividends amounts to around $750,000 in twenty-years time.
As can be seen from the above figures, money put away regularly over time adds up to a nice nest egg in the future. This is money that can help finance your lifestyle when you retire in the future.
The total amount of money invested in the above example is $240,000 over twenty years.
1. Bonds. The capital increase is $60,000 for the investment in bonds at 2.5%.
2. Stocks. The capital increase is $510,000 for the investment in stocks at 10%.
Yes Stocks generally return more than Bonds but they are also considerably more volatile. This means that the year to year returns fluctuate considerably with some years giving negative returns. As a general rule stocks are best held over the long-term.
1. Bonds. They will provide an income in the future at the future rate (currently 2.5%). On $300,000 the annual income received amounts to $7,500.
2. Stocks. Large-cap stocks also provide an income in the form of a dividend at around 2% which gives an annual income of $15,000 in twenty years time.
A twenty-year investment period means that the person starts investing whilst they are 45-years old assuming they retire when 65-years old.
Starting to invest earlier, say at 35-years, means the investment period increases to thirty years. This has a profound effect on the investment value when retiring
30-year Investment Period
1. Bonds. At 2.5 they will be worth $540,000 with an annual income in 30-years of $13,500 with the total amount invested being $360,000.
2. Stocks. At 10% Large-cap stocks will be worth $2.2 million with an annual dividend income in 30-years of $44,000 with the total amount invested being $360,000.
While not everyone can start investing while they are in their thirties or younger, as the above figures illustrate the younger you start then the much more the retirement investment nest egg will be worth.
The main purpose of investing is to provide future wealth - this enables you to hopefully maintain your lifestyle - or at least provide a significantly better lifestyle than what a pension on its own could provide when you retire.
After thirty years investing a total of $360,000 in stocks actually gave a massive increase of $1,840,000 to give a total worth around $2.2 million. As a bonus there's an annual income from dividends of $44,000.
Investing generates future wealth through the principle of compounding interest. There are two factors that affect the returns.
Two factors that affect the returns
1. The higher the annual percentage return then the more the investment will be worth in the future.
2. The longer the investment period then the more the investment will be worth in the future.
Stock returns are usually higher than the returns from Bonds which provides a larger best egg, but stocks are considerably more volatile than bonds - especially in short to medium-term.
Therefore it's best to take a long-term view with stocks and to accept that there will be some really bad years with negative returns. The trick to investing in stocks over the long-term is not to panic and sell when returns are bad. In other words, don't take a short-term view with a long-term investment.
For those investors who find the short-term volatility of stocks to much to bear, a popular strategy is to combine stocks with bonds in the one portfolio. There is a tendency for bond values to move in opposite direction to stock values, thereby one helps to offset the other which lowers the volatility but also lowers the long-term returns.
The Silly Things Investors Say
Investors come up with all sorts of explanations why stocks behave the way they do. They feel that this is why something happened, they say "that's the reason why!". However there's usually some other reason why it happened. The following is a list of some of the silly things investors say.
1. The stock price is as low as it can go
This is a common statement from investors, but there is no absolute rule that tells you how low a stocks price can fall. The stock price could fall to one cent. How far it will actually fall is dependant on the supply and demand for that stock.
The book value tends to hold for the most part - this is evident by the fact that its difficult to find stocks below book value nowadays, but book value is certainly no guarantee. Bear markets can see many stocks drop below book value.
The whole issue of how far a price can fall comes about from investors buying at a certain price drop level and then expecting that to be the bottom. They buy with the expectation that prices will raise after they have bought. However, the stock price usually drops some more after they bought and they then sell. Their selling applies even more downward pressure on the stock price.
This does not mean that the stock price will not rebound and go higher in the future - price can go way above where it is now and this is generally what happens with good quality investment stocks over the long-term.
Just don't expect it to happen in the short-term. When buying a falling stock price you must accept that the price can fall further. Most investors when buying a falling stock price wrongly assume that that price fall is the bottom and the price will magically go up as soon as they buy.
Companies with strong fundamentals will very likely see their long-term stock price eventually go up in line with their fundamentals - but in the short-term (one year) and even over the medium-term (five years) the stock price may well be lower than the price is now.
Companies with poor fundamentals may never see their stock price go above where the price is now - even after ten years (assuming the company even lasts that long).
There is no rule that says the stock price must go up - even over the long-term - it's just more likely with companies with strong fundamentals.
2. You know when the stock price has bottomed
While this may seem the same as with the above where the stock price is as low as it can go - the difference is that with this statement investors use some form of analyses to determine that a stock's price has bottomed, whereas with the above statement investors just assume that when they've bought then that's the bottom.
Even with some form of analysis there's still no absolute way to know the stock price has hit the bottom.
Even when using chart patterns or chart indicators, this still requires the investor to wait for a rebound to confirm that a bottom has occurred. Even then chart patterns and indicators are nowhere near 100% accurate at determining bottoms - even allowing for the time delay.
