So you think you have what it takes to make money on the stock market?
Let me tell you something, you most definitely do.Making money with stocks can be simple, even for complete beginners who are willing to spend some time to carry out thorough research and gain an understanding of how the markets work.
I already described in my previous article on ETFs how you can easily invest in indexes with almost no effort.
The truth of the matter is that the FTSE 100, an index which measures the performance of 100 UK stocks, has increased an average of 7% annually.
Do you know how much money you would have if you had invested 1000 pounds back in 1918 and reinvested the earnings on a yearly basis?
The answer is a staggering £867,716 pounds.
And that’s the simplest form of investing. With a little bit more effort, you can reach returns on your money twice as high as that. All you have to do is be willing to save and invest.
So, let’s start with the basics.
How do I buy stocks?
It’s a simple yet fair question that you shouldn’t be afraid to ask. There are some important considerations to take into account and, as there are literally millions of options out there, it is important to choose the most appropriate one for you.
The easiest and most common way to access global stock markets around the world is through a broker. A broker is an intermediary that will buy stocks and other assets for you in exchange for a commission or fee.
Most likely, your personal bank will offer the possibility of opening a brokerage account for you. This might be the simplest way for you to get started.
However, before you do anything make sure you check out some of the many, many online brokerages out there, as they may fit your needs better.
When looking for a broker, there are a few things you need to consider.
- Fees: The way most brokers make money is by charging a commision for every transaction (possibly also a yearly fee for maintaining your account, but this is next to nothing). As of writing this, I would say that anything between 5-10 pounds is normal.
- Capital requirements: How much money do you have to begin investing? Some brokers require a certain minimum to open an account.
- How much support you want. Consider the broker’s offerings of educational tools, investment guidance, stock-trading research and access to personal support via phone, email, online chat or branch offices.
- Product availability: Make sure you pick a broker that has a wide array of stocks. This will depend a lot on where the brokerage is set up geographically.
Deciding on an investment strategy
Once you have gone through the arduous process of selecting a broker, entering all your information, verifying your identity and transferring funds, which, be warned can take as long as 72 hours, you are ready to buy some stocks!
But wait! Hold your horses! Before you do any actual investment it’s imperative that you take a moment to decide what your overall approach to investing will be.
- In other words, what is your strategy?
- How much time are you willing to dedicate to researching stocks?
- How much money do you plan to invest?
- What does your timeline look like?
- Do you plan to invest and hold for the next 5, 10 or 20 years?
- And most importantly…what is your risk tolerance?
These are just some of the points you must consider before you begin to invest.
Of course, everyone’s needs and ideas are unique, and so will your investment plan.
But let’s outline here some overall general approaches that most people can take.
In 1949, Benjamin Graham identified five strategies for common stock investing in “The Intelligent Investor”.
- General trading. The investor predicts and participates in the moves of the market similar to dollar-cost averaging.
- Selective trading. The investor picks stocks that they expect will do well in the market over the short term; a year, for example.
- Buying cheap and selling dear. The investor enters the market when prices low and sells stock when the prices are high.
- Long-pull selection. The investor selects stocks that they expect will grow quicker than other stocks over a period of years.
- Bargain purchases. The investor selects stocks that are priced below their true value as measured by some techniques.
My own personal strategy can be defined as a combination of strategy 3 and 5, and perhaps also a bit of 4. I like to think this falls under the umbrella of value investing
You can read extensively on the subject of value investing from great authors and successful investors. Warren Buffet is one of the best-known investment gurus to utilize this investment philosophy. Benjamin Graham’s “The Intelligent Investor.” is actually one of the books Buffet recommends to new investors.
The basic idea is quite simple and intuitive, though many people refuse it.
- Using some basic measurements of a company’s performance, you determine its value.
- Once you’ve done that, you compare that value to the price of the stock.
- After all, the stock should reflect a proportionate value of the company, since it essentially represents a part of the ownership.
So when Warren Buffet decides that company X is worth 1 million dollars, he then compares this valuation to the value of the stock. The value of the stock can be calculated by multiplying the price of the stock by the number of stocks, again, quite simple and intuitive.
