How to Invest in Stocks
And what makes a great stock to buy?
|Written by Tom Yeung, CFA | CDFA
Investment Advisor & Fund Manager, Jurnex Financial Advisors
You’ve heard for years that you should invest your retirement funds in stocks. Perhaps you already own some in your retirement portfolio through ETFs or mutual funds.
But when it comes time to invest in stocks, it’s easy to feel overwhelmed. Which stocks should you buy? Are you diversified enough? What should you do when prices go down? There are lots of details, and it’s easy for anyone to feel confused.
How are you supposed to invest in stocks when you don’t even know where to start? One of the best places to start is by talking to a financial advisor or asset manager. They can help educate you on your investment options, and what each means.
But if want to learn for yourself about how to invest in stocks, you’ve come to the right place. In this article, I’ll cover what stocks are, how to find good investments, and how to go about making a great portfolio.
What are stocks?
Before we cover how to invest in stocks, it’s helpful to define what a stock is.
In short, a stock is a share of company ownership. It entitles you to receive a portion of the company’s dividends and votes. You can also sell your shares to others if you choose to.
Example: Imagine you own some rental-producing real estate and want to divide it between your 3 children. Each child might get 1/3 ownership, also known as one share. And each share would entitle each kid to 1/3 of the rental income. Now, imagine one of the children sold their share of the house to someone else, transferring the 1/3 rental income rights to a new owner. That’s known as stock trading.
Stocks work on the same premise. They divide up dividends and ownership of a company into thousands of shares.
The major benefit of stocks is that they allow investors to invest in many different companies without having to buy the entire company. And if you have a retirement savings account, such as a 401(k) plan or an investment account, you can use it to invest in individual stocks.
How do you make money from stocks?
When prices of stocks go up, you as an investor can sell the shares for a profit. Successful growing companies can see their share price increase hundreds of times. Shares of Intel, for example, have grown over 100 times since their IPO. Amazon’s increased more than 1,000 times.
You can also make money by receiving dividends. Companies will periodically distribute cash earnings, and these dividends can be reinvested to buy more shares. You’ll then receive even more dividends in the future. And so on.
But the most important factor in making money from stocks is finding great companies and investing consistently for a long period of time. Great companies produce higher earnings for their shareholders and investors who reinvest dividends see their profits rise much faster than those who trade in and out of stocks.
I advise people to choose investments with a long history of above-average returns and stick with them for the long haul.
Are stocks good investments?
Over the long run, stocks have returned amazing results, earning 10% per year for the past century.
Stocks can also go down in value. But if you’re patient, they tend to recover over time.
In all of the US stock market’s history, there’s never been any 20-year period where stocks ended any two-decade period lower. In other words, Rip Van Winkle would have made a phenomenal investor. Even if he had the misfortune of investing all his money at the 2007 stock market peak, he would never have noticed anything amiss when woke up 10 years later and checked his account balance.
“It took just over 15 years to recover the money invested at the 1929 peak, following a crash far worse than Smith had ever examined. And since World War II, the recovery period for stocks has been even better.” – Jeremy J. Siegel, Stocks for the Long Run
The most common way that people underperform in stock investing is by missing out. That’s when investors become afraid and sell without ever rebuying their investments. A great financial advisor can help you resist that temptation.
How to invest in stocks
Stock investing may seem complicated. But with a few simple rules, you can create a great portfolio that will help you grow your nest egg over the long-run. Once you have an investment account set up, follow these simple steps to help you make great investments in stocks.
1. Save 15% of your income
Building your net worth takes discipline and work. There are no magic shortcuts. If you want to invest for the long run, you’ll have to invest consistently.
That involves saving 15% of your income. Your workplace may already have certain tax-advantaged programs, such as a 401(k). This is a great way to get started. And if your company matches your contributions, make sure you also take advantage too. It’s basically free money.
Some people may need to save more, especially those with greater future financial needs. Some people may also need to catch up with investments. But thanks to the magic of compound interest, the vast majority of people can retire comfortably by saving 15% of their income. That’s because one dollar saved in your 20’s should grow into seven dollars by retirement. And that adjusted for inflation.
Even if you aren’t in your 20’s anymore, saving is still a very good option. Every dollar saved in your 50’s can still double in value by you retire.
2. Create a savings plan
I tell everyone this: make your financial plan and then write it down. It might fit on the back of an index card, but it must be written down.
That’s because it’s easy to lose track of your plan. So much else happens in life, and it’s easy to get distracted. Or perhaps the market falls and we start selling our hard-earned investments at a loss.
