A Practical Guide to Investing in Stocks
So you want to invest in the stock market but you're not sure how to do that. Great! This article will clear things up for you and serve as a practical guide.
Stock Market Fundamentals
A stock, also known as share, is a portion of a company. If Facebook had 1000 shares and you bought one, you would own 1/1000th of Facebook.
Companies issue stocks to raise money in order to finance different projects. It's an alternative to taking a loan from a bank.
They list their stocks on one or more of the exchanges (e.g. Nasdaq, LSE, TYO etc.) that make up the stock market. That is where the public, you and I, can buy and sell these stocks.
The stock market bases the value of companies on their expected future earnings. Hence, it's forward-looking which explains why unprofitable companies like Uber can have high valuations.
Stock prices fluctuate due to changes in stock market supply and demand. The market is full of people with different opinions and speculations.
Simply put, if there are more buyers then sellers of a particular stock then the price will go up and vice-versa.
Every transaction needs a buyer and a seller. The stock exchanges use computers to take care of the matching. But remember that at the core the stock market is simply a place where you trade portions of companies with other people.
Before you start investing, it's good to understand the economic cycle. This is the long-term pattern of alternating periods of economic growth and decline.
Growth periods are expansions (a.k.a. booms) of the economy. Periods of decline are contractions (a.k.a. recessions) of the economy.
The highest point of a boom is called a peak; the lowest point of a recession is called a trough. The expansions and contractions are measured by changes in Gross Domestic Product (GDP).
To see what's going on, there are two types of indicators.
1. Leading indicators like the stock market and consumer sentiment are used to determine where the economy is heading, and to estimate the degree of expansion or contraction in the next phase of the economic cycle.
2. Lagging indicators such as unemployment rate, interest rate and business spending confirm what has already happened in the economy, and measure where we are in the current economic phase.
The Cyclical Lag
Making investment decisions based on what the stock market did yesterday or last year is like trying to drive while looking in the rear-view mirror. It doesn't end well...
This is because, as mentioned before, the stock market is forward-looking: valuations reflect expected future earnings. Hence the stock market often turns upward while the economy is still in recession!
This lag between the stock market cycle and the economic cycle creates a challenge for investors as strong emotions at both peaks and troughs push people into buying high and selling low. That's exactly the opposite of what they should be doing.
Relation Between the Stock Market and the Economy
Image from Encyclopedia of Business Terms and Methods
This means that those who stay invested through the entire economic cycle do significantly better than those who try to time the market by buying and selling.
Sitting on the sidelines and missing the best trading days is more harmful than losing some money from the crash.
Yet, it doesn't feel that way. Overconfidence is part of the problem. Many investors think they are smarter than the rest and are able to predict the through.
Cycle of Market Emotions
Image by Capital Group
Because emotions can be such a threat to your financial health, it is important to be aware of them.
Knowing the cycle of market emotions can protect you from the negative consequences of impulsive and irrational reactions to these emotions.
Here are some facts that should ease your mind:
1. On average, corrections have occurred about once a year since 1900.
2. Less than 20% of all corrections turn into a bear market.
3. Historically, bear markets have happened every 3 to 5 years.
4. Nobody can predict consistently whether the market will rise or fall.
5. Bear markets become bull markets, and pessimism becomes optimism.
6. The stock market rises over time despite many short-term setbacks.
Now you can see why Warren Buffett likes to say that you should be fearful when others are greedy and greedy when others are fearful.
He knows how quickly the mood can swing from fear to exuberant optimism.
In fact, when the mood in the market is overwhelmingly bleak like it is now with COVID-19 causing panic left and right, intelligent investors such as Buffett tend to view it as a positive sign that better times lie ahead.
The biggest danger isn't a correction or a bear market, it's being out of the market. Sitting on the sidelines even for short periods of time may be the costliest mistake of all.
Now that you got the basics, let's think of the different strategies you can use to make money in the stock market.
Firstly, you have to decide whether you want to trade or invest. Those are two different things.
Trading is about buying and selling stocks for short-term profit while investing is about buying stocks for long-term gains. I invest so that is what I will be writing about.
These are the main investing strategies you can chose between:
I. Buy-and-hold ⇒ buy stocks and hold them over long periods.
II. Growth investing ⇒ buy stocks of companies you expect will grow fast in the future.
III. Value investing ⇒ buy undervalued stocks and hold them over long periods.
IV. Dividend investing ⇒ buy stocks that pay dividends to get a regular income stream.
To be clear, a dividend is a distribution of excess profit a company makes to its shareholders.
