Loading...

Trading vs. Investment; Which one should you choose?

Investing and trading are two very different methods of attempting to profit in the financial markets.

Investing is used by investors to achieve higher returns over a longer time. Traders, on the other hand, use both rising and falling markets to enter and leave positions more quickly, resulting in smaller, more frequent profits.

So what should you choose?

In this article, we’ll discuss the differences between trading vs. investment and what could be the lucrative option for you.

What is Trading?

Buying and selling stocks or other securities in a short period to make quick profits is referred to as trading. Traders think in terms of weeks, days, or even minutes, whereas investors typically think in years. Stocks, commodities, currencies (forex), and other financial instruments are common trading examples.

Traders are divided into four groups:

  • Position Trader: Positions are kept for a time ranging from months to years.
  • Swing Trader: Positions are held for a period ranging from days to weeks under swing trading.
  • Day Trader: Positions are held and sold within the same trading day
  • Scalp Traders: Positions are held for seconds to minutes at a time. 

The fundamental principle of trading is to “Buy low, sell high”.

Experience traders also use strategies such as reverse trading and short-selling, in an attempt to make bigger profits.

What Does ‘Investing’ Mean? 

Traditionally, investing involves the purchase of stocks or other financial instruments that are intended to provide profits over a long period of time. Stocks, bonds, funds, and other investment vehicles are the most popular choices for investing.

Market fundamentals, such as price-to-earnings ratios and management projections, are often more important to investors. An investor aims to build a well-balanced portfolio of stocks and bonds that provide returns in the form of price appreciation, dividends, and interest income.

What are the Key Differences Between Trading and Investing? 

Here are the key differences between long-term investing and trading.

Time period 

Investing is a strategy based on the buy-and-hold premise. Investors invest their money into the market for years, decades, or even longer.

Whereas, trading involves owning stocks for a short period. It could be for a week or even just a single day.

Capital Growth

Investing is the practice of building money over time using price appreciation and dividends of high-quality equities in the stock market.

On the other hand, traders keep an eye on the market’s stock price change. Traders may sell their stocks if the price rises. Simply said, trading is the ability to time the market.

Risk

Investing takes time to master since it is an art. It has a lower risk and lower return in the short term, but if held for a longer length of time, compounding interest and dividends result in higher returns.

Trading, on the other hand, has a larger risk and bigger potential reward in the short term because the price might go high or low in a short time.

Focus 

In investing all financial decisions are based on an investor’s belief in the company’s expansion plans.

Traders tend to ignore what the company does in favor of focusing solely on the stock price and trade frequency.

Investment Strategy

Investors conduct their study and invest only once they are entirely convinced of a company’s potential.

Stock trading is more inclined to invest in stocks based on suggestions from friends, other stock market traders, the media, and other third-party sources.

What are the Pros and Cons of Stock Trading? 

There are benefits and drawbacks to trading summarized below. Let’s start with the pros:

Hassle-Free

The difficulty of waiting a long time for rewards has been avoided-thanks to online stock market trading and share trading platforms. You can virtually instantly execute a trade using online platforms. When trading stocks in the stock market, time is of the essence, the ability to execute online trading portals quickly is a benefit to many stockholders.

Low – Commissions

Thanks to recent advances in computing and the internet, large commissions on any trading stock are now a thing of the past. Online stock trading is an appealing option in terms of economics, with the most advanced trading technology and the lowest commissions.

And here is the biggest disadvantage of stock trading;

You May Lose money Easily

Many people believe that trading is the simplest way to profit in the stock market, but it is also the simplest way to lose money.

A study by the U.S. Securities and Exchange Commission of forex traders found 70% of traders lose money every quarter on average, and traders typically lose 100% of their money within 12 months.

What are the Pros and Cons of Investing You Must Know? 

Let’s start with the reasons why individuals should invest in the stock market.

1. Long-Term Returns

Investing is likely to yield favorable long-term returns. Historically stocks have outperformed all assets in the long run. While the stock market has always been volatile, it has always recovered from downturns, corrections, and crashes.

For instance, in the last 50 years, the S&P 500 has had an average annual return of 10.83%. This means, if you had invested $10,000 into an S&P 500 fund in 1970, the investment would be worth $2.13 million today.

2. Hassle-Free Buying

The introduction of discount brokers has made it easy to buy stocks. All you need is a brokerage account. Once you are done creating an account, you can buy stocks instantly.

3. No need for an Investment Degree

One of the biggest pros of stock investing is that it does not require an investment degree to be successful. You can invest passively and still have nearly the same returns as the stock market as a whole.

S&P 500 index funds are ideal for investors who prefer to take a passive approach to investing. When you buy in an index fund like this, you’re investing in hundreds of equities all at once. You don’t have to bother about researching which stocks to invest in or choosing whether to buy or sell specific shares because the fund does all of that for you.

Disadvantages of Investing 

Here are the cons of investing you cannot ignore;

1. Requires patience

You can get wealthy with stocks, but it will take years or decades. So, if you’re looking to get rich overnight, sorry but that’s not going to happen.

2. Stock Market is Volatile

The stock market is indeed volatile. It has always risen through time, although not in a straight line. There will be lots of corrections and crashes along the way. Thus, you must have the courage to not panic and sell in a panic when they occur.

3. You Might Break Your Bank 

Another but important demerit of stock investing is that if you don’t know what you’re doing, you could lose a lot of money, if not all of it. There are numerous methods to lose money in stocks, as well as numerous common investment blunders to avoid like purchasing equities on a margin using borrowed funds, being unable to pay off high-interest debt before beginning to invest, predicting the market’s movement, and more.

Bottomline 

The approaches, risk, and time involved in investing and trading are the most significant distinctions. Investing is a long-term strategy with lower risk, whereas trading is a short-term strategy with high risk.

If reducing exposure to volatility and achieving long-term returns are your primary objectives, long-term investment is the way to go.

What are the Key Takeaways? 

– Investing is a long-term gain solution to the markets that are frequently used for things like retirement plans.

– Trading entails using short-term techniques to increase profits on a daily, monthly, or quarterly basis.

– Traders will want to make transactions that would help them benefit rapidly from volatile markets, whilst investors are more inclined to look for long-term gains.

What Is Volatility: Overview, Types, Causes, How to Handle it, More

What is Volatility?

When a market or asset has periods of unpredictable and sharp price swings, it is referred to as volatility. In general, indexes such as the S&P 500 gain or lose less than 1% per day. However, the market does experience major price movements from time to time, which experienced investors refer to as “volatility.”

In this article, we’ll cover all you need to know about;

  1. What is volatility in the stock market?

  2. What are the causes behind it?

  3. What is the right level of market volatility?

  4. How to handle market volatility?

What is Volatility in the Stock Market?

The pace at which the price of a securities rises or falls for a particular set of returns is known as volatility. It measures the risk associated with a security’s fluctuating price by calculating the standard deviation of annualized returns over a specified period. In simple terms, it’s a measurement of how quickly the value of securities or market indexes changes.

What Causes volatility?

Volatility can be caused by a variety of factors that include:

1. Political and economic factors

When it comes to trade agreements, law, and policy, governments have a big role in regulating sectors and can have a big impact on the economy. Everything from speeches to elections can elicit reactions from investors, affecting stock prices.

Economic data is also important because once the economy is doing well, investors are more likely to respond positively. Market performance can be influenced by monthly job reports, inflation data, consumer spending figures, and quarterly GDP calculations. If these, on the other hand, fall short of market expectations, markets may become more volatile.

2. Factors affecting the industry and sector

Volatility in an industry or sector might be triggered by certain occurrences. For example, in the oil industry, a significant weather event in a large oil-producing region might cause oil prices to rise. As a result, oil distribution-related companies’ stock prices may climb, as they are likely to benefit, while those with significant oil costs in their business may see their stock prices decline.

Likewise, higher government regulation in a particular industry may cause stock prices to decline as a consequence of enhanced compliance and personnel costs, which may influence future income growth.

3. Company performance

Volatility may not always be market-wide; it might also be specific to a single company.

Important news, such as a solid earnings report or a new product that is impressing customers, can boost investor confidence in the company. If a large number of investors are interested in purchasing it, the greater demand may help to drive up the share price significantly.

A product recall, data breach, or bad management behavior, on the other hand, can all cause investors to sell their stock. This favorable or poor performance might have an impact on the larger market, depending on the size of the company.

What Is a Reasonable Level of Stock Market Volatility?

Markets are subjected to times of increased volatility regularly. As an investor, you should expect around 15% fluctuation from average returns over a year.

“Every five years, you can expect the market to drop around 30%,” says Brad Lineberger, CFP, president and founder of Seaside Wealth Management in Carlsbad, Calif.

“You really shouldn’t be an equity investor if you can’t manage that kind of volatility, since that’s about common.”

The stock market is rather tranquil for the most part, with brief episodes of above-average market volatility. Stock prices aren’t always bouncing around—there are extended stretches of little movement, followed by brief spikes in either direction. These events cause average volatility to be higher than it would be on regular days.

Bullish (skyward trending) markets are known for their low volatility, whereas bearish (downward-trending) markets are known for their unpredictable price movements, which are frequently downward.

Lineberger explains, “This is how it works.” “And, if you can take it, you’ll be able to outperform inflation by about three times per year.” “Embrace volatility and know that it’s normal,” is my greatest advice.

How to Handle Market Volatility in Stock Market? 

1. Keep in mind your long-term strategy.

Investing is a lifelong pursuit, and a well-balanced, diversified portfolio was designed specifically for times like these. If you need money shortly, don’t put it in the market, where volatility can make it difficult to get it out quickly. But, in the long run, volatility is a necessary aspect of achieving big growth.

2. Take Advantage of Market Volatility

Consider how much stock you can buy while the market is in a bearish downward trend to help you mentally cope with market volatility.

“Volatility periods, especially in stocks that have been strong over the last few years, actually allow us to purchase these stocks at discounted costs,” says Freddy Garcia, a Naperville, Illinois-based CFP.

After nearly a decade of uninterrupted growth, you could have bought shares of an S&P 500 index fund for approximately one third of the price they were a month before during the bear market of 2020.

3. Maintain an Emergency Fund

Market volatility isn’t a concern unless you need to liquidate an investment, because you may be obliged to sell assets if the market falls. That’s why investors must have an emergency reserve of three to six months’ worth of living expenses.

If you’re nearing retirement, financial advisors recommend putting aside up to two years’ worth of non-market associated assets.

How to Get the Best Out of Market Volatility?

Once you’ve decided to try to profit from a turbulent market, you’ll need to think about your objectives. Here are some helpful hints to get you started.

1. Pay Special Attention to Trending Stocks

Since the market as a whole is volatile, the key to success is identifying specific stocks. In a volatile market, this will allow you to make quick gains.

2. Manage Risk

Trading in volatile markets entails risk, so be aware of this and be prepared to mitigate it. Risk can be managed in a variety of ways, from diversifying your portfolio to making smaller trades with less risk.

Is Risk the Same as volatility?

You might think that risk and volatility are the same things based on the definitions presented here. They aren’t, however.

Risk is only a prediction of loss — and, by extension, irreversible loss — whereas volatility is a prediction of future price movement that includes both losses and gains.

The two are linked. And when it comes to risk mitigation, volatility is an important issue to consider. However, combining the two could drastically limit your portfolio’s earning potential.

The Bottom Line on Market Volatility

Market volatility is common, and it’s understandable to be anxious. Seeing large—or even small—losses on paper might be frightening.

Finally, keep in mind that market volatility is a normal component of investing, and the firms you invest in will react to a disaster.

Investors who understand volatility and its causes may be able to capitalize on the investment possibilities it presents to achieve higher long-term profits.

Explore our other articles, videos, and infographics about investing through volatility.

Key Takeaways: 

  1. Volatility is a statistical measure of an asset’s return dispersion. It shows how large an asset’s values move about the mean price.

  2. Since the price of volatile assets is anticipated to be less predictable, they are often regarded riskier than less volatile assets.

  3. Though volatility isn’t the same as risk, volatile investments are sometimes regarded as riskier due to their less predictable performance.

  4. Volatility is a significant factor in determining option prices.

What is ETF? Meaning, function and why you need it

The first exchange-traded fund (ETF) was launched in 1993.

Fast forward to date, and the global ETF assets stand at a whopping $9.1 trillion.

In 2020 alone, investors poured more than $730 billion into ETFs.

So what makes ETFs so popular among investors?

Exchange-traded fund (ETF)

Exchange-traded funds (ETFs) are tradable securities that track an index, commodity, sector, currency, or other assets. They are called exchange-traded funds, as they are traded on the stock exchange, just like stocks. And that allows investors to buy and sell ETFs, like stocks.

To understand ETFs better, imagine you’re grocery shopping. Now, you can either fill your basket with the essentials by walking down the aisles of the supermarket, finding each of the items, and adding it to your basket. Or you can simply buy one of those pre-filled baskets that have all the essential groceries.

ETFs are just like these pre-filled baskets, but for stocks. And unlike mutual funds, ETF shares can be bought and sold using your brokerage account, just like you would do with stocks.

ETFs can be structured to track anything from the price of a commodity to a collection of tradable securities. To do this, the fund will own the assets it is supposed to track. When it comes to tracking indexes, ETFs work almost the same way, as a low-cost index fund.