But with a written savings plan, you vastly diminish the temptation to overspend or sell investments at the wrong time. Suddenly, you have a quick reference that can use to remind yourself about your long-term goals. And that can be greatly beneficial to your financial well-being Because once you have a written plan in place, it becomes far easier to stick to the plan.
3. Select 8-12 great stocks
Once you have your savings plan in place, it’s time to choose which stocks to invest in. And that involves focusing your energy on identifying 8-12 great companies in different industries. Make sure each investment is truly worthwhile to invest in.
What about diversification? It turns out that buying 8-12 stocks already achieves 85-90% of the diversification that buying 100 stocks does. That’s because, beyond 12 holdings, the benefits of diversification start to trail off exponentially. (You can learn more about diversification here)
With more than 12 stocks, you may start buying worse companies. This is also known as “diworsification.” While it may feel like “diversifying”, all it does is reduce your overall investment returns. This can lead to worse long-run outcomes.
Instead, you should concentrate on buying 8-12 great companies and focus your full attention on keeping track of them. You’ll get the benefits of diversification AND achieving above-average returns.
We’ll cover how to identify 8-12 great stocks later in this article.
4. Find an investment professional
If you find yourself overwhelmed, an investment professional can help you with investing too. A great investment professional can help you sort through the different companies and determine which investments line up with your investment objectives.
It’s ultimately up to you to make the investment decision. But having someone to help guide you through each investment can help you make better decisions for your future.
Remember to take your time and interview several financial advisors before making a decision. Because finding the right financial advisor to make a difference.
And even if you already know a lot about investing, having an advisor can still help you monitor your investments and make suggestions.
5. Monitor your investments
Once you have created a plan and invested your savings, you need to keep track of your progress.
To stay engaged, I recommend revisiting both your financial plan and investments at least once a year. It’s also good to review them anytime you have a major life change. Staying involved will help make sure your savings stay aligned with your investment goals.
There’s no need to take monitoring to extremes. Monitoring share prices daily simply creates worry for those watching the ups and downs. Instead, we should recall the (unintentional) wisdom of Rip Van Winkle and do nothing when “doing nothing” is the right response.
What makes a great stock?
Investing in just 8-12 great companies means you have the ability to pay attention to each investment. But what makes a great stock to invest in? Here are the 4 key items you should look for:
1. Understandable business
My #1 piece of advice on how to invest in stocks: never invest in anything you don’t understand. That’s because your future is important. Throwing money at things just because people have told you to is a recipe for disaster.
Instead, buy stocks in companies you truly understand.
Some investors might think they don’t understand ANY industry. But don’t sell yourself short! Even if you don’t work in a technical field, you still probably have a good idea about the companies you see day-to-day. Some of my best investments were in airlines when I started noticing it becoming more difficult to buy extremely discounted airline tickets!
2. High and stable profits
Profitable companies are some of the best long-term investments. That’s because high-profit companies can reinvest their earnings and generate even more profits in the future. That’s how companies like Starbucks were able to expand so quickly: the average new store returned profits so quickly that the company could use those profits to expand into even more territories and earn even more profits.
While some downtrodden companies can produce excellent short-term gains, investors looking to hold companies for the long run are far better served by companies with high returns on capital.
3. Good company and industry outlook
Equally important to profitability? Companies with great business outlooks.
Because you’re looking to buy investments for the long-run, you want to avoid companies in fading industries. These companies tend to have reduced profitability and falling stock prices. Instead, try searching for companies that can continue to be relevant, and serve their customers going forward.
You can find great companies in both high-growth and mature industries. Even if you aren’t comfortable with tech companies like Microsoft, Intel, and Amazon, there are plenty of other companies like General Mills and Disney that operate in more traditional fields.
4. The stock can be bought for a reasonable price
It can be tempting to chase returns and focus only on companies that have gone up in price. But I caution against using that strategy by itself. That’s because companies with overvalued shares are susceptible to falling back to earth. A common refrain on Wall Street goes as such: “up like a rocket, down like a stick.”
However, don’t let this deter you from buying companies with rising share prices. Rising share prices may signal an improving outlook. Just remember that you’re buying companies for the long-run, so you want to make sure you’re acquiring companies at fair prices.
Talk with an investing advisor
If this sounds like a lot of information to go through, don’t worry. The good news is that you don’t have to do it alone.
Great investment managers can help you understand and make investments. Regardless of your level of experience, seeking advice can help improve your long-term investing skills.
Where to find more resources
If you’re looking to revamp your stock portfolio, there’s no better time than now. All it takes is a phone call.
That’s because I’ve helped invest client money for over a decade in the same old-fashioned way: seek out great companies in great industries that can be purchased at a discount to their fair value. Sounds too simple to be true? Give me a call today and I’ll show you that it’s still possible after all these years.
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