I use an automated buy-and-hold strategy with some variations. I will now explain this in detail and why I think it's one of the best ways to invest in stocks.
The Automated Buy-And-Hold Strategy
There are 5 simple steps in this strategy that repeat themselves in a loop.
1. Create a Savings Plan
The first step is to decide how much money you can save. This obviously depends on your personal situation. Personally, I save 10% of my income.
Make sure you pick a feasible goal and pay yourself first. I made the mistake of not paying myself first and it made it hard to invest consistently. So, when you get your pay check, immediately transfer the fraction you are saving to your investment account. Pay yourself first!
2. Find Good ETFs and/or Undervalued Stocks
Instead of stock picking, I prefer to buy Exchange Traded Funds (ETFs). They are baskets of assets that you buy and sell through a brokerage firm.
When you buy an ETF, you invest in a bundle of companies. ETFs track a certain index like the S&P 500 or the CAC 40 so they are inherently diversified. This makes life much easier for you.
Essentially by investing in an ETF tracking the S&P 500, you are investing in the US economy! By investing in ETFs that track economies around the world, you can build a highly geographically diversified portfolio.
Diversification is essential to building long-term wealth. I will explain why this is the case a bit further down so keep reading!
Occasionally I will also invest in undervalued stocks. This means buying stocks that are priced below their intrinsic value. This is hard to calculate because it usually means calculating the present value of predicted future cash flows which always involves uncertainty.
For example, the price of Airbus stock has decreased almost 65% from the COVID-19 panic. According to my calculations, Airbus is heavily undervalued so I bought some shares.
3. Automate the Process
Prices of assets fluctuate so if you buy them consistently you will be less affected. Automation is key!
Investing a set fraction of your income at regular intervals is known as cost averaging and it's a great way of reducing volatility in your portfolio. Personally, I invest on the first day of each month.
You can also invest in lump-sums. Research has shown that both methods are good. Personally, I prefer cost averaging because automation builds a habit and after a while you won't even think about the process anymore.
4. Don't Trade
Looking back at history, from 1997 through 2016, the S&P 500 returned an average of 7.7% per year. But your returns would almost be cut in half by missing the best 10 days in 20 years. It gets worse, take a look:
Moreover, 6 of the 10 best days in the market over the last 20 years occurred within 2 weeks of the 10 worst days.
So selling your shares when the market falls, hoping to buy the dip is very dangerous since you could miss the rebound if you time it incorrectly (which is almost certain).
Now, do you see why you shouldn't sell in panic? Fear isn't rewarded, courage is.
Just keep strengthening your position in index funds and buy undervalued assets. Don't fear market turmoil. It's the greatest opportunity for you to leapfrog to financial freedom.
5. Adopt a Long-Term Perspective
Be patient. If you have automated the investment process then just sit back, relax, and watch your investments grow exponentially over the years.
This sounds easy but is the hardest part! In the short-term you will see your portfolio go up and down and get the impression that you are not making any progress.
You need to realise that the stock market constantly goes up and down. But prices follow a long-term upward trend. Take a look at the evolution of the MSCI world index from 2008 to 2020.
Chart from Trading View
Remember that the stock market rises over time despite many short-term setbacks. Hence, regularly buying stocks should make intuitive. Even more so when you take compounding into account.
To illustrate this, consider this situation: you have €1,000 to invest right now and you can save €100 every month. The average annual interest rate of a savings account is 0.1% and the long-term average annual return of the MSCI world index is 10%.
You can choose between 4 scenarios:
A. Only use the €1,000 and invest it in the savings account.
B. Only use the €1,000 and invest in the ETF.
C. Use the €1,000 and monthly savings to invest in the savings account.
D. Use the €1,000 and monthly savings to invest in the ETF.
Returns Over 20 Years Compounded
Option D looks the most attractive right?
That is because of the power of compounding. This goes to show that so much of financial success involves good habits practiced over a long time!
🔁 Repeat the Process
The reason I emphasise on the automation part is that I believe that creating a habit of saving and investing is crucial to building long-term wealth.
“Champions don’t do extraordinary things. They do ordinary things, but they do them without thinking, too fast for the other team to react. They follow the habits they’ve learned.” - Charles Duhigg, The Power of Habit
The Earlier The Better
You just saw the immense effect compounding can have on your returns.