For example, if an ETF needs to track the performance of the S&P 500, the fund will buy stocks of all the companies in the S&P 500 and allocate them accordingly. So if you buy a share of this particular ETF, you’ll have invested in all the companies in S&P 500.

ETFs can have hundreds of assets in their holdings, to track stocks across various industries. Or it can focus on a particular industry or sector.

A very popular exchange-traded fund in the US is the SPDR S&P 500 ETF (SPY), which tracks the S&P 500 Index.

The popularity of Exchange-traded funds

As you can tell from the chart, the popularity of ETFs has risen rapidly over the years.

So what makes ETFs so popular?

Ease of use

ETFs are especially popular among newer investors. Most of them would start with a broad market ETF like SPY rather than picking individual stocks.

Why? It’s an easy choice.

Having to go through each individual stock deciding whether it’s the right choice for them, is intimidating to most newer investors. Whereas with ETFs, you’re instantly investing your money in the largest companies in the market.

ETFs trade on exchanges with ticker symbols similar to stocks. That makes it really easy to find them with a brokerage account.

Diversification

Investing in ETFs brings in immediate diversification.

As we’ve discussed earlier, ETFs are a basket of stocks. So buying a single ETF share will ensure that you’re investing in multiple companies. And if it is a broad market ETF, your investment will be spread across companies in different sectors and industries. That helps in decreasing volatility.

Because it’s highly unlikely that companies across all sectors will go down at the same time.

Also, for someone who picks individual stocks, ETFs can help in getting exposure to a certain sector, they might not be familiar with. For example, if you believe that the marijuana industry has significant room for growth, but you’re not quite sure which company to pick, choosing an ETF that focuses on marijuana stocks can save you time, and still make sure you don’t miss out on the industry winners.

Passive investing

Another advantage of ETFs is that you don’t need to frequently intervene with your assets. You can invest your money in a broad market ETF and forget all about it, and still grow your portfolio.

In many instances, these constant interventions and changes are the reason people lose money in the markets.

And the fund itself is passively managed. Meaning ETFs are generally automated to imitate changes in the underlying index/asset it tracks. Often, that results in having almost the same performance as that of the underlying index.

Having said that, there are also actively managed ETFs. These are run by professionals who make changes to the fund’s holdings more often. As a result, the fees tend to be higher when compared to passive ETFs. ARK Innovation ETF (ARKK) is an example of an actively managed ETF.

In general, most ETFs tend to be passively managed.

Low cost and commissions

This is a major factor in the wide popularity of ETFs. It’s cheap to invest in them.

The thing with investment vehicles is that they’ll charge you a substantial amount, for allowing you to invest in them. Actively managed mutual funds, for example, charge anywhere from 0.5% – 2% of your investment, annually.

But not ETFs.

On average, ETFs tend to charge anywhere between 0.02% – 0.75%.

You might wonder why we’re fretting over such a small percentage difference. After all, mutual funds are managed by finance professionals – they must know what they’re doing.

Well, think again.

A study by Vanguard found that only 18% of active mutual fund managers beat their benchmarks over a 15-year period. And, of these outperforming managers, 97% of them experienced at least five years of underperformance.

So basically, when choosing to invest in a mutual fund, you’re paying them huge sums of money every year, only to underperform the market.

With ETFs however, that’s not the case.

Sure, you might not beat the market. But you’ll likely match its performance every year. And believe me, you’ll be far ahead of most investors out there.

Different types of ETFs

As I said, there are ETFs for almost every asset, sector, and industry. Let’s look at some popular types.

Stock ETF

These are baskets of stocks that focus on a specific industry or sector. This also includes broad market ETFs such as SPY, which tracks the S&P 500, thereby tracking the performance of the 500 largest companies in the US. As illustrated before, stock ETFs have lower fees when compared to stock mutual funds.

Industry ETF

These ETFs are also stock-based. However, industry ETFs focus on a particular industry or sector (known as sector ETFs) rather than the broad market. This helps investors in getting exposure to an industry, which they might not be familiar. Especially with high-growth industries like technology, investors might be confused as to where they should invest.

So instead of looking for a specific company, they can invest in an ETF that focuses on major technology companies out there, making sure they don’t miss out.

Bond ETF

It’s what the name says – an ETF for bonds. Bond ETFs hold various kinds of bonds such as treasury bonds, corporate bonds, and municipal bonds. Their income distribution depends on the performance of their underlying assets. Investors generally choose bond ETFs, when they are looking for regular income from their investments.

Commodity ETF

These ETFs track the price of a commodity like gold or crude oil. These funds can be used to hedge your portfolio from downturns in the stock market. It is also far better than owning the physical commodity, as it involves a lot of complications. Commodity ETFs invest in all kinds of commodities.

For example, the popular coffee ETF in the US is iPath Dow Jones-UBS Coffee Subindex Total Return ETN (JO).

Inverse ETF

This is a different kind of ETF. While most funds are trying to capitalize on the price appreciation of underlying assets, inverse ETFs do the quite opposite. They aim to earn gains when the underlying asset goes down. This is done using something called shorting.

ETFs vs Stocks 

ETFs and stocks are inseparably linked.

ETFs have lots of similarities with stocks; how they can be bought and sold, ticker symbols, etc. More importantly, the majority of the ETFs are made of stocks.

As for which of these is the better investment choice, I would say that’s entirely up to you.

ETFs can be helpful if you’re a complete beginner and don’t know where to start. Or if you do not have the time to spend picking individual stocks, ETFs might be the ideal choice for you.

You may also choose ETFs as a way of getting exposure to industries that are unfamiliar to you. Thereby enhancing your portfolio and ensuring diversification.

ETFs vs Mutual Funds

Cost

To iterate what we have discussed before, ETFs have several advantages over mutual funds.

ETFs are certainly cheaper. On average you’ll be charged anywhere between $75-$200 a year, for every $10,000 you invest in mutual funds. Whereas in ETFs, you’ll only be charged $2 – $20 a year, for the same investment.

This is because mutual funds are actively managed by a finance professional who is constantly in the pursuit of beating the market. Yet, over the past 15 years, only 1 in 13 managers have succeeded in doing so.

Tax Efficiency

And ETFs are more tax-efficient than mutual funds.

Generally, when you sell shares and realize the gains, you’ll incur capital gains taxes, which will be taxed depending on how long you’ve held the assets.

ETFs are passively managed. So buying and selling within the fund is less. However, as mutual funds are actively managed there are more buying and selling shares. This can incur taxes.

This means, even if you don’t sell any mutual fund shares, you might still incur taxes due to the nature of how mutual funds work.

Bottomline

ETFs are your go-to choice if you are a complete beginner, or if you don’t have the time to do due diligence in individual stocks. ETFs allow you to get started with investing. And for someone who has a portfolio of individual stocks, it helps you in diversifying your assets and getting exposure to different sectors.

However, it is important to know that your returns will be average. You might never beat the market.

But if you can put aside 20 mins a day, you could potentially generate substantial returns and beat the market year over year, by choosing individual stocks.

Check out the workshop to learn more.

Why do we need the stock market? Function and importance

The answer is simple.

The stock market provides companies access to money.

That is the primary reason we need stock markets.

But that’s not the only reason.

Let’s take a look at what constitutes a stock market and why do we need it.

What are stocks?

Before we dive deeper into the stock market, it’s essential to understand stocks. Thankfully, it’s not that hard.

Let’s say four friends wanted to start a company, so they put in equal amounts of money for the initial capital. All of them will be given shares that represent the ownership of the company.

The number of shares each person will receive depend on the amount of money they put in. In this case, they all will receive the same number of shares as all of them put in equal amounts of money.

Owning shares means you have a chance of receiving a portion of the profits the company might make in the future. Now, this is not guaranteed. Because the company might never make profits, and even if they do, they might decide not to distribute profits among shareholders.

But if the company decides to distribute profits, each shareholder will receive a portion of the profits, in proportion to the number of shares they own.

The company always keeps track of who owns its shares and how many. So that if in future they decide to pay out profits as dividends they’ll know who to pay.

And the stock is transferable. Why is that so important?

Because it means that if you own stock shares of one company, you can hand them over to another individual or organization, in exchange for money. You can also gift your stock shares to your friends or family, or your children could inherit them.

The stock market exists because the stock is transferable.

Why would someone buy stocks?

Individuals invest in companies (by buying shares) to make profits.

When you invest in a company, there are two ways you can potentially make a profit. The first one is through capital appreciation. That means selling shares for a price, more than you bought them for, and pocketing the difference.

Over time, stocks tend to rise in value. The S&P 500 – an index that tracks the performance of the stocks of the 500 largest companies in the US – has a produced an average annual return of 13.6% in the last 10 years. And investors make money off of this price appreciation.

The second is through cash payouts called dividends.

Like I mentioned earlier, companies might distribute a portion of their profits among shareholders. The amount each shareholder will receive will be relative to the number of shares he/she owns. These payouts can act as an active income from your investments.

There are many more reasons why people buy stocks, but these are the most common.

What is the stock market?

The stock market serves as a marketplace for stocks.

The stock market refers to financial institutions that facilitate the transfer of shares from one party to another. The stock market makes it easy for people to buy and sell stock shares.

Why is this so important?

Every transaction – whether it’s goods, services, or money, involves a certain level of uncertainty. The buyer might be uncertain about the quality of the goods, whereas the seller might be worried whether the buyer will pay in time.

The same goes for transactions of shares. The stock market lowers that uncertainly surrounding the buying and selling of shares, by providing a common marketplace for all participants – known as stock exchanges.

If you would like to know more about how the stock market works, read this article.

Stock exchange

A stock exchange is where the trading (buying and selling) of the shares happens. Market participants (individual and institutional investors) use the stock exchange to place orders to buy or sell. All the orders (to buy or sell shares) are processed at the stock exchange, and the shares and the cash is delivered to the respective participant.

New York Stock Exchange (NYSE) is one of the oldest and largest stock exchanges in the world. Stock exchanges in the US are regulated by the Securities and Exchange Commission (SEC). The institution oversees the smooth functioning of exchanges.

The stock market makes sure that you are free to buy and sell shares whenever you want. Institutions like the SEC lowers the uncertainty around investing in companies and protect investors from fraud and manipulation.

What if there was no stock market?

Buying and selling stocks won’t be easy

To begin with, investors would have a hard time buying and selling stocks. The whole investing process will be complex and expensive. You would need to approach the companies directly to buy shares. And every time you want to sell shares you will need to find a buyer on your own.

As a result, people will be very unwilling to invest in companies as they are not sure whether or not they can get their money back, let alone profits.

Funds will be hard to access

It’s worse for companies.

An initial public offering (IPO) is when a company’s shares are made available to the public to buy for the first time. An IPO has the potential to bring in a lot of funds to a company. And if the company is already well known at the time of its IPO, the company will be able to raise a significant amount of money.

But this won’t happen if there is no stock market.

And companies might decide to issue new shares in the future to raise capital. This opportunity gives them access to funds from the public, and they can access them as and when it seems necessary.

Needless to say, if there is no stock market, companies can forget about these funds.

So they’ll need to find and approach investors who would be willing to provide funds in exchange for money. It will be time-consuming and expensive. And companies won’t have access to large amounts of money. So they’ll be forced to look at alternate sources for capital.

This means they’ll have to take on debt; they’ll need to borrow money – large amounts, to grow the business. And that could be a burden later on, especially for newer businesses.

And due to the lack of sufficient capital, company growth will substantially slow down. As it would be hard for them to expand their business, introduce new products/services, or invest in R&D without enough money to spare. Also, if it’s a competitive market, the company might end up losing its customers and could potentially go out of business.

Now, let’s talk about the overall economy.

Economy and the stock market

Many of the largest publicly traded companies we see today grew their businesses using the funds they raised from the public through the stock market. And these companies might not exist today if it wasn’t for an active stock market and a large number of enthusiastic investors.

When these companies grow, naturally there will be more revenue, which means they’ll hire more people, which will grow the business. All of this means that the government will receive more money in taxes.

Don’t believe me? Check this out;

The US government received $230.2 billion in corporate taxes, in FY2019. Most of that money could disappear if there was no stock market.

So no stock market means fewer jobs, less income, fewer taxes, all of which will result in a weaker economy.

Bottomline

Financial markets are viewed as an indicator of the overall economy of the country; an active stock market shows a robust economy and vice versa. An active stock market can help individuals grow their wealth and companies grow their businesses.

To know more about how you can grow your wealth through investing, check out our bestseller The 8-Step Beginner’s Guide to Value Investing.

Invest in index funds; A complete beginners guide for 2021

 “Don’t look for the needle in the haystack. Just buy the haystack!” 

That’s John Bogle, on the importance of index funds.

John Bogle was the founder and Chief Executive of The Vanguard Group. Most of all, he was the biggest proponent of index funds.

To understand how big of a deal this introduction was, you need to know what an index fund is, and how they have helped individuals invest, over the years.

What is an index fund?

An index fund (also known as an index mutual fund) is a fund that tracks a market index. A market index is a hypothetical portfolio of stocks that represent a certain section of the stock market. Often market indices represent the stock market as a whole. For example, S&P 500 is the most popular index in the US. It tracks the 500 largest public companies in the US. When you hear people say the market was down today, they’re likely to be referring to a broad market index.

So an index fund that tracks the S&P 500 will have shares of all the 500 companies in the index. By doing so, the index fund is trying to replicate the performance of the market index.