If the actual value of the company is above that of the stock, we would say the stock is undervalued and this would be a buying opportunity. If the value is below that of the stock, then the stock is overvalued, which means we’d expect the price to go down.
To better understand the underlying principle of value investing, we have to understand a couple of principles regarding the workings of markets.
One of the basic principles of economics is that of Market Equilibrium. The idea that, in the long-term, the price of goods and services, and in this particular case stocks, will be equal to its intrinsic value.
The price, we must also take from this, is not something perfectly objective. The price is simply determined, as I referenced in my last article, by the intersection between supply and demand.
In other words, the price is simply an agreement between a buyer and a seller. Their valuations are subjective. If this weren’t the case there would be no mutually beneficial transaction.
If I sell you a banana for 1 dollar, I obviously value the dollar more than the banana, while you, the buyer, value the banana more than the dollar. Who is right? Both of us, since our valuations are subjective.
The stock market works in much the same way. Prices are determined by transactions between buyers and sellers. The market price you see on charts and graphs is nothing but a kind of summary or evolution of these transactions.
Stock prices don’t actually mean much, beyond what people think the price should be, or what they think the price will be. This is why stock markets are subject to bubbles.
So back to value-investing. We can now understand the point behind finding the “true” value of a company. The idea is that, in the long-term, the price will get closer to the true valuation.
If a company is truly profitable, and the market isn’t seeing it, there’s an opportunity for us to get in there. Buy the company’s stock “cheap”, and keep the juicy dividends, or sell when the price increases to a fair value.
So what is actually, the true value of a company?
Believe me, when I say, this is no easy task. It can be tedious and can take years to perfect. However, there are some overall metrics you can follow.
This is simply a helpful list to help you get started, but I would not expect many beginners to fully understand what these are. I encourage you to follow the links provided and read more on the subject.
Value investing metrics
A share price that’s no more than two-thirds of intrinsic value. For example, if the intrinsic value is $30, the share price should be no more than $20.
- A low price-earnings (P/E) ratio. The P/E ratio measures a company’s current share price relative to its per-share earnings. It’s calculated by dividing the market value per share by earnings per share.
- A low price-to-book ratio or P/B ratio, which measures whether a stock is over or undervalued by comparing the net assets of a company to the price of all the outstanding shares. . The P/B ratio divides a stock’s share price by its net assets, or total assets minus total liabilities
- A low price/earnings to growth (PEG) ratio. This ratio is used to determine a stock’s value while considering the company’s earnings growth. It’s calculated by dividing a stock’s P/E ratio by the growth of its earnings for a specified time period. Value investors typically look for PEG ratios below one.
- A low debt/equity (D/E) ratio. D/E measures a company’s financial leverage and is calculated by dividing its total liabilities by its stockholders’ equity.
- A dividend yield that’s at least two-thirds of the long-term AAA bond yield. For example, if the AAA bond yield is 3.61%, the company’s dividend yield should be at least 2.38%.
Picking a good stock with good fundamentals and value is an important task, but this is only half of the job.
A good investor has to be able to recognize, not just a good stock, but also a good buying or selling opportunity.
When it comes to investing, we must understand that the ultimate goal is to achieve a return on our investment. Because of this, it is absolutely vital to follow the evolution of stock prices, as well as looking for concrete measures of performance.
At the end of the day, almost any company can be a good investment, as long as the stock price is low enough. In the same way, we must be willing to let go of a stock, by which I mean sell it when the price is high enough. In other words, we have to be able to identify when stocks are under/overvalued.
Put simply, we have to be able to identify the proper price/quality ratio of stocks, much in the same way we do with goods and services.
However, this is even more important when it comes to stocks, as their prices are ever changing, bringing about profitable opportunities for good investors.
For those investors willing to dedicate some extra time, money can be made by following the stock prices regularly, as well as looking in-depth at company balance sheets.
There is money to be made even after bad news makes the price of a share drop, as long as we believe there is not a fundamental problem with the stock.
As I said before, the price is determined by people, and people can be short-sighted and group-minded.
In investment, like in life, swimming against the current can actually set you apart and prove to be very, very beneficial.