If you are like most people who have yet to delve into the world of stock market investing, the main thing that is holding you back is the fear of losing money. However, when it comes to journeying into stock market investing as a beginner, it is like anything else in life, it tastes pretty bland without risks.
Yes, there are risks, but take into consideration what Peter Lynch, renowned portfolio investor of the Magellan Fund from 1977 to 1990, has to say about stock market investing, “If you can make it through fifth-grade math, you can do it.”
Taking Mr. Lynch's advice to heart, don't let fear stop you from being successful at stock market investing. To help you avoid losing money in the stock market the Rules of Thumb blog from MoneyThumb is offering the following six tips for investing in the stock market as a beginner. Hopefully, the following pieces of advice will help you succeed at stock market investing and keep the risks at a minimum:
1. Set Long-Term Goals
Before investing in the stock market, you should understand why you want to and the likely time in the future you may have need of the funds. By knowing how much capital you will need and the future point in time when you will need it, you can calculate how much you should invest and what kind of return on your investment will be needed to produce the desired result.
Retirement calculators, ranging from the simple to the more complex including integration with future Social Security benefits, are available at Kiplinger, Bankrate, and MSN Money. Similar college cost calculators are available at CNNMoney and TimeValue. Many stock brokerage firms offer similar calculators.
Remember that the growth of your portfolio depends upon three interdependent factors:
- The capital you invest
- The amount of net annual earnings on your capital
- The number of years or period of your investment
Ideally, you should start saving as soon as possible, save as much as you can, and receive the highest return possible consistent with your risk philosophy.
2. Understand Your Risk Tolerance
Your risk tolerance is how you feel about risk and the degree of anxiety you feel when risk is present. In psychological terms, risk tolerance is defined as “the extent to which a person chooses to risk experiencing a less favorable outcome in the pursuit of a more favorable outcome.” In other words, would you risk $100 to win $1,000? Or $1,000 to win $1,000? All humans vary in their risk tolerance, and there is no “right” balance.
By understanding your risk tolerance, you can avoid those investments which are likely to make you anxious. Generally speaking, you should never own an asset which keeps you from sleeping in the night. Anxiety stimulates fear which triggers emotional responses (rather than logical responses) to the stressor. During periods of financial uncertainty, the investor who can retain a cool head and follows an analytical decision process invariably comes out ahead.
3. Control Your Emotions
The biggest obstacle to stock market profits is an inability to control one’s emotions and make logical decisions. In the short-term, the prices of companies reflect the combined emotions of the entire investment community. When a majority of investors are worried about a company, it's the stock price is likely to decline; when a majority feel positive about the company’s future, it is stock price tends to rise.
When you buy a stock, you should have a good reason for doing so and an expectation of what the price will do if the reason is valid. At the same time, you should establish the point at which you will liquidate your holdings, especially if your reason is proven invalid or if the stock doesn’t react as expected when your expectation has been met. In other words, have an exit strategy before you buy the security and execute that strategy unemotionally.
4. Handle Basics First
Before making your first investment, take the time to learn the basics about the stock market and the individual securities composing the market. There is an old adage: It is not a stock market, but a market of stocks. Unless you are purchasing an exchange-traded fund (ETF), your focus will be upon individual securities, rather than the market as a whole. There are few times when every stock moves in the same direction; even when the averages fall by 100 points or more, the securities of some companies will go higher in price.
The areas with which you should be familiar before making your first purchase include:
- Financial Metrics and Definitions. Understand the definitions of metrics such as the P/E ratio, earnings per share (EPS), return on equity (ROE), and compound annual growth rate (CAGR). Knowing how they are calculated and having the ability to compare different companies using these metrics and others is critical.
- Popular Methods of Stock Selection and Timing. You should understand how “fundamental” and “technical” analyses are performed, how they differ, and where each is best suited in a stock market strategy.
- Stock Market Order Types. Know the difference between market orders, limit order, stop market orders, stop-limit orders, trailing stop-loss orders, and other types commonly used by investors.
- Different Types of Investment Accounts. While cash accounts are the most common, margin accounts are required by regulations for certain kinds of trades. You should understand how margin is calculated and the difference between initial and maintenance margin requirements.
Knowledge and risk tolerance are linked. As Warren Buffett said, “Risk comes from not knowing what you are doing.”
5. Diversify Your Investments
The popular way to manage risk is to diversify your exposure. Prudent investors own stocks of different companies in different industries, sometimes in different countries, with the expectation that a single bad event will not affect all of their holdings or will otherwise affect them to different degrees.
Diversification allows you to recover from the loss of your total investment (20% of your portfolio) by gains of 10% in the two best companies (25% x 40%) and 4% in the remaining two companies (10% x 40%). Even though your overall portfolio value dropped by 6% (20% loss minus 14% gain), it is considerably better than having been invested solely in company E.
6. Avoid Leverage
Leverage simply means the use of borrowed money to execute your stock market strategy. In a margin account, banks and brokerage firms can loan you money to buy stocks, usually 50% of the purchase value. In other words, if you wanted to buy 100 shares of a stock trading at $100 for a total cost of $10,000, your brokerage firm could loan you $5,000 to complete the purchase.
Leverage is a tool, neither good nor bad. However, it is a tool best used after you gain experience and confidence in your decision-making abilities. Limit your risk when you are starting out to ensure you can profit over the long term.