Index mutual funds are passively managed. The funds are automated to make adjustments according to the shifts in value in the underlying companies. 

Since the funds are not actively managed, the fees tend to be lower than actively managed funds. On the other hand, actively managed funds usually have a fund manager and a team of analysts, who are constantly trying to find new opportunities, in an attempt to beat the market. As a result, they usually have higher fees associated with them.

Traditionally, there are two types of index funds – Stock index funds and bond index funds. As the name goes, stock index funds track a stock market index (like S&P 500), a bond index fund tracks a bond market index (a market index that tracks the price of bonds, like the Bloomberg Barclays U.S. Aggregate Bond Index).

Why are index funds popular?

These are some of the reasons why index funds are so popular.

Easy to invest

Most individuals put off investing because they don’t have the time to do the research that is essential in making informed investment decisions. Also, many have a hard time understanding all the jargon that comes with the stock market. So people put off investing altogether. This is where index funds come in.

Index funds provide you a hands-off approach to investing. Even if you have no clue how the stock markets work, you could invest in index funds and still get around 8%-10% return annually. Because that’s the average annual return of the S&P 500, during the last 10 years. And since the index funds by definition are the market average, that’s the return you will receive.

Low-cost index funds

This is another aspect that makes index funds so great. Index funds are less expensive compared to other funds. On average, low-cost index funds annually charge 0.02% – 0.2% of your total investment. Whereas mutual funds charge 0.5% – 2.5% of your investment.

You must be wondering why we’re losing our heads over some fractions of a percentage. Do they really matter?

You bet they do.

In fact, these small fractions can have a massive difference in the long run. Consider this; assume you invest $10,000 in two funds that charge 0.5% and 2.5% of your investment, respectively. Assuming you get an annual return of 10%, this is how your investments will look like in 20 years.

a table comparing investment growth relative to different expense ratios

As the table illustrates, the $10,000 invested in the fund that charges 2.5%, will be worth $46,022 in 20 years. Not bad, right?

Actually, it is bad.

Not in itself, but compared to the other $10,000 invested in an index fund that charges 0.5%. After 20 years, it would be worth $61,159 – a 33% improvement over the more expensive fund.

There’s another reason why passively managed index funds are the better option when compared to actively managed funds. A 2018 report from S&P Dow Jones Indices suggests that more than 92 percent of active fund managers in large companies were unable to beat the market over a 15-year period.

This means with actively managed funds, you’re paying more money, only to underperform the market.

Diversification

A major advantage of investing in index funds is that you are diversifying your investments. As I mentioned, market indices usually consist of several companies that belong to different industries and sectors. So with index funds, you’re diversified from the get-go. For example, SPY is an exchange-traded fund (ETF) that tracks the S&P 500. ETFs work basically the same way an index fund does. So when you buy one share of SPY, you own shares of 500 companies.

This immediate diversification leads to less risk. As your investment is sprawled across companies from different sectors, you’re less likely to suffer losses. And even if you do, your losses should be balanced by your gains from other stocks in the fund.

Remember the quote at the beginning? That’s another reason why investors choose index funds. Instead of looking for the next big winner among thousands of stocks (needle in hay), you can buy an index fund (the hay), and make sure that you don’t miss out on the winners.

Disadvantages of index funds

Since we talked about all the good things that make index funds a popular form of investment, I feel like we should look at the other side of the coin too.

When it comes to the demerits of index funds, these are what I can think of;

Average returns

With index funds, you’ll only ever make average returns. That is because the performance of the market index is considered the market average. Since that is the performance your index fund tries to match, you’ll end up with the same returns. So it’s unlikely that you’ll ever beat the market.

Less choice with stocks

When you invest in an index fund, you’ll be investing in several different stocks; you might be interested in some of those, not so much with other ones. Your choice is limited with index funds. You’ll likely end up owning stock you’d rather not own.

Moreover, you might miss out on certain stocks that may not be a part of any index, but you believe has a huge potential.

How to invest in index funds?

The first step to investing in an index fund is choosing one.

A couple of things to be kept in mind while choosing an index fund are expense ratio, tracking error, and the index that it tracks.

Underlying index

When you’re investing in an index fund, you’re basically investing in the underlying index. So it’s important to identify which index is worth investing in. Generally, people go with index funds that track a broad market index such as the S&P 500, or the Dow Jones Industrial Average (DJIA). You also have the option to choose indices that focus on specific sectors. Even better, you have index funds that track the index of global stocks – like Vanguard Total International Stock Market (NASDAQ: VXUS).

Expense ratio

It is the amount you’ll be charged annually, for investing in the fund. It is expressed as the percentage of the amount you invest. For example, if you invest $10,000 into a fund with an expense ratio of 0.02%, you’ll be charged $2 every year. Like I mentioned earlier, the average annual expense ratio for index funds is around 0.02% – 0.2%.

As illustrated earlier in the article, the more the expense ratio, the less the returns.

Tracking difference

Basically, tracking difference is the difference in the index fund’s performance to that of the underlying index. If a market index produces an annual return of 10%, and the index fund produces 9.8%, the tracking difference is -0.2% (9.8% – 10%).

The negative value indicates that the index fund is underperforming the market index it tracks. So when the tracking difference is positive, the index fund is outperforming the market. Usually, the tracking difference tends to be marginal.

Once you decide which index fund you want to invest in, you can open a brokerage account with, either a broker or the mutual fund company that issues the index fund. Since you’ll likely make more investments in the future, it’s better to go with the broker. Once your brokerage account is up, you can transfer funds electronically and invest in the index fund.

Bottomline

If you are looking to grow your money, but don’t have the time to do the necessary research, index funds are the way to go. You can also choose index ETFs because it also works pretty much the same way. Index funds are certainly a lot better than mutual funds, as index funds charge lower fees and over the long run, they generate better returns.

That being said, there is something I would like to bring your attention to.

As it turns out, most index fund investors seem to be individuals who’d rather invest in individual stocks but don’t have the time nor the resources to do so.

Well, the truth is, if you can spend just 20 mins a day, you can achieve market returns substantially higher than the market average – just by using what you already know. To know more, check out our bestseller The 8-Step Beginner’s Guide to Value Investing.

Differences between stocks and bonds; A complete guide

Most individuals when they are starting with investing, tend to have a lot of questions. And one of the most common questions of them all is – should I invest in stocks or bonds, or if I invest in both, how much should I allocate to each one?

For a lot of people, their investment journeys end right at that point. Because they look into stocks and bonds but can’t seem to decide which is a better investment, so they put off investing altogether. And they think they’re better off putting their money in savings accounts.

Here’s the thing – savings accounts with their 0.04% interest are not going to make you any money – in fact, they don’t even save your money when inflation rates are around 2%.

The point is, you should get started with investing as soon as you can. And we’re here to help you do that.

In this article, we’ll talk about the difference between stocks and bonds and which might be the better investment option for you.

Stocks and the stock market

Stocks are securities that represent partial ownership in a company. When you buy a share of stock, you’re buying a portion of the company. Hence stocks are also known as equity securities. For example, if you buy 10 shares of Microsoft stock, you are buying a portion in the company that is equivalent to 10 shares. Because Microsoft has more than 7 billion shares, your stake might be insignificant. Nevertheless, you’re still a shareholder of Microsoft.

A stock market allows companies to raise money from the public. Companies exchange a small stake in the company for cash. This allows them to raise huge amounts of cash that can be used for expanding the business and grow the company. For investors, it is an opportunity to be a part of the company and get rewarded.

A stock exchange is where individuals come together to trade in stocks. Stock exchanges act as an intermediary between companies and investors, where the company can list their shares and the individuals can trade them. New York Stock Exchange is one of the largest stock exchanges in the world and lists some of the biggest companies in the US.

Stock markets in the US are heavily regulated. The Securities and Exchange Commission (SEC) oversees the activities of stock exchanges and has set strict rules to ensure the smooth and transparent functioning of the market.

Bonds and the bond market

With bonds, you’re lending money. When you invest in a bond issued by a company, you’re basically lending them money with a promise that the money will be returned to you along with interest. It’s almost the same way a bank pays its debtors.

Assume you invest $1,000 in a bond that pays 2% interest for the duration of 5 years. During this holding period, you’ll be paid $20 (2% of $1,000) every year. And at the end of the duration, you’ll be paid back the initial investment i.e. $1,000, so you end up with a total of $1,100.

The bond market does not have a centralized location like a stock exchange. Bonds are mainly sold over the counter (OTC). Bonds are also given an investment grade by credit rating agencies like Moody’s and Standard and Poors. These ratings help investors understand how risky a particular bond is.

Generally, there are three types of bonds;

  1. Corporate bonds
  2. Municipal bonds
  3. High yield bonds

Corporate bonds are the ones that are issued by private and public companies. These generally have a high credit rating, meaning that they’re likely to pay you back your money along with interest.

High-yield bonds, on the other hand, offer higher yields but have a low credit rating. So they’re more likely to default, and hence offer higher yields for the increased risk.

Municipal bonds are the ones issued by states, cities, and other government entities. US Treasury securities are an example of it. Treasury bonds are considered the safest form of investment, as they are backed by the US government, making them a popular choice.

Difference between stocks and bonds

By now you have a decent idea of the differences between stocks and bonds. Anyway, we’ll take a closer look at how they are different.

Making money; bonds vs stocks

Capital gains and dividends

When it comes to stock investments, there are two ways you can make money; capital gains and dividends. Capital gains are when you make money from the price appreciation of stocks over time. In simpler terms, you sell the stocks for a higher price than you bought them for. Capital appreciation occurs when the underlying company performs well; the company generates more revenue and profits, expands the business, enters new markets, etc. When a company performs well, investors will be willing to pay more for its stock, and you capitalize on that.

The second way to make money from stocks is through dividends. These are cash payouts paid by the company to its shareholders. A portion of a company’s earnings is distributed to shareholders in the form of dividends as a token of appreciation for investing in the company. These payouts are made at frequent intervals, usually annually or quarterly, although some stocks pay a monthly dividend. So you invest in stocks that pay a dividend and get paid frequently.

Notice I said ‘stocks that pay a dividend? That’s because not all stocks pay a dividend. Instead of paying shareholders, the company might reinvest those earnings into R&D, expansion, or acquiring businesses. And that can drive up the price – which ultimately benefits the shareholders.

And both capital gains and dividends can be reinvested into equities which will compound your returns over time.

Interest payments

Similar to stocks, investors can make money from bonds with capital gains or interest payments. Bonds, just like stocks, can be sold on the market for more than you bought them, and pocket the difference. However, the primary source of income from bonds is through interest payments.

Generally, interest payments will be paid every year, distributed throughout the year. This predictable regular income is what attracts most investors to bonds. Hence bonds are considered as fixed income securities. Also, with bonds, the initial capital is guaranteed, as long as the bond issuer is solvent. As for government bonds, they are backed up by the US government, so it is considered the safest form of investment.

Ownership; equity vs debt

When you own stocks, you become a shareholder in the company. That means you own a small portion of the company. Depending on how well the company performs, that portion could be a lot more valuable in the long run. And you can hold on to it, as long as the company exists, and get rewarded all the while. As a reason, stocks are the most popular liquid financial asset in the US.

With bonds, however, you don’t own anything. When you lend money to a company, you’re not given a stake in the company. Instead, you’re merely promised that you’ll be returned the capital along with interest.

Risks and rewards

Whether you invest in stocks or bonds, there are risks and rewards involved in both these. Let’s look at it in more detail.

Stocks

The risk with stocks starts with the returns. For stocks, returns are not guaranteed. If anybody tells you that a certain stock is a ‘guaranteed’ ten-bagger, run for your life. Because stock price can move up, down, sideways – pretty much in all directions. This is especially true in the short term. You can invest in a promising company and still lose money in the short term.

If you would like to know more about how a stock market works, check out this article.

A lot of factors can affect stock prices. It could be issues within the company in question, or the industry, or the economy in general. Remember March 2020? Between March 4 and March 11, the S&P 500 index dropped by 12%. On March 12, the S&P 500 plunged 9.5%, its steepest one-day fall since 1987. This was due to the outbreak of the global pandemic.

But if you take a step back and look at the markets, you’ll see that the markets rise in the long run. The S&P 500 for instance, was back on its feet, and by January 2021 it had reached a new record of 3,849.62. And as of the time that I am writing this, it’s at 4,352, up 88.83% from its lowest in March 2020.

The point is – investing in stocks can be extremely rewarding. Especially if you hold on to your stocks for a longer period of time, say more than 20 years. Consider this for example; if you had invested $8,000 in the S&P 500 index in 1980, your investment would be nominally worth approximately $783,086.76 in 2021, despite several market crashes and downturns along the way.

And this is only the market average. You could have achieved this just by passively investing, using an index fund, or a broad market ETF. Also, when it comes to stocks, there is virtually no limit to the returns you can generate. Using a proven investment strategy such as value investing can bring returns substantially higher than the market average.

There are also dividends, which can provide a steady stream for as long as you hold the stocks. And if you can reinvest those dividends, your returns will compound over the years, and it can bring massive returns to your investment portfolio.

Let’s assume you invested $100,000 into an ETF that tracks the S&P 500 and remain invested for 20 years. Also, you chose to reinvest your dividends using a dividend reinvestment program (DRIP).

Assuming a steady dividend yield of 2% and an average annual return of 8%, this is what your investment will look like in 20 years, compared to the one where you did not reinvest your dividends.