Chart patterns and indicators really do no more than giving the investor some cues to the possibility that a bottom has occurred. The best the investor can say is that the stock price is now cheaper than it was.
For the shorter term investors and speculators it's generally better to wait for a rebound before buying. In other words, it's generally a bad idea to buy a stock while the price is falling.
For the long-term investors there is nothing wrong with buying a fundamentally sound stock with a falling stock price - just don't expect that you have bought the bottom of the price fall. Investors may have to wait a considerable amount of time for the stock price to recover and there is always the possibility that it never recovers.
When buying fundamentally poor stocks with a falling stock price - don't expect the stock price to recover as it very well may never recover even over the long-term.
3. The stock price is so high, it can't go any higher
There is no arbitrary limit to how high a stock's price can go. Fundamentals give some insight to how expensive a stock's price might be, but the fundamentals gives no indication of how high the price can go.
Stock prices keep climbing because there's an imbalance with the supply and demand. The demand for that stock keeps exceeding supply. That is, there are more broker orders placed to buy the stock than there are broker orders placed to sell the stock. For the buy orders to fill they have no choice but to bid higher prices to attract the required quantity of sell orders - which results in the price rising.
Rising stock prices attracts the attention of the speculators who track the price increase. These speculators become short-term buyers which fuel the price increase. They buy which increases the demand for the stock and then shortly after they become sellers which provides supply at the higher prices.
Strong price rises create strong upward trends which attract a large volume of trading activity from the general public. A significant portion of the stock market is speculative - their decision to buy and sell is based solely on a stock's price increasing with no regard to the company's merits.
These speculators include not only the professionals but also the general public which includes position traders, swing traders and day traders. All this trading activity increases the stock's liquidity which makes it easier for the public traders to enter and exit their positions. It makes it easier to buy and sell (especially with market orders) as spreads become tight which means less slippage (the difference between the Bid and Ask price).
Another source of demand comes from investors (with no trading interest) who see a stock's price continue to climb and buy on fear of missing out.
Another source of supply comes from investors who already own the stock and see its price climb higher and higher and start to panic - but what if this is the top, I will miss out on the maximum profit - so they convince themselves this is the top and thereby sell. So the investor sold out of fear of missing the top. The investor convinced themselves that this was as high as the price could go, but they usually just simply end up selling into a continuing uptrend. Typically the stock price continues to climb higher after they've sold.
Investors selling based on the notion that the stock price can't go any higher is a silly reason to sell - a decision which at some future date they usually regret. Investors who sell their stock early with strong price gains generally always miss out on making the strong returns over the long-term.
4. The stock price is under $5, I can't lose much
A lot of investors (mainly new investors) have this view. The notion is that a really low stock price means a small dollar investment so if the stock flops then only a small amount is lost
The problem with this philosophy is that with the American stock market most stocks trading under $5 have terrible fundamentals - most don't make a profit at all and a lot have deteriorating balance sheets - quite a few don't even generate any revenue at all.
These low priced stocks are mostly highly speculative with high bankruptcy risks. While they are cheap, investors mostly lose money buying these speculative stocks. Most speculative stocks (but not all) are high risk and not suitable for investing.
While it's true that buying low priced speculative stocks won't lose much money - the investor mostly loses buying these. While the loss per stock might be small, a lot of small losses adds up.
While buying speculative stocks is usually a bad investment, they can with selective picking make good speculative trades. The difference here is that with speculative trading the speculator knows the stock is a fundamental piece of junk - they use technical analysis techniques with includes trade management. The speculative stocks are evaluated for their risk and potential reward (how much they could lose compared to how much they could make based on probability).
5. If the stock price drops, it will come back up if I wait long enough
This situation arises when investors buy a stock and the price then drops leaving the investor with a paper loss. This makes most new investors extremely uncomfortable and even some experienced investors - the natural reaction is that the investor wants the stock price to recover and trade above their purchase price.
After all, investing is a long-term endeavor and you say to yourself I'll just wait and the stock price will recover.
The problem here is that the stock price may never go back above the purchase price. Investors will usually lose patience and sell the stock because they were expecting the price to recover.
Selling stocks that are below their purchase price is common with investors with a short to medium-term view.
A lot of the higher quality stocks do tend to recover (especially over the long-term) but the investor had already sold them. Investors are notorious for selling a profitable stock for a loss.
However with the lower quality stocks a lot of these stocks never recover. If the investor waits for a recovery it may never come.
Investors must expect that while some stocks do go up in price straight away and never go down, others go down and recover and some go down and never recover.
The investor will never know in advance as to which stock will be the one to go down and never recover.
6. The stock market's gone up for so long; it'll just keep going up
Bull markets with rising stock prices leads to complacency. As the stock market climbs higher and higher investors assume this will continue. Most investors are fairly new and have no idea of market cycles yet alone what a bear market is. These investors simply see stock prices climb higher and higher and assume that this is the way the stock market is.