Starting early is the key to such results. Time is one of the most important component in investment success.
Imagine you want to retire at 62 with $1 million. If your average annual return were 8%, here’s how much you’d need to invest every month to reach that $1 million, starting at different ages:
Starting at Age 22 (40 Years of Compounding): $310 per month
Starting at Age 32 (30 Years of Compounding): $710 per month
Starting at Age 42 (20 Years of Compounding): $1,757 per month
Starting at Age 52 (10 Years of Compounding): $5,552 per month
As you can see, the earlier you start investing, the more wealth you will accumulate over time.
Time to talk about the importance of diversification.
The basic intuition is that you want assets that move in different directions. Correlation measures the degree to which two assets move in relation to each other.
Ideally, you want assets that are negatively correlated so that as one goes up, the other goes down. But as long as the assets are not perfectly positively correlated, you will see diversification benefits.
Stocks are one asset class. Some stocks have small or even negative correlations with each other but the stock market as a whole moves in cycles so you are exposed that cyclical risk.
Furthermore, it's easy to fall in the trap of recency bias: stocks have been doing good over the past couple decades so this must continue. No it must not.
By any measure of financial history, the last 4 decades were some of the most significant periods of asset price growth ever.
According this research paper by Artemis Capital Management, 91% of the price appreciation for a classic stocks + bonds portfolio (60/40) over the past 90 years comes from just 22 years between 1984 and 2007!
This period of 1984 to 2007 is an outlier comparative to any other period in economic history, yet it's treated this period as normalcy...
Think about that. Most of our consensus knowledge on investing is informed from 4 decades of unparalleled asset price appreciation.
Stocks don't always perform as good as they have recently. The same goes for bonds and real estate which also perform well during periods of secular growth. Secular meaning long-term in this context.
That's because there are periods of secular decline where these asset classes perform worse.
I explained the economic cycle earlier. Asset classes also follow long-term cycles.
Graph by Artemis Capital Management
So if history teaches us one thing, it's that to build long-term wealth, you need to find assets that can perform when stocks and bonds collapse, and boldly own them regardless of short term performance.
So what are those assets?
Volatility funds since they are a great hedge for sustained trends in the stock market (up or down). For this you can buy ETFs that track a volatility index. You profit when stock prices move a lot in any direction. Using a football analogy, this would be winning by not letting in goals rather than scoring.
Gold because it protects against devaluation of cash. It's the classic hedge to stocks, meaning that the price of gold tends to go up when the price of stocks go down. Buying physical gold and storing it in a safety deposit box is the best way to invest in gold.
Cryptocurrencies have low correlation with stocks and bonds but it's relatively recent so hard to assess on the long-term. You can buy them on cryptocurrency exchange like Binance.
Commodity trend following funds is another great hedge but hard to access for us retail investors since you have to invest in hedge funds which tend to have high minimum investment amounts.
These are considered defensive assets and people think their role is to make money during a rainy day, but history shows the real reason to hold these assets is to make money during a rainy decade.
That was a bit vague but I won't delve into more detail because this topic deserves its own blog post. If you want to learn more, read the research paper by Artemis Capital Management.
So I hope you understand the benefits of diversification now.
Now if you decide to diversify your portfolio, you will need to come up with an asset allocation: how much to invest in each asset class?
When it comes to asset allocation, I encourage you to think for yourself. Do your own research, decide on how much risk you're willing to take, what time horizon you want to invest on etc.
You can see my asset allocation and portfolio return here.
Fees and Taxes
Lastly I want to cover fees and taxes. The boring stuff that makes all the difference!
This is generally the last thing we think about when investing. However, fees and taxes can represent a huge cost if you are negligent about them.
Investment success should be measured by your net profit, not gross. Subtract transaction fees, management fees, and taxes. If you have not paid attention to those areas, you are likely to be shocked at how little of your returns you can actually keep.
One of the reasons I recommend that you invest in ETFs is that the fees are low compared to mutual funds or trading individual stocks.
The average ETF carries a fee of 0.44%, which means the fund will cost you $4.40 per year for every $1,000 you invest. Most brokers have a wide selection of ETFs so make sure you look at the fee when selecting the fund you want to invest in.
The main tax when investing in stocks is generally the capital gains tax which is paid when you sell your investments.
This is why you should not sell your positions unless you really have to. I would recommend you to do some research on the taxation in your country.
Personally, I invest through a French broker