As you can see, there is a big difference in the value of the investment after 20 years. In fact, you earned 48% more by reinvesting your dividends for 20 years, than the one where you did not reinvest.

Bottomline – dividends or no dividends, in the last 15 years stocks have outperformed every other asset class with an average annual return of 9.88%.

Bonds

Bonds help you preserve capital and earn a steady income. You get an additional stream of income with the regular interest payments from the bond. And these payments are generally tax-deductible, which is an added benefit. On top of that, certain bonds such as the Treasury bonds can be the safest investment during bear markets.

Having said that, there are downsides to bonds as well, the most important one being that the returns are limited. The returns from bonds are guaranteed, but they are limited and lower compared to other asset classes. In fact, bond yields are so low that when accounted for inflation, the returns might be marginal or in some cases – none.

Liquidity is another important factor when it comes to bonds. Bonds can also be bought and sold like stocks, but they are less liquid, meaning they cannot be easily converted into cash. Bonds are traded on over-the-counter (OTC) markets, which means regular investors like me and you are less likely to participate in trading bonds.

Rising interest rates add to this issue. When interest rates rise, bond prices fall. Because the newer bonds will be more appealing to investors, as they offer a higher rate of interest. And when you try to sell a bond with a lower interest rate, you might have to do so with a loss.

Which is best for you; stock or bonds?

It depends.

Your investment goals, timeline, and risk tolerance are some of the factors that need to be considered before deciding what’s best for you.

You might be investing with a specific goal in mind that needs to be achieved within a specific timeline-like buying a house. Or you might be investing for retirement. Also, how much risk are you willing to take; are you okay with your investments going down 10-15% at times? What about your timeline – are you flexible with your timeline, or do you have a timeline that must be met at all costs?

All of these need to be considered, before deciding whether to invest in bonds or stocks or both. But as a rule of thumb, when you are looking for the capital appreciation you should go for stocks. On the other hand, if you are looking to preserve your money, and get low but consistent income from your investments, maybe you should go with bonds.

You can also mix it up with stocks making up the majority of your portfolio. This is applicable when you’re looking to limit your downside, or simply put, protect your investments, rather than trying to grow it substantially.

Bottomline 

Stocks and bonds can be beneficial to your portfolio, whether to go all-in on one of these, or have a mix of both depend on your goals, timeline, and risk tolerance.

When it comes to growing your money, stocks have the upper hand, as it has historically outperformed all other assets. However, if you’re hesitant about going all-in on stocks, you can go with a mix of both, with allocations such as 70% stocks, and 30% bonds or similar.

The important thing is that you invest in the market, rather than depending fully on savings accounts to save your money. Have a long-term view when it comes to investing in stocks, and also investing in general, and do your homework when investing in any asset, and you’ll be good.

While this is enough to get started, you’ll need more information as you sail through your investment voyage. Here is The 8-Step Beginner’s Guide to Value Investing to help you.

PS:  The book features the 20 best stocks & ETFs to buy and hold for the next 20 years that can give you a jumpstart.

Dividend investing for beginners; A guide to passive income

“How many millionaires do you know who have become wealthy by investing in savings accounts? I rest my case.”

— Robert G. Allen

There are a lot of misconceptions when it comes to investing in the stock market. Investing is the same as trading or gambling, or it is a get-rich-quick scheme – to name a few. Not only are these misleading, but they also lead people away from the most effective way of growing your money. Investing – in a nutshell – is a proven way to build wealth over a long period of time. There’s data that goes back decades that proves this. Consider this for example; if you had invested $8,000 in the S&P 500 index in 1980, your investment would be nominally worth approximately $783,086.76 in 2021.

So let’s break it down.

There are two ways you can make money in the stock market  – capital appreciation and dividends. In simpler terms, the first way to make money is where you sell stock shares more than you bought them for. For example, you buy Apple stock at $50 a share, and sell when the share price hits $120 a share, and pocket the difference.

The second way to make money is through dividends. A dividend is a cash payout by the company to its shareholders. A portion of a company’s earnings is distributed to shareholders in the form of dividends as a token of appreciation for investing in the company. The payouts are made at frequent intervals  – usually annually or quarterly, although there are some stocks that pay a monthly dividend. So you invest in dividend stocks and get paid frequently.

Keep in mind that, apart from cash dividends, there are other types of dividends such as stock dividends, property dividends, etc. However, within the scope of this article, we’ll be only discussing cash dividends.

Dividends are a great way to generate passive income, as there’s virtually no effort involved in earning dividends. Hence, investors often look for stocks that pay dividends, in order to generate returns on top of the capital gains from the stock. This strategy is referred to as dividend investing.

Let’s dive deeper into it.

What is dividend investing?

As I said, investors buy dividend-paying stocks to increase their profits, generate passive income or compound their returns over time. Investing in dividend-paying stocks allows investors to generate cash from their stocks, at virtually no extra cost or effort. Also, dividend stocks act as a hedge against market volatility. The reason is, whether it’s a bull or bear market, dividend-paying stocks will ensure returns for your portfolio. Especially in a bear market, when you see your investments lose value, it’s good to have a consistent income that can alleviate the impact.

However, bear in mind that not all stocks pay a dividend. Instead of paying shareholders, the company might reinvest earnings into R&D, expansion, or acquiring businesses. And that can drive up the price – which ultimately benefits the shareholders. Whether or not to pay dividends is determined by the board of directors. For instance, Amazon has never paid a dividend, and perhaps they never will. Despite that, the stock has produced returns of 193,521.39%. So not paying a dividend alone, does not make it a bad investment.

Whether it’s retirement planning, long-term wealth creation, or whatever the goal may be, dividend stocks are an integral part of every investor’s portfolio.

Look for these criteria in dividend stocks

Now you know what dividend stock investing is. Let’s take a look at how you can find the best dividend stocks for your investment portfolio.

When it comes to selecting stocks that pay dividends these are some metrics to look at:

Dividend yield

Dividend yields are the first metric investors look at when assessing potential dividend stocks. It is the annualized dividend, expressed as a percentage of the stock price. So if a company pays a total dividend of $5 a share and the share price is $100, the dividend yield is 5%. The higher the dividend yield the more you get in dividends.

But there’s a catch here.

High dividend yields are not always ideal. Because you see, when calculating the dividend yield, the dividend that was paid in the previous year is taken into consideration. So a decline in stock price will result in a higher dividend yield. Novice investors might see this as a great dividend-paying stock when actually it isn’t.

So investors should ideally look at more metrics to get a clearer picture of the company.

Payout ratio

The dividend payout ratio or simply – payout ratio – is a measure of how much of a company’s earnings are distributed to shareholders as dividends, in a year. It is calculated by dividend paid divided by net income and expressed in percentage. For instance, if Apple pays 24% of its net income in dividends, then Apple’s payout ratio is 24%. It can also be calculated by dividing dividend per share by earnings per share (EPS).

The idea is to find companies that have a high yield but only pay out a sustainable portion of their income. For example, Apple only pays out 24% of its net income.

As for an ideal ratio, consider investing in companies that pay not more than 55% of their net income. This makes sure that they can keep paying dividends consistently without having to compromise reinvestments in the business.

How to find the best dividend-paying stocks

The first step is to identify great dividend stocks.

Select dividend stocks

There are a couple of ways to go about this. The easiest way is to start with a stock screener. Most online brokers have inbuilt stock screeners that are based on different investment strategies. You can find the dividend screener there.

Once you have a list of potential stocks for your dividend investing strategy, it’s time to do a deep analysis of each stock.

Look for the payout ratio

Now that you know about dividend yields and payout ratios, it’s time to put them to use. I have already explained why looking only at dividend yield can trick you into investing in yield traps. So ideally you should look at the payout ratio when evaluating stocks. Remember, you are looking for a good payout ratio, at the same time you want it to be sustainable. Meaning, you don’t want the payout ratio to be too high or too low.

It mostly depends on the industry and the company. If it’s a large company and it is in an industry where you don’t need to invest large amounts of money into R&D, or capital expenditures, it makes sense to pay out a significant amount of your earnings to shareholders. Coca-Cola is an example of this.

Whereas it does not make sense for a biotech company to pay out a substantial amount of its earnings since a biotech company needs huge investments in R&D, capital expenditures, etc. to succeed in the industry.

So ideally you should look for a payout ratio between 1% to 35% for a mature company. Mature companies are the ones that dominate their respective industries. Coca-Cola, P&G, Johnson, and Johnson are some examples. Certainly, there are exceptions. Coca-Cola pays out 73% of its earnings as dividends since they have a superior cash flow.

The point is, it’s a little tricky to narrow it down to a specific number when it comes to the payout ratio. As a rule of thumb, you should stick to companies that pay no more than 55% of their earnings.

Dividend growth and past payouts

Another aspect to consider is how well the company has paid out dividends in the past. Have they been consistent with dividend payouts? More importantly, have they been consistently increasing their dividend payouts? Because there are companies that pay a dividend only when they have a good year. Sometimes, companies make a one-time dividend payment. On the other hand, growing companies might cut dividends now and then to expand their operations. So it’s quite important to look at how well the company has paid dividends in the past. Even though past performance does not guarantee future results, it gives you an impression of where the company is heading.

If a company has been consistently paying dividends and has also been increasing payouts, you are looking at a healthy company with good earnings growth and a potential dividend stock for your portfolio. AT&T is an example of this. Not only has it paid dividends consistently, but it has also been increasing payouts since 1987. Currently, AT&T yields 7.15%.

Some companies have been increasing their dividend payouts consistently for over 50 years. These companies are known as the Dividend Kings. P&G, Coca-Cola, and 3M are examples of Dividend kings. Then some companies have been doing this for 25 consecutive years, they are known as Dividend Aristocrats. McDonald’s, Kimberly-Clark, and Realty Income are some examples. There’s also Dividend Achievers who have increased their payouts for the last 10 years. Microsoft, Visa, and Nike are examples of Dividend Achievers.

Bottom line – focus on the combination of payout ratio and past dividend appreciation – growth and consistency are what we’re looking for. It should tell you how healthy the business is, and how likely it will continue to pay and increase its dividends.

Here’s something to help you; 

Dividend growth investing is a popular strategy when it comes to growing your money. But we have barely touched upon the most important aspects. To understand more about how a combination of capital gains and dividend income can grow your money exponentially, check out our guide to Dividend Growth Investing. This will give you a head start with your dividend investment strategy, and much more.

Frequently asked questions

How do I start investing in dividends?

You can start by selecting a dividend stock using the metrics we discussed above. Once you buy the stock, you’ll be notified when the dividends are distributed to the shareholders. Note that the brokerage may deposit the cash from dividend, directly to your bank account. Some brokers allow you to reinvest those dividends. Check with your brokerage to know more.

Are dividends good for beginners?

Yes, dividends are good for beginner investors. Dividend stocks allow you to generate a return on your investment, with less due diligence. You can start with Dividend Kings, Dividend Aristocrats, or Dividend Achievers.

Investing vs saving; Which one should you choose?

“It’s not how much money you make, but how much money you keep, how hard it works for you, and how many generations you keep it for”

– Robert Kiyosaki

Whether you’ve got your first paycheck, or you’ve been earning for quite a while and you want to start working on your finances, it’s likely that you’re deciding between saving vs investing. How much money should you invest, where should you invest, is investing safe – are some of the questions that come up when confronted with the choice of saving or investing

So let’s break it down.

What is considered Saving?

Saving is when you set aside money in safe accounts or securities with virtually no risk. The objective is to save as much as money and keep it secure for future use. As long as you don’t make any withdrawals, the dollar amount in a savings account will not decrease. Also, your savings are a liquid option, meaning the cash is readily available, at your time and place.

A bank account, for example, is virtually a no-risk option when it comes to putting your money, besides you can access your money whenever you want.

Why should you save?

One might think that saving money isn’t really necessary when you can always get things on credit using credit cards or personal loans. And you’re right – you can buy things using your credit card and it’s quite easy to avail yourself of a personal loan when you have a bigger purchase to make.

However, with every purchase you make using your credit, you’ll end up paying more money than the cost of the product since there’s added interest for the money you borrowed. Whereas if you had enough money in savings, you only need to pay the cost of the product, nothing more. It might take a while to have enough money in your savings to make a bigger purchase – like a car. But it’s worth the wait.

Where should I save?

When it comes to savings, these are the most popular options

  1. Savings account
  2. Checking account
  3. Treasury Bills
  4. Certificates of Deposit (CD)

Keep in mind that, with Treasury bills and CDs there might be a minimum time period for which you should not make any withdrawals to get interest on your money. If you make an early withdrawal, you might have to pay a penalty, and you probably won’t earn any interest.

What is considered investing?

Investing is the act of committing your money or capital to an asset hoping to generate a profit. It is similar to saving, in that you’re preserving money for future use. But the difference between saving and investing is that, with investing you’re trying to get a higher rate of return on your money by allocating it to certain assets.

Generally, a profit from an investment would be through capital appreciation or active income. Capital appreciation is the increase in value of the asset over time – if you had bought Apple stock at $70 and waited a couple of years and sold it at $140, you’d have a profit of $70. Active income from investing will be in the form of dividends (stocks) and rental income (real estate), etc.  Remember, not all assets provide you with an active income.

The goal of investing is to grow your money. For that, you need a high rate of return on your capital. The rate of return varies from asset to asset. But keep in mind that this is not a guaranteed rate of return. When it comes to assets like stocks, there are no guarantees.

However, historically, stocks have appreciated in value. On average, the stock market has produced an annual return of 13.9% in the past 10 years (2011-2020). For context, the average annual rate of return on a savings bank account is around 0.04%.

Why should I invest?

Before I answer this question, let me tell you what inflation is. Inflation is an aspect of the economy that results in a decrease in the value of money over time. Inflation leads to a decrease in the purchasing power of the currency – most of the products you could buy with $10 in 2010, can’t be bought with the same amount anymore.

The inflation rate is around 2% a year in the US. Whereas the interest rates for a savings account are close to zero. So ‘saving’ all of your money is not a good idea.

Investing helps you beat inflation. If you look at S&P 500, an index that tracks the prices of the largest 500 companies in the US, had an annual rate of return of 13.9% in the past 10 years. This shows not only you beat inflation, but you also managed to grow your money.

So to answer your question, investing allows you to grow your money over time, despite inflation.

Where should I invest my money?

These are the most popular options when it comes to investing:

  1. Equities
  2. Bonds
  3. Funds – mutual funds, ETFs, etc.
  4. Real estate

Stocks are one of the most popular investment options. Investing in stock is the best way to grow your wealth over the long term. The stock market has consistently appreciated in value-generating profits of millions of dollars, for thousands of individual investors.

Consider this – if you had invested $10,000 in an S&P 500 index fund in 1993, it would be worth $95,370 today (as of 26 May 2021).

Saving and investing

Now we know what is considered saving and investing. The next question you might want to ask yourself, when should you invest and when should you save?

Well, that depends.

It is up to the individual to decide as per their financial goals, time horizon, and risk tolerance.

As a general rule, saving should come before investing.

There are a couple of reasons behind this. The first being, the money to invest should come from your savings. It makes sense, right? Savings should be the capital that fuels your investments. The last thing you want to do is to borrow money to invest.

Secondly, in the occurrence of an emergency where you require money on an immediate basis, you shouldn’t be in a position to sell your investments to raise cash. Since markets tend to be volatile in the short term you might end up selling your investments for a loss. To quote the legendary mutual fund manager, Peter Lynch – “When you sell in desperation, you always sell cheap”.

So you should ideally have an emergency fund. Also, the emergency fund should be able to cover all of your essential expenses for at least three to six months. And no, your investment is not your emergency fund. Even then, at the time of an emergency, you might be forced to sell your investment, if you’re short on savings. To avoid being in such a position, make sure you have your emergency savings ready.

Also, make sure you pay off your debts, especially ones with high-interest rates. Even though what is a high-interest rate depends on the individual, make sure to pay off anything with an interest rate above 10%. That includes credit card debt.

Another area you should take care of before you start investing is retirement planning. Whether it’s your 401(k), or IRA, make sure you invest and max out your retirement account. Especially if your employer adds a matching contribution. As these are retirement accounts have tax advantages, you’ll likely end up with a substantial amount of money.

Once all of these are in place, you can start investing.

When should you invest?

Invest for the long term.

Any amount of money that you reckon you wouldn’t need in the short term is worth investing in. As for when you should invest, start as early as possible. Because time is an important factor when it comes to investing. If you give more time to your investments, the returns will compound and then you’ll end up with a significant amount of money.

Invest for long-term goals that you don’t have a specific time horizon in mind, or you’re flexible with the timeline. The reason is, if the market is in a downturn when you’re thinking of withdrawing your money, you should be able to delay it for a while. So you can sell out when investments return to a higher value.

When should you save?

Save for everything that is short-term.

That means if you think you’ll need the money in six months, or a year or even five years, save it. Buying a house, for instance, is a short-term goal, as you plan to do it within a year. The money you need for this should be kept in savings, as you can’t predict when the market might go down, and if that coincides with your house purchase, you might be forced to sell your investments at a loss.

Saving vs Investing

All that being said, you need to look at the downsides as well. Should you go all-in on savings? That’s a bad idea. The interest rate on savings accounts is so low, you’ll end up losing the value of the ‘saved’ money over time, due to inflation.

How about investing all of your money? Not a particularly good idea. If you invest all of your money, you’ll be running short on cash for your short-term expenses, even for essentials.

Ideally, it should be a combination of saving and investing – you save first and then you invest. The allocation of how much to invest and how much to save is totally up to you. As I said, it depends on your priorities, circumstances, financial goals, and risk tolerance.

Know that investing isn’t that hard. If you’re someone who doesn’t have time to spare, you can buy an index fund and still get the average market return. But if you put in some time and effort, you can achieve substantial returns in the long run.

For a headstart, check out our Amazon Bestseller The 8-Step Beginner’s Guide to Value Investing.

Frequently asked Questions

Is it better to invest or save?

Ultimately it is up to each individual to decide. As a rule of thumb, you should ideally save first, and invest a certain portion of your savings.

Which is more important savings or investment?

Both are equally important. Avoiding one for the other isn’t ideal. You don’t need to invest a lot of money. You can start off with as little as $10 or $50, in case you don’t have a lot of money in savings. Remember, the money you invest in is the money that works for you.

How do I start saving and investing?

The key to start is to spend less than you earn. Plan your finances, layout your living expenses, and build up your savings. Even if the contribution to the savings is small, be consistent. Open a brokerage account and start investing small amounts of money, and slowly build up your portfolio.

Growth investments; A beginner’s guide finding growth stocks

The goal of any investment strategy is simple – maximize returns. So what makes growth investing different? Well, with growth investing you’re buying stocks that can produce a significantly higher average rate of return than the overall market.

Let’s look at how it is done.

What is growth investing?

Growth investing is an investment strategy that focuses on increasing your invested money. Even though that is the objective of all investing strategies, a growth investing strategy focuses on growing your capital faster than the overall market. This strategy advocates investing in stocks that are poised to grow significantly, or have room for aggressive expansion. Generally, these are smaller companies. It would also mean investing in companies, industries, or sectors that are currently growing or expected to grow continuously over a long period of time.

A growth investing strategy is more of an ‘offensive’ investment where the objective is to generate greater returns on your investment. Whereas in a defensive strategy, you invest in dividend stocks or blue-chip stocks where the objective is to generate a passive income from your investments while protecting it from downturns.

A long time horizon is a great advantage for investors. This is especially true for growth investing. As companies tend to be smaller, they might take more time to grow and generate returns for their investors. As with any investment, the more time you stay invested, the more valuable the investment will be. And that coupled with the higher growth rate of these stocks will give you superior returns.

With growth investing, the focus is on capital appreciation. Even though that is the focus on most investments, with growth stocks that’s the only way you’ll make money, as it’s unlikely that you’ll receive dividends. This is because growth stocks are generally newer or smaller, growing companies and they might use the cash to improve their products, expand their services, or invest in R&D. This is important because many investors use the cash from dividend payouts as a passive income from their investments. With growth investing, that might not be possible.

Types of growth investments

A growth stock can be from any industry, sector, or geography. However, these are some of the most popular types of growth stocks.

 Small-cap stocks

Even though the term ‘small-cap’ is loosely defined, companies with a market cap between $300 million to $2 billion are generally considered small-cap stocks. They are relatively new companies and have a lot of room for growth. With a lot of room for growth comes room for substantial earnings growth. Whereas large-cap stocks tend to have an annual growth rate of 4 – 7%, a good small-cap stock can have an annual growth rate between 15 – 20%. Bear in mind that this can be as much as 100%, or more, depending on the company and the overall industry.

Note that most of these companies might be really small and they might not even be profitable. That makes the stocks highly volatile, and stock prices might fluctuate more frequently. It is up to each investor to decide whether or not to go with growth stocks, as the risk tolerance varies from investor to investor. But if you do proper homework, small-cap stocks can be greatly rewarding.

High growth industry stocks

Like I said, even though a growth stock can come out of any sector, these are sectors that have consistently produced growth stocks.

Technology stocks

Companies that deal with technology tend to be potential growth stocks. As the world is driven by new advancements in technology, smaller companies that come up with innovations in software, hardware, or devices could very well increase their revenue and earnings substantially, which in turn will be reflected in the stock price.

However, keep in mind that not every technology company is going to the next Google or Facebook, just like not every electric vehicle manufacturer is Tesla. Blindly going behind a company just because it has something to do with technology, is the same as you betting your money on the roll of a dice.

Healthcare stocks

Healthcare is another sector that usually has plenty of growth potential. As everyone needs to visit a hospital or get treatment at some point in their life, healthcare companies are constantly trying to come up with new medicines, medical devices, treatments that will help people take care of their health. Innovative and revolutionary drugs can change the future of these companies.

Intellectual property is one of their major assets. That includes patents, licenses, approvals, etc. It gives them a key competitive advantage over their competitors (referred to as moat) and significantly increases their earning potential. As the IP is an intangible asset, it cannot be measured in a balance sheet. So, healthcare companies usually have a higher Price-to-earnings ratio (P/E) compared to other industries.

Growth investors can also choose exchange-traded funds (ETFs) that are focused on healthcare and technology stocks. These ETFs will simplify diversification and research for growth investors.

Researching growth stocks

To start, you should know that there is no universally accepted format for the valuation of growth stocks. However, as growth is the priority here, these are some of the metrics a growth investor looks at;

Projected earnings

While investing in established companies, it’s easy to look at past performance and speculate the future performance of the company. But with growth stocks, most might not have historical earnings, as they are generally newer companies. While this might seem like a disadvantage, this presents an opportunity. Look for the company’s projected earnings growth – you can either look at analysts’ forecasts (given that analysts are covering these stocks), or you can do it yourself.

Firstly, understand the business model and its power to generate profits over the long term. Look for any key competitive advantages that set the company apart from its competitors. Make sure you see a path to profitability for the company. Once you understand their earning potential, make sure to check back on their earnings reports released quarterly.

Profit margin

Profit margin is calculated by deducting expenses from revenue (sales) and dividing by revenue. Pay attention to profit margin, because that’s an indicator of how good the management of the company is. Generally, if the company’s revenue is rising, but profit margin stays low, it is an indication that management is not doing a decent job in cutting costs and expenses.

However, with growing companies, they might need to spend a lot of money on advertising, marketing, and expanding their operations. This might have a negative impact on the earnings. Keep in mind that this effect is short-term. Once the company establishes itself in the industry, the expenses will decrease, generating greater earnings and returns for the shareholders. In such cases, it’s better to study the company’s management, their experience, and track record, as they will be key in the future of the company.

Return on Equity (ROE)

Return on equity is a measure of the profitability of a company. It is obtained by dividing net income by shareholder equity (money from investors) and expressed in percentage. It is a measure of how much profit the company generates using the money invested by shareholders.

For example, if one company has shareholder equity of $100 million while another has $400 million and both have managed to generate a net income of $50 million, then the first company has a greater return on equity, as it is generating the same net income with lesser equity.

Generally, a stable or increasing ROE tells you that the company is putting your money to good use. When using stock screeners, you should ideally look for companies with an RoE of more than 15%.

Growth and value stocks 

Growth investing and value investing are generally portrayed as diametrically opposed approaches. This is misleading. Both growth and value investing aim to bring value to investors. While value investing is defined as buying stocks that are undervalued i.e trading under their intrinsic value, most of the time growth stocks are undervalued. The reason is, growth stocks tend to be smaller companies and the media and analysts tend to overlook these stocks, which results in the stocks being undervalued. So the value investing principle of buying undervalued stocks is followed in growth investing.

Similarly, it is important to keep value principles while investing in growth companies. Because both investing strategies aim to do one thing and one thing only – maximize value for investors. So growth investors should try to buy stocks at a lower price to enjoy the maximum return. This investment strategy that aims to buy growth companies using traditional value investing indicators is known as Growth at a reasonable price (GARP).

Conclusion

Incorporating growth investing into your investment strategies can be extremely rewarding. Make sure that the different aspects of growth investing including high volatility aligns with your investment goals. With any investment make sure that you do your due diligence before you invest. Study the company and the industry, look for competitive advantages that set the company apart from its competitors, and always look at the long term. Remember, with growth companies, we buy stocks we are content holding for at least the next 5 years.

When done right, growth investing can give superior returns over the broader market.

Wondering where to start? Check out our top 3 growth stocks for 2021.

Investing terms: Important terms every investor must know

Investing can seem intimidating, especially when you’re just starting out. Well, you’re not alone. We have made a list of investing terms for you, as you embark on your investment journey. Here is an introduction to the world of investing and the important investing terms.

General investing terms

Investing: Investing is the act of committing capital to an asset, expecting a profit. The profit could either be through capital appreciation; the increase in value of the asset with time, or it can be through active income from the asset; dividends (stocks), rental income (real estate), etc. In the stock market, investing is generally considered as buying and holding stocks over a period of time, at least 5 years.

Stock: An asset class that represents the partial ownership of a company. When you own a stock, you are owning a portion of the company. It is also known as equity. In investing, the stock is used synonymously with the underlying company. However, it is important to look into the underlying company, which will determine everything about the stock in the long run. For example, Amazon is the company, and the Amazon stock you own represents your ownership in the company.

Share: It is a portion of an asset or security like a stock. When you are buying a stock, you are buying a specific number of shares of the stock, it could be one, a hundred, a thousand, or whatever you want. Let’s take Amazon as an example; you can buy one or a hundred shares of Amazon stock (AMZN).