Their philosophy is that a stock with an increasing stock price must be a good investment. Because the stock market has gone up for so long they expect their stock purchases to continue going up and during the bull market many stocks do just that.
Any suggestion that this may be a bubble is dismissed by the investors as they reassure themselves that this in not a bubble - it's a good investment.
There investors buy stock which creates buying pressure and this creates an imbalance in the supply/demand for stocks which creates upwards pressure on stock prices. New investors come along seeing the rising value and they want a piece of the action so they buy.
This whole process continues along merely, but sooner or later this all comes to an end. Stock prices now start to fall - a lot of these investors (mainly new investors) sell their stocks into the declining market - which in turn creates an excess in supply which further drives the market lower.
Unknowingly these investors bought into the latter stage of a bull market cycle and sold into a bear market cycle.
The market never just keeps going up - never - it cycles through bull market phases and bear market phases. The bull market phase usually last for many years even a decade. The bear market phase is usually much shorter and can last for a year or two and sometimes less than a year.
Unfortunately for the investor who sold into a bear market cycle they are usually quite short in duration and the investor often sell towards the bottom of the cycle.
The lessen here is that investors must realize that the market does not just go up but that it cycles and works its way higher over the decades with ups and downs - that's why a long-term approach is best.
Words of Wisdom
The following words of wisdom are based on investing over the long-term. This does not reflect the short-term view from speculation or trading.
Words of Wisdom
- Investing in a long-term process.
- Over the years quality (fundamentally sound) stocks generally increase in value.
- Long-term means 10 to 20 years - not one or two years.
- Don't confuse investing with speculation or trading (which is short-term in nature).
- The financial media can influence the short-term direction of the market but has no influence over the long-term. Economics and company fundamentals dictate the long-term.
- Sometime in the future the stock market will decline - a bear market will develop.
- Stock market declines provide great opportunities to buy fundamentally sound stocks.
- Trying to predict the level that the stock market will be at in a year's time is impossible. It's only through pure luck if you get it right.
- In 10 years time the market will likely be higher than it is now.
- In 20 years time the market will almost certainly be higher than it is now.
- The direction in one year's time is unknown.
- To invest profitably you do not need to pick every winning stock. There will always be some losing stocks in your portfolio.
- The really big winners are never the ones that you thought would be.
- Tomorrow's next new blue-chip is not known until tomorrow.
- Different categories of stocks have different risks and rewards.
- You can achieve good solid returns from ordinary stocks if you hold them for long enough.
- A stock that has given good returns in the past may not do so in the future.
- A company that has made strong profits in the past may not do so in the future.
- Stock prices may well move in opposite directions to what the fundamentals suggest in the short-term, but long-term stock prices generally do follow the fundamentals.
- A company that is doing poorly fundamentally can do even worse in the future.
- A stock price that has gone down can still go down even further.
- A falling stock price can only fall to just above. You cannot sell a stock for a negative sum of money nor can you buy a stock for less than zero or even for zero.
- A raising stock price in the short-term does not mean you were right. In the short-term you are only right if you sold for more than you paid.
- A falling stock price in the short-term does not mean you were wrong. In the short-term you are only wrong if you sold for less than you paid.
- Over the long-term, short-term price declines are only important if you want to buy more. If you want to sell now then you are not long-term.
- Long-term price advances are irrelevant if you have already sold that stock.
- Buying a fundamentally poor stock just because it's cheap is a loser's game.
- Selling a fundamentally sound stock just because the stock price has declined in the short-term is not a good long-term investing reason to sell.
- Buying a fundamentally poor stock just because the stock price has increased in the short-term is not a good long-term investing reason to buy.
- There is a reason why a company is growing.
- Growing companies do not grow for ever.
- Most investors cannot own every growing company and if even if they could it is not necessary.
- If a stock goes bankrupt you lose the same amount whether you paid $200 or $20 or $2 - you lose the amount you invested.
- If a stock bought on 50% margin deposit then halves - you lose halve of the total purchase value, not just halve of the margin deposit.
- Be careful rotating stocks in your portfolio based on earnings results. You may end up with a portfolio of yesterday's winners.
- Be careful rotating stocks in your portfolio based on price gains. You may again end up with a portfolio of yesterday's winners.
- Buy and Hold is not a dirty word, even if Wall Street says it is!
- Dollar Cost Averaging is not a dirty word, even if Wall Street says it is!
- Dividend investing is not a dirty word, even if Wall Street says it is!
- When fundamentally sound stocks you own become cheaper - consider buying some more.
- You won't improve your returns by replacing good quality stocks that have gained significantly and replace them with poorer quality stocks that are cheap.
- Invest some time in understanding the stock market.
- Enjoy your life. Don't spend all your time worrying about the stock market or the value of your portfolio.
- Creating wealth is a long-term process.