Investing in the stock market can feel like trying to play a game of chess without being taught the rules. You know the general goal of the game, but you need someone to explain the position and legal movements of the pieces. Then you can learn how to combine them into a coherent strategy.
If you are set on learning the art of investing in the stock market, prepare yourself for some serious research and a steep learning curve. Making a profit by consistently timing the market is tough. However, there is no lack of training materials and research tools. Large brokerage firms, such as TD Ameritrade, USAA, and TradeKing, provide free training materials and the chance to practice your skills using simulators and virtual money.
If you are not interested in having a hands-on approach to your investment, you can allow professionals to design an investment portfolio that aims to yield the highest return for the lowest amount of risk. Investment companies, such as Betterment, Personal Capital, and EverBank, use the Modern Portfolio Theory proposed by 1990 Nobel Prize winner, Harry Markowitz, to create a personalized portfolio that reflects your goals and risk tolerance. Many of these companies use algorithms called robo-advisors to automatically create and manage your portfolio.
Regardless of what investment route you choose, there are some basic concepts you need to understand. Here are 8 basic concepts to get you started:
Buying stock in a company is buying a piece of that company
It may seem obvious, but it helps to remember you are buying into real companies when researching what trades to make. At times it may feel like it, but buying stock is not gambling. If you own 5% of the shares in a company, you own 5% of the enterprise. Buying into a company is a bet on the future success of the company. For companies not yet making a profit, investing in them expresses confidence they will eventually become profitable.
Internal and external forces determine the value of a stock
Multiple factors determine the price of a company’s stock. The company’s performance and the ability of its management team are important. Yet, there are many other variables that businesses have little or not control over. For instance, the media, political unrest, and natural disasters are all factors that are out of the hands of CEOs, but that can make a company’s stock price go up or down.
Stocks perform best as long-term investments
Predicting the long-term performance of the stock market is extremely difficult. Predicting the short-term performance of individual stocks is nearly impossible. Investors who try to make a profit by buying and selling shares in the short term rarely succeed. On the other hand, they are a great cash cow for the brokerage charging transaction fees. A smarter strategy is to buy and hold shares in well-managed companies with long-term potential that have a clear advantage over their competitors.
Diversification is your friend
Diversification is an investment technique that reduces risk by spreading assets over various financial instruments, sectors, and even countries. The idea is to maximize the return on your investment by investing in companies and industries that will react differently to the same event. Although diversification is not a guarantee against loss, it is an effective way to hedge your losses and improve long-term returns.
Bear Market Vs. Bull Market
Even if you’ve never bought a share in your life, you have probably heard these terms used to describe the mood of the stock market. But do you know they mean? The stock market is a bull market when stock market indexes, such as the S&P 500 or the Dow Jones Industrial Average, rise by 20% or more from a recent low. Conversely, a bear market is a stock market when key stock indexes have dropped by 20% or more from a recent high-point. In a bear market, the general trend is for stock prices to drop, while in a bull market prices tend to rise.
Growth Stock vs. Value Stock
One of the most important decisions you have to make as an investor is to decide what your risk tolerance is. The terms growth stock and value stock provide a framework with which to categorize stocks by their potential for risk (and profit). Growth stocks are volatile when compared to broad market indexes and they are tied to the health of U.S. economy as a whole. These companies are more likely to reinvest their profits in the company rather than focusing on providing dividends to shareholders. Growth stocks carry the most risk of losing value but they are also the stocks with the greatest potential for profit. New businesses in the technology, alternative energy, and biotechnology sectors are classic examples of growth stocks.
Value stocks, on the other hand, are much more stable. Instead of boundless potential, these companies offer steady growth prospects and focus on providing shareholders with generous dividends. Classic value stocks include McDonalds, IBM, Microsoft, and AT&T. Of course, nothing is set in stone in the stock market and value stocks can quickly become value trap stocks.
The stop-loss order
A stop-loss order sets an automatic sell order once a share reaches a particular dollar value. For instance, if you buy a stock for $20 and set a stop-loss order at $18, your broker will automatically sell the share when its market price hits $18. The advantage of using stop-loss orders is you don’t have to monitor stocks daily. The tradeoff is there are no hard and fast rules when it comes to stock fluctuations. A stop-loss could cause you to miss out on future gains.
Set a specific goal for the investment
Is it a college fund for the kids? If your children are still toddlers, you have plenty of time and can afford to take some risks. If you’re going to need the money in a couple of years, keep it away from high-risk investments. Saving for your retirement? The same principle applies. Young investors can afford to throw caution to the wind. Older investors may want to stick to Treasury bonds and value stocks. Figuring out what your investment goals are is a top priority when deciding how much to invest and what methods to use.
Playing the stock market is not for the faint of heart. There are no “participation trophies.” You either win or lose. But there is a wealth of information and professional services available to help make it a profitable (and even fun) experience.