Ticker: A ticker symbol is an abbreviation used to identify publicly listed stocks on a stock exchange. Remember AMZN? That’s the ticker symbol for Amazon stock.

Portfolio: A portfolio is a collection of investments like stocks, bonds, funds, etc. Every asset you have currently invested in is a part of your portfolio, the investments constitute your portfolio.

Stock exchange: It is the place where stocks are bought and sold. Stock exchanges are institutions that host a marketplace for both buyers and sellers to come together to trade shares with one another. The transactions can only take place during business hours. Each country has its own stock exchange. The largest stock exchange, in terms of the value of companies listed, is the NYSE (New York Stock Exchange). A company must meet a certain set of requirements to be listed on a stock exchange.

Liquidity: The liquidity of an asset is the ease with which it can be converted into readily available cash. The most liquid asset is cash itself, as it can be exchanged for cash or any asset easily. Stocks on major exchanges are generally liquid in nature, so you can buy and sell them, at your time and price. You can also cash it, whenever you want. An example of an illiquid asset is a house, as you cannot easily convert it into cash. You would need to find a buyer who is ready to buy the house at your price, and the whole transaction could take a while to complete.

Market index: It is a hypothetical portfolio of stocks, that represents a section of the stock market. If you’ve heard people talking about how the ‘market’ is performing, they are talking about the index. Because often people see indexes as a representation of the stock market as a whole. The index tracks the prices of a set of stocks. The stocks might be selected based on their market cap, industry, or revenue. S&P 500 is the most followed index in the world. It tracks the largest 500 companies in the US, by market capitalization. The Dow Jones industrial average (DJIA) is another popular index in the US.

Bull market: A bull market is a market that is moving upward, that is rising in value. When someone says they are ‘bullish’ about a stock, it means they expect the stock price to rise.

Bear market: A bear market is a market that is declining 20% or greater. But investors generally use the term to describe a market that is declining in value. Also, when someone says they are ‘bearish’ about a particular stock, it means they think the stock will go down. A bear market generally occurs every six years or so.

Initial public offering (IPO): You might have heard of a company going public. That’s an IPO. It is when the shares of a company are made available for the public to buy for the first time. Once a private company becomes a publicly listed company through IPO, the shares will be available in the public market for investors to trade.

Capital gains: There are two ways by which investors hope to make a profit out of their investments. Capital gain is one of them. Also known as capital appreciation, it is the rise in the value of an asset (stocks) over a period of time. This allows investors to sell the stocks for a price that is higher than the price they bought the stocks for.

Dividend: This is the second way through which investors make a profit out of their investments. Dividends are cash payouts by companies at specific intervals, quarterly or annually (mostly quarterly). This is a way for companies to show their appreciation towards their shareholders (anyone who holds at least a stock share of the company). Shareholders will be paid a certain amount for each share they own. Dividends are an important part of investing as it provides an active income from your investments; you’re being paid just for holding the stocks. It is important to note that not all companies pay a dividend, particularly, younger and fast-growing companies.

Trading: Trading is the process of buying and selling stocks. Mostly, it is used synonymously with day trading. Day trading is the process of buying and selling stocks within a day. Day traders buy huge quantities of shares and hope to sell them within the day for a higher price than they bought them for, and pocket the difference. Day trading is a high-risk option, mainly due to the limited time frame, as they must sell the shares by the end of market hours.

Volatility: It is the degree to which the market fluctuates up and down. When someone says the market is moving up and down, they’re most likely referring to the rise and fall of the market index. The increase and decrease in stock prices are what cause these fluctuations. A volatile market will see constant fluctuations, as the stock prices will move up and down. The more frequent the fluctuations, the more volatile the market. It is to be noted that volatility is a short-term element and in the long term, the market tends to rise in value.

Stockbrokers: A stockbroker is an individual that buys and sells stocks on your behalf. They act as an intermediary between you and the buyer or seller. They often charge a commission for their services.

Full-service brokerages: Full-service brokerages are institutions that act as an intermediary between buyers and sellers and facilitate the transactions of stocks. They also provide services such as financial planning and money management. They often charge comparatively high fees.

Discount brokerages: These are generally online trading platforms that facilitate the buying and selling of shares. Unlike traditional brokerages, they only charge a small amount as commission. Some discount brokers provide zero-commission trades which means you don’t need to pay anything to buy or sell shares. Popular discount brokers include TD Ameritrade, Charles Schwab, E-Trade, etc.

Brokerage Account: You need a brokerage account to buy and sell stocks, bonds, funds, etc. It works similarly to a bank account. This is an account you open either with a full-service brokerage or a discount brokerage. This account will hold all your current investments. On opening a brokerage account, you can electronically transfer funds to the brokerage account, and use the fund to buy stocks. On placing orders to buy stocks, the brokerage will execute the order on your behalf, and deliver the stocks to your account.

Rate of return: It is the net gain or loss of an investment over a period of time that is expressed as a percentage of the initial investment. In other words, it is a measure of the profit or loss you have made relative to the money you invested. If you bought a stock at $50 a share and held it for a year, and the price rises to $80 in that time, you would have made a profit of $30 a share. If you divide the profit, by the initial investment, and multiply by 100 you get the rate of return of your investment. In this case that would be 30/50 multiplied by 100, which is 60. Hence for an investment of $50, you had a rate of return of 60% in a year.

Intrinsic value: Intrinsic value is a measure of how much an asset is worth. Intrinsic value takes into account tangible and intangible factors of the assets, to determine a value that accurately reflects its worth. In the case of stocks, investors study the fundamentals of the company; financial statements, corporate performance, management, industry, etc. to determine its intrinsic value. More often, it is different from its market value, as market value is more about how the stock market perceives the stock, which might take into account factors such as supply and demand from investors.

Ways of investing; terms you should know

Apart from individual stocks, you have plenty of ways you can invest in the stock market. From a low-cost index fund to a financial derivative, here’s everything you need to know.

ETFs: Exchange-traded funds (ETFs) are funds that track a market index, sector, commodity, or asset. But you can buy a share of an ETF, just like you buy a stock. Let’s say you want to invest in marijuana companies because you know they will make a lot of money. But you don’t know which marijuana company to buy nor have the time to research and study marijuana companies. So you can buy an ETF that holds shares of marijuana companies. Now, instead of one company, you have invested in several different marijuana companies.

Index fund: An Index fund is how you buy an index. Similar to ETFs, they track a particular index and attempt to mirror the performance of the underlying index (the index that it tracks), by buying shares of all the stocks in an index. Index funds are passively managed, which means there are no fund managers actively changing the holdings according to market conditions. Instead, the fund merely adopts the changes in the underlying index.

Mutual fund: Mutual fund is a fund that pools money from individual investors and invests in different assets like stocks, bonds, commodities, etc. A mutual fund is managed by finance professionals (generally referred to as Fund managers or Portfolio managers), who actively make changes in the investments in order to ‘beat’ the market. However, mutual funds tend to underperform the market in the long run. A 2018 report from S&P Dow Jones Indices suggests that more than 92 percent of active mutual fund managers in large companies were unable to beat the market over a 15-year period.

Hedge fund: Hedge funds pool money from rich investors. I say rich because there is a minimum investment amount, that is comparatively higher. Hedge funds use the pooled money to engage in a wide range of investment activities. They often use borrowed money to amplify their returns. Besides, the fund managers charge huge amounts of money in management fees. Due to the risky nature of hedge funds, the government has put in a number of regulations, which makes it hard for a regular investor to invest in hedge funds.

Expense ratio: It is a measure of how much of a fund’s assets will be used for administrative and operating expenses. Basically, it is the percentage of your money you need to pay when you choose to invest in a fund. For example, if you invest $10,000 in a fund with an expense ratio of 0.5%, you would need to pay $50 annually for the associated expenses. Generally, index funds and ETFs have a lower expense ratio compared to mutual funds, as index funds are passively managed. Remember, the higher the expense ratio, the less the returns.

Bonds: A bond is similar to a loan. When you invest in a bond, you’re lending money to the government or a company, with a promise that you’ll be returned the principal amount along with interest. The time period for which you’re lending money is the maturity date, on which the bond is matured and the borrower should give you back the money with interest. There are different types of bonds including Treasury bonds issued by the government and bonds issued by companies, known as corporate bonds. Bonds are generally considered to be a ‘safe’ investment as it promises a fixed rate of return.

Commodities: A commodity is a raw material that can be bought and sold. Commodities are generally categorized into two; hard and soft. Hard commodities are those which are mined or extracted; gold, oil, rubber, etc. Soft commodities are agricultural products such as coffee, wheat, sugar, etc. Investing in commodities can be done either through buying shares of companies that are directly involved in the commodities or by investing in commodity futures contracts.

Derivatives: A derivative is a financial security that derives its value from an underlying asset. The underlying asset could be stocks, bonds, commodities, etc. Derivatives are generally used to mitigate risk. Derivatives derive their price from fluctuations in the underlying asset. Consider an oil company that agrees to buy 100 barrels of oil at $50 a barrel from a supplier. Here the oil, a commodity, is the underlying asset and the futures contract between the oil company and the supplier is the derivative.

Asset management company (AMC): It is an institution that invests capital on behalf of its clients. They generally manage everything from high-net-worth individual portfolios to hedge funds and pension funds. They often create mutual funds and ETFs to cater to individual investors. Some famous asset management companies in the US include Vanguard Group and Fidelity Investments. AMCs charge their client a percentage of the assets the company manages for the client – assets under management (AUM).

Alternative assets: These are assets that do not come under the traditional asset classes like stocks, bonds, or commodities. It could be collectibles, antiques, rare stamps, or coins. These assets are traded infrequently and hence are illiquid. However, cryptocurrencies are another alternative asset that has high liquidity. These are digital currencies that can be used to make purchases. Bitcoin, the most popular cryptocurrency, is currently traded at $60,792.00 per coin.

Risk Management: It is the process of understanding, analyzing, and mitigating potential risks to your investment portfolio. As every investment involves a certain amount of risk, investors perform risk management to reduce risk as per their level of tolerance. Generally, investors do this by diversifying their assets, choosing stocks that are less volatile (blue-chip stocks), etc.

Asset allocation: It is the process of allocating your assets according to your risk tolerance (a measure of how much risk you can take on), investment goals, and time horizon (how long do you plan to stay invested). This is done to balance risk and reward by focusing on the overall portfolio. Diversifying assets across different asset classes, different geographies, companies of different scales (smallcap, mid-cap, and large-cap) is a method that is commonly used in asset allocation.

Financial advisor: A financial advisor is a professional who provides financial advisory services to their clients for compensation. Their services generally include financial planning, investment management, and tax planning. After understanding the client’s financial situation and goals, a financial advisor devises an investment strategy for their client that is tailored to their investment goals and horizon. Basically, they tell their clients what, when, and where to invest.

Investment terminology; companies

These are investment terms that are associated with a company and its business. Having a basic understanding of these terms will help you in finding the best company (stock) to invest in.

Outstanding shares: These are stock shares of a company that is currently held by all shareholders, including shares held by institutional investors and company insiders. Outstanding shares are used to calculate the market value of a company referred to as market capitalization.

Market capitalization: Commonly referred to as a market cap, it is a measure of how valuable a company is, according to the stock market. Market cap is the price of one share multiplied by the number of outstanding shares. Consider a company whose stock price is $100 per share, and it has 10 million shares outstanding, which means the company has a market cap of $1 billion. As per the market cap, companies are categorized into small-cap ($300 million to $2 billion), mid-cap ($2 billion to $20 billion), and large-cap ($20 billion to $200 billion), mega-cap ($200 billion or more)

Enterprise value: While market cap is the value of a company as seen by the stock market, enterprise value is the total value of all assets and liabilities of the company. It is basically what you need to pay if you wanted to buy the company in whole and have 100% ownership. Apart from the market cap, it also takes preferred stock (a special class of stock that offers benefits such as larger dividends), debt, and cash reserves into the account. To calculate the enterprise value, add a market cap, preferred stock, and outstanding debt together and subtract cash and cash equivalents found on the balance sheet. You subtract the cash because once you acquire the company, the cash is yours.

P/E ratio: Price-to-earnings (P/E) ratio is the ratio of the company’s share price to its earnings per share (EPS). Earnings per share is the total profit of a company (earnings) divided by the number of shares outstanding. If a stock trades at $50 per share, and its EPS is $5, then its P/E ratio is 10.

P/B ratio: Price-to-book (P/B) ratio is the ratio of a company’s share price to its book value – which is the total value of all assets of the company. Typically, a ratio less than one is ideal. However, many newer companies (especially software/technology companies) have a higher P/B ratio, as more of their value derives from intangible assets which cannot be quantified on their balance sheet. Because if the stock price is lower than the book value of the company, the stock might be undervalued.

Free cash flow: Free cash flow is the cash left after paying for all the expenses including operating expenses and capital expenditures – which are used to purchase, maintain, or upgrade physical assets. If a company is generating free cash flow, it means the company has plenty of cash to invest in future business, pay off debts, or pay dividends to shareholders.

EBITDA: EBITDA stands for earnings before interest, taxes, depreciation, and amortization. It is a measure of the overall profitability of a company and often used as an alternative for net income. EBITDA can be calculated by adding net income, interests, taxes together with depreciation and amortization expenses.

Dividend yield: Dividend yield is a measure of how much a company pays its shareholders in dividends each year, relative to its stock price. If a company’s stock trades at $100, and they pay a dividend of $5 per share, then the dividend yield would be 5%. It is important to note that a higher dividend yield is not always ideal, as it might be a result of a decline in the stock price. While looking at dividend yield, you should ideally check whether the company has consistently paid dividends in the past.

EV/EBITDA: EV/EBITDA ratio is enterprise value (EV) divided by earnings before interests, taxes, depreciation, and amortization (EBITDA). It is also known as EV multiple. The ratio is used to compare the value of a company including money it owes, to its earnings less non-cash expenses.

Income statement: An income statement is a financial statement that shows you the financial performance of a company over a period of time – a quarter or a year. It is one of the three most commonly used financial statements (the other two being balance sheet and cash flow statement) that conveys the financial position of the company. The income statement shows you how profitable the company was during the reporting period. It shows the revenue, expenses, and profit of the company during the period.

Balance sheet: A balance sheet is a financial statement that basically shows what the company owns and owes, along with the amount invested by shareholders. The balance sheet reports the company’s assets, liabilities, and shareholders’ equities at a given point in time. Investors look at balance sheets to derive various financial ratios to understand the financial position of the company.

Cash flow statement: A cash flow statement is a financial statement that reports the movement of cash into and out of the company during a given period of time. It gives you an idea, of where the money comes from and how it is being used. Free cash flow in the cash flow statement, is a measure you can use to determine the profitability of a company. Because the more free cash the company has left, that can be used to expand the business, or return to shareholders, after paying dividends and paying off debt.

Form 10-K: It is a detailed report published annually by every public company. The Securities and Exchange Commission (SEC) requires every publicly listed company to publicly disclose all the information that surrounds the company, including the recent financial performance and the risks faced by the business. It is much more detailed than an annual report, which is a report that is sent to all the shareholders before the annual meeting. You can find all the information about the company in a Form 10-K; from how the company makes and spends money to the risks they currently face, everything you need to know about the company can be found in Form 10-K.

Fundamental analysis: Fundamental analysis is the process of studying business fundamentals and financial statements to determine the intrinsic value or ‘fair market value’ of a company. This is done to understand whether the stock is undervalued or overpriced. Investors and analysts look at the financial position of the company and other business fundamentals like overall industry, competitive advantage, management of the company, business model, etc. for fundamental analysis.

Brokerage terminology: buying a stock

These are investment terms you should know before you buy your first stock. It starts with the type of order you should choose when you buy a stock. Generally, there are two options; market and limit order.

Market order: A market order is selected when you want to get the stock as soon as possible for the current price. Market order puts no parameters on the share price, so the order will be fulfilled immediately. Since price fluctuations happen all the time, there might be a slight difference between the price you saw when you selected the stocks, and the price you paid. This price difference is negligible for an investor who plans to buy and hold these stocks for a long time. Investors generally use market orders as their priority is the completion of the trade.

Limit order: Limit order focuses on the price at which the trade should be executed. You have more control over the price with this order. Let’s say the stock Brookfield Asset Management (BAM) is trading at $50 per share. But you want to buy the shares at $48. With a limit order, you can set the price at $48, and the order will only be completed, once the price drops to $48 from $50. If you’re selling, you can set the price above the current price, say $52, and the trade will only complete once the price climbs to $52. Limit orders are mainly used by day traders, for whom even the slight fluctuations in the share price matter a lot.

Stop order: This is an order to buy or sell a stock, where you can specify a price, and on reaching the price, the trade will be executed at the next available price. The price you specify is referred to as the ‘stop price’. Consider Dell (DELL) trading at $100. If you think DELL is going to go up, but you want to buy it only, if and when it crosses $105, you can set the stop price to $105. Once it crosses $105, the order will be executed as a market order, which means the order will be fulfilled immediately at the available price. If you’re selling a stock, the same can be done, only you’ll set a price lower than the last traded price, and on crossing the price, the stock will be sold immediately. This is often used by investors to mitigate loss, hence it is referred to as a stop-loss order.

Trailing stop order: Similar to a stop-loss order, this type of order can be used to buy or sell a stock, the difference is the stop price moves when the stock price moves in your favor, and it stays at the stop price when the stock price moves against you. To explain this better, imagine you’re selling Dell (DELL) trading at $100, and you set trailing stop at $99. If the stock price goes up to 101, the trailing stop would move to $100. However, if the stock price lowers to $100.50, the trailing stop won’t move. If the price drops again to $100, the order will be converted to a market order and fulfilled immediately. A trailing stop order is mainly used by day traders as it helps them to lock in the profits while protecting them from any losses.

Bid and ask: Every time you want to buy or sell a stock, you can find the bid and ask the price for that particular stock. The bid price is the maximum amount a buyer is willing to pay for the stock share. The ask price is the lowest price at which a seller is willing to sell the stock share.

Margin: Margin refers to the amount of money you borrow from your brokerage firm to buy an asset. It is similar to availing a bank loan, only here, your investment portfolio will be the collateral, and your brokerage is the lender. Just like a bank loan, you’ll need to pay interest for the borrowed money. Leverage incurred from margin can amplify your losses and could lead to the brokerage acquiring your portfolio, without prior notification.

Retirement investing

Here you have terms that are related to investing for retirement.

Traditional IRA: It is a traditional Individual retirement account where you can save money for retirement. Anyone over the age of 18 with a job can open a retirement account, however, some retirement accounts have specific requirements. IRA offers tax advantages, and traditional IRAs are tax-deductible. That means the contributions you make to these accounts won’t be considered as your taxable income. If you earn $100,000 a year and contribute $20,000 to your IRA, you’ll only be taxed for $80,000. With a traditional IRA, you’ll only be taxed when you start withdrawing money from your IRA account.

401(k): This is a common retirement account offered by many employers to their employees. Similar to traditional IRA, contributions to 401(k) are also tax-deductible. Also, it allows you to invest money in stocks or mutual funds. Employers often match contributions, with up to 50%. The money is only taxed when you start withdrawing it, which you can only access when you are 59.5 years old.

Roth IRA: Roth IRA is a type of retirement account that offers some great tax benefits. Unlike traditional retirement accounts, you need not pay taxes on the money you withdraw from the Roth IRA. Also, the profit you make from the investments held within the Roth IRA, is tax-free, even when you withdraw those profits. You can invest in stocks, bonds, and other securities within the Roth IRA. Note that the contributions you make to the IRA are post-tax, which means you are already paying taxes for that money.

Conclusion

You’re right. Investing can be quite complicated at times. But we’ve got you. Understand all these terms, and you’re off to a great start. Even if you don’t understand everything in the beginning, it’s fine. Start small, buy your first stock, learn a little every day, and you’ll be good.

If you’re still not sure, whether or not should you start, it might be because you’re missing an investment strategy. Maybe you should try value investing. It is an approach where you buy stocks that are currently trading for less than their intrinsic value. Legendary investors like Warren Buffett used the value investing strategy that made him one of the richest men in the world. Learn more about value investing with our Amazon Bestseller The 8-Step Beginner’s Guide to Value Investing. 

Is investing gambling? Understanding the difference

To answer the question, ‘Is investing the same as gambling?’ First, we should look at what exactly is investing and gambling.

Gambling and investing

Investing is the act of committing capital to certain assets, expecting to make a profit. Let’s take the stock market for example; you put money in stocks and hold those stocks for years, and sell them later for a higher price than you bought the stocks for. Capital appreciation and active income (dividends and interests) are two ways by which you can make a profit out of your investments.

Gambling is staking money on an event whose outcome is uncertain and mostly involves chance. Gamblers hope to make money by betting on the ‘most likely’ outcome, even though generally it is a random chance. A flip of a card, a roll of a dice, the outcome of a sports game are some of the most common gambling events.

Investing vs gambling; similarities 

Now, that you know what each of these is, let’s look at some common characteristics both have.

Investing and gambling are, essentially, you risking your money for future profit. And both investing and gambling have risks associated with them. However, the risks are quite lower in investing when compared to the risk associated with gambling. Also, whether you want to invest or gamble, you have plenty of options to choose from; different asset classes (stocks, bonds, funds) in investing and different betting events in gambling (casino games, horse races, sports games).

Generally, both involve a certain amount of fees to be paid regardless of whether or not you make a profit; ‘points’ in gambling which is charged by the body/organization that hosts the bets, and ‘commissions’ charged by the brokerages when you buy or sell shares. Another characteristic that both investors and gamblers share is information, particularly information on the outcome of the investment/gamble.

As an investor, you want to know the past performance of stocks, financials, and fundamentals of the company. Gamblers, on the other hand, look for information regarding the most frequent outcome of the event. If it is a football game, gamblers learn more about the teams; their past performance, the line ups, etc. It’s easy for investors to find information on stocks, but gamblers, usually have a hard time finding information about the likely outcome of the gambling event, which often leads them to fully rely on chance.

Investing vs gambling; differences

Even though gambling and investing share some similarities, there exist a lot of differences between these two.

Research vs luck

Investing is a planned activity performed with a specific goal in mind. A lot of research goes into investing. The past and estimated future performance of the stock, risk tolerance, financial goals are taken into account while investing. Investors analyze the fundamentals of the underlying company before investing in the stock; financials and business fundamentals are studied closely to make sure the stock is suitable for the investment strategy. The strategy is prepared with a specific goal and time period in mind – saving up for retirement, increasing long-term wealth, children’s education, etc.

Gambling, however, mostly involves chance and speculation. Gamblers are staking money on an uncertain outcome. Gamblers have no way of predicting the outcome of the random event on which they have staked their money, and it mostly depends on luck. Consider the rolling of a dice. In the case of an unbiased die, all six outcomes have equal probabilities, and the gambler could win or lose money based on the outcome.

The risk factor

Investing involves risks – nobody can deny that. However, there are a lot of ways you can mitigate risk in investing. You can have a diversified portfolio, dividing the risk into different asset classes and industries. Moreover, even if you lose money in investing, you can always get it back- either by using a different investment option or just by waiting for the stock to go up. And you can always take out your money and put it elsewhere, even with a small loss. In investing, it’s highly unlikely that anybody will lose all of their money, only partial losses. Even the partial loss occurs only when you sell stock. So if you can hold on to those stocks, you might get a chance to sell them for a profit later.

However, in gambling, there is no way to mitigate risk – and the risk is exponential. Because gambling follows an all-in strategy; when you bet on something, you either win and get rewarded or lose all of your money. And there is no way to get that money back. If you bet on a certain horse at a horse race, and the horse does not win the race, it does not matter if the horse got the second position, you’ll lose all your wager. If you plan to get back the money you lost by playing again, you still have the same chance, and moreover, now you could lose additional money. In gambling, the probability of losing money is higher than the probability of earning a profit.

Investing vs gambling; Long term vs short time

This is a major difference between gambling and investing; one is short-term and the other is long-term. Investing is usually done in years or decades even. Because the basic principle behind investing is the more time you allow your investments to grow, the more valuable they will be. Gambling, on the other hand, is a short-lived activity – a couple of minutes, few hours, or even some days.

Due to the lesser time available with gambling, you seemingly have no way to claim your money if you see that you are losing the bet –  the bet is over once the game or hand is over. Within this short period of time, you either lose all your money, or you win some. Also, in gambling ‘the house’ always has an edge – a mathematical advantage over the gambler that increases the longer the gambler plays. Whereas, in investing the stock market tends to appreciate in the long term. Between March 1980 and March 2021, the S&P 500 had a total return of 10344.471% (dividends reinvested), an average annual return of 12%. This means, if you had invested $1000 in 1980, you’d have $104,218 by 2021. So if you keep at it, the odds will be in your favor as an investor, and not in your favor as a gambler.

With investing, you’ll also be rewarded for the time you commit the capital to a particular stock, which means, you’ll be paid just for holding the stock. And that brings us to the next distinction.

Ownership; nothing vs something

When you gamble, you own nothing. You merely stake money on a random outcome of an event.

When you invest in a stock, you own a share of the underlying company, which means you are a shareholder in the company. Most companies reward their shareholders for the risk they take by committing the capital, in the form of dividends. These are cash payouts paid to the shareholders in specific intervals for each share the investor owns. That way, you’ll have active income just from owning those stocks.

Instant gratification

In gambling, there is always instant gratification or instant disappointment, depending on the outcome – you win, or you lose. So that leaves you no room for error.

With investing, there is no instant gratification. You’re in it for the long term. On the bright side, that gives you plenty of time to improvise if something goes wrong. Say, in one of the stocks you own, the underlying company is on the verge of bankruptcy, you can still get out and put that money elsewhere.

Addiction vs the healthy way

Gambling can be addictive; the notion of doubling or tripling your money is certainly attractive. That might even happen once or twice, which will persuade you to stake all of your money on the next bet – because we are human beings, and it can be difficult to resist those temptations. Most likely, you’ll lose that bet, thereby all of your money. Some gamblers would be adamant to win their money back, so they’ll keep playing, till they get their money back. But most end up without a penny.

Investing is a proven and healthy way to build wealth in the long run, as the stock market tends to appreciate over time.

Why shouldn’t you gamble?

For all the reasons above, you shouldn’t gamble with your money. There is a high chance that you’ll lose all of your money then make a profit. You might win some in the short term, but you’ll lose in the long run.

Is investing a form of gambling?

The answer is no.

Just because returns are uncertain with investing, that does not make it gambling. Investing gives you ownership of an asset with the potential for capital appreciation (increase in value of the asset over time). You might even be rewarded while you wait, in the form of dividends or interests. Whereas gambling is staking money on the outcome of an event – which is uncertain, highly risky, and you won’t own anything.

That being said, there are investors who gamble with their investments. Some of them buy and sell huge quantities of shares in a single day (referred to as trading), and some bet on stocks to go down (shorting). These are high-risk options and not sustainable in the long run. Also, there are investors who just buy ‘hot’ stocks, without understanding what they are getting into – which is simply gambling, but with stocks instead of horses or cards.

So if you want to start investing, make sure you start off on the right foot. Read how you can start buying stocks and what you should keep in mind.

Why should you invest?

Investing in the stock market is an efficient way to beat inflation. Inflation is the decline of purchasing power of a given currency over time. It can also be seen as the increase in the price of goods and services for daily consumption. To put it into perspective, say you add $10,000 into savings every year. In 5 years you’ll have $50,000, but that’ll only be worth 47,500, assuming the inflation rate is 5% a year.

However, if you invest $10,000 in an index fund with an average annual return of 10%, in 5 years, you’ll have $58,370, which will be worth $55,870, assuming that you’ll invest $10,000 in the four consecutive years and the inflation rate is 5% a year. Not only did you beat inflation, but you also managed to level up your personal finance game.

Investing is also a proven way to build long-term wealth. If you had invested $10,000 in the S&P 500 index in 1980, the investment would be nominally worth approximately $978,858.45 in 2021. This is a return on investment of 9,688.58%. Legendary investors like Warren Buffett build their wealth from stocks, using an investment strategy known as value investing. It is an investment strategy where investors look for stocks that currently trade for less than their intrinsic value.

Frequently asked Questions

Is the stock market basically gambling?

No. On the contrary, investing in the stock market is a proven way to build long-term wealth.

Is stock trading a form of gambling?

Day trading is buying and selling shares on the same day. Due to the high-risk nature of trading and the potential to lose a lot of money, it is often compared with gambling. Like gambling, day trading is not sustainable in the long run.

If you would like to learn more about value investing, try our Amazon bestseller The 8-Step Beginner’s Guide to Value Investing

First-time stock buyer? Here’s everything you need to know

Welcome to the stock market!

Awesome! You’ve chosen to invest in stocks. Let me show you how you can buy your first stock(s), to start investing. And no, this is not as difficult as you think. In fact, today, it is much easier for first-time buyers.

Now, you can even start investing from your phones!

Also, let me take you through some stock market basics you need to know before and during your stock buying process.

Once again, welcome to the world of investing!

Decide what kind of an investor you are

Let’s start with the duration for which you’ll be keeping the stocks.

Do you plan to buy and sell stocks on the same day? Or would you be willing to hold them for a long time, say more than 5 years? The former, where you buy and sell stocks the same day, is referred to as trading. And, the latter, where you buy stocks and hold them for more than 5 years or so, is referred to as investing. The big players in the game like Warren Buffett, are investors.

Trading focuses on short-term profits. In simple terms, trading is like gambling in a casino. Sure, you might win some money once in a while. But ultimately, in the long run, you’ll lose, and the casino will win. If you’ve ever heard of people losing money in the stock market, that’s usually the traders. Investing, on the other hand, does not focus on short-term gains. It is a way to build your wealth consistently for the long term. Markets tend to have ups and downs in the short term, but in the long run, they consistently rise in value.

For example, between 1990 and 2020, the S&P 500 (a stock market index that tracks the 500 largest companies in the United States) produced a total return of 2,007.31% or 10.33% per year. That means to say if you had invested $100 in the S&P 500 at the beginning of 1990, you would have about $2,107.31 at the beginning of 2020. That’s how investors like Warren Buffet built their wealth over the years, making him one of the richest men in the world.

Another factor to consider is how much time you will spend on your investments after buying stocks. You have the choice to be actively investing – choosing individual stocks, regularly optimizing your portfolio, keeping up with the market, and researching new investments. However, if you can’t spare time for this, you have the option to invest passively – that would be index funds and exchange-traded funds (ETFs). With these passive investments, you can invest your money into any one of these, and forget about it. There is also the option to choose a Robo advisor, wherein an automated system chooses the stocks and invests for you.

Once you decide the duration of investment and your involvement in the process, let’s move on to opening a brokerage account.

Open a brokerage account

To buy stocks, you need a brokerage account. The easiest way is to open a brokerage account online. Most of the major brokerages allow you to open zero-commission accounts, which means there is no commission to buy or sell stocks. Most popular brokerages in the US include Fidelity, TD Ameritrade, Charles Schwab, and Robinhood.

Gone are the days, when opening an account was a real struggle. You had to be present in person at the brokerage office to start an account. Fast forward to today, opening a brokerage account online is as easy as opening a bank account. You fill out the application, provide identification, and transfer funds electronically to your brokerage account – all of this can be done online, even on your phone. Read our detailed guide on How to Open a brokerage account.

Even though most brokerages have adopted a zero-commission policy, be sure to go through the various fees involved. There might be an account maintenance fee and intraday charges, also make sure there are no hidden fees.

Once that is done, let’s pick some stocks for you.

Research Stocks

A good rule of thumb is to buy shares of companies whose products you’ve used, or quite familiar with. As Warren Buffett says “Buy into a company because you want to own it, not because you want the stock to go up”. However, that shouldn’t be the only criteria to select stocks. A good way to start would be reading the annual reports of the company you would like to own. You can find that in the ‘Investor Relations’ of the company website.

These are the types of stocks you can start investing in.

Blue-Chip Stocks

These are companies that have been in the market for a long time and are less prone to market volatility compared to newer companies. These are generally large-cap companies with billions of dollars in revenue each year. It’s highly unlikely that they will be majorly affected by any negative news, hence a less risky option. Walmart (WMT) is an example of a blue-chip stock. With a market cap of $368 billion, they are the biggest company in the world by revenue. It is a good choice for a first stock.

Value Stocks

Value investors focus on understanding a stock’s value by analyzing the fundamentals of a company. The idea is if you can read the fundamentals of the company and understand its financial situation, you can find undervalued stocks that will give you consistent returns in the long run. Value investing is followed by top investors including Warren Buffett and Bill Ackman.

Wells Fargo (WFC) and DermTech (DMTK) are examples of value stocks.

Dividend Stocks

Generally, investors make money in the stock market by selling shares more than they bought them for. The idea is the longer you hold on to your stocks, the more valuable they will be (this is referred to as capital gains). Another way to make money from the stock market is to buy stocks that pay a dividend. These dividend stocks pay small cash payouts to the investors in specific intervals (mostly quarterly) for every share the investor owns. If you are looking to generate active income from your investments, dividends are the way to go. Coca-Cola (KO) and Walmart (WMT) are examples of dividend stocks.

Growth Stocks

With large companies like Walmart, it’s unlikely to see a high growth rate, and while the gains from the stock might be consistent, but it won’t be huge. That’s because they’re already a large business. Hence, there is very little room for high percentage growth. However, smaller companies have a lot to grow. Growth stocks are more volatile than stocks of larger companies, but it often rewards with their high growth, and thus exponential capital gains. While this might not be ideal for a first-time buyer, it can be added to your portfolio, once you get more familiar with stocks.

Decide the number of shares you want to buy

Now that we have the stocks to buy, the next question is, how many shares should you buy?

While there is no minimum number of shares you should buy, and no maximum either, it’s better to start small. Buy a single share of a company just to understand how it feels to own individual stocks. Some brokerages even offer the option of buying fractional shares, so instead of buying a full share of the company, buy fractional shares of several companies. This also allows you to get your hands on rather expensive stocks, like Amazon (AMZN) which currently trades at $2,977. This is also quite useful if you have limited capital or just want to start really small. You can add more stocks to your portfolio over time, as you’ll be constantly learning new things.

Many brokerages including Charles Schwab and Robinhood offer the option to buy fractional shares.

Understand orders

You’re all set to buy your first share. You’ve figured out the stock to buy, and you now know how many shares to buy. Let’s see how you can start buying.

When you select the stocks you want to invest in, you’ll see that you have two options regarding the type of order you can make. Namely, a market order and a limit order. Let’s briefly go over both of these order types.

Market Order

With a market order, you are looking to buy the share as soon as possible, for the available current price. Since the order puts no parameters on the share price, the order will be fulfilled immediately. You might note, sometimes the price you bought the share for isn’t the same as when you made the order. This is because price fluctuations happen all the time. This price difference is negligible for the long-term investor, who plans to buy and hold these stocks for a long time, and hence the priority is to completion of the trade.

Limit Order

Limit order focuses on the price at which the trade should be executed. You have more control over the price with this order. Let’s say the stock Brookfield Asset Management (BAM) is trading at $50 per share. But you want to buy the shares at $48. With a limit order, you can set the price at $48, and the order will only be completed, once the price drops to $48 from $50. If you’re selling, you can set the price above the current price, say $52, and the trade will only complete once the price climbs to $52. Limit orders are mainly used by day traders, for whom even the slight fluctuations in the share price matter a lot.

Since you are buying a share or two, or a few, you can go with a market order.

Optimize your portfolio

Well done! You’re now officially an investor.

That was easy, wasn’t it? As you move ahead in your investment journey, things won’t always be the same. There will be good times when the stocks you own will skyrocket, and there will also be times when you see your stocks losing their value. Understand that every investor, at least once in their lifetime has gone through bad times. The key is to holding on to your investments and looking at the bigger picture, that is the long-term gains. Know that market fluctuations are not something that you can control. That doesn’t mean that you can’t do anything about it.

The first step to get through a bear market (generally used to indicate the market’s downward trend) is to diversify your portfolio. That will act as a protection during times of crisis. Diversifying your investments is investing your money in different asset classes (stocks and bonds), or across different industries (information technology, consumer products, automobile, etc.). As it is highly unlikely that all the markets will go down at the same time, your losses in some stocks will be balanced by gains from other stocks.

Make sure you have an investment strategy based on your risk tolerance (a measure of the risk you can tolerate), as your portfolio grows. A good strategy will ensure that you are consistent with your investments, regardless of the market performance. Dollar-Cost Averaging might be a good starting point. It’s where you invest a fixed amount every month. This will allow you to buy more shares when the market is down and less when the market is up, thereby being consistent with your investments.

Once you are familiar with stocks, it’s time to look at different options for investing. These are some of the most common options investors choose.

1. Exchange-traded funds (ETFs)

Exchange-traded funds (ETFs) are funds that track a market index, sector, commodity, or asset. For example SPY, an ETF that tracks the S&P 500, has shares of all the companies on the S&P 500. The fund tries to mirror the performance of the underlying index. Like an index fund, ETF is also a great way to diversify your portfolio, as buying one share of SPY will give you exposure to the 500 largest companies in the United States.

2. Index fund

Index funds are a type of fund whose holdings track an underlying index. They buy shares of every company on the index it tracks, to try and mirror the performance of the index. Similar to an ETF, an index fund is also passively managed, which means that the investments aren’t chosen by professionals, they just try to mirror the index it tracks. The advantage of passive management is that the expense ratio is very low.

3. Mutual funds

Mutual funds are actively managed funds that take money from investors and invest in various assets like stocks, bonds, commodities, etc. Professionals manage mutual funds, allocate the money in different assets, and make capital gains for the investors. Since the fund is actively managed, the expense ratio is high, compared to ETFs and index funds. Even though they are actively managed, they generally tend to underperform the market.

Remember, stocks are not something you set and forget about. It needs frequent optimization to adapt to changing market conditions. Do your research to find potential growth industries, identify the key players, or companies that could become the key players, look at its fundamentals (financials, management, etc.), and invest.

Keep in mind that information will be abundant. From ‘experts’ on social media to the reporter on your favorite news channel, everyone will have an opinion on what you should buy and sell. Don’t get caught up in those. While it is important to keep up with what is happening in the market, the news should not determine your investment strategy.

Happy Investing!

Frequently Asked Questions

How do I buy stocks for the first time?

  1. Open a brokerage account online
  2. Transfer money to your brokerage account electronically
  3. Search for the company whose shares you would like to buy
  4. Select the order type
  5. Buy

What is a good first stock to buy?

Whether or not a stock is ‘good’ depends upon various factors. A good way to start is to look at the fundamentals of the company i.e financials, management, industry growth, market share, etc. However, if you are not sure how to value a stock, check out this video that explains how we value a stock. Also, for your first stock, you can buy the top companies in the S&P 500 index, which tend to be less volatile and hence a less risky option for new investors.

How much money should a beginner invest for the first time?

While there is not an ideal amount to start investing, try to start with the money you need to buy a single share of a company on the S&P 500. Having said that, you can also start with as little as $100 or even $50, as many brokerages allow you to buy fractional shares, which will be less expensive.

Is it OK to buy 1 stock?

It is perfectly fine to buy just one share of a single stock. In fact, first-time buyers should try buying a single share, just to get a feel of owning a stock, and to understand the stock-buying process. You can add more stocks later on.

How do I learn more about investing?

The internet is a good place to start, as a lot of websites have guides for beginners. However, if you would like to learn how ordinary investors can beat the pros, check out our Amazon bestseller The 8-Step Beginner’s Guide to Value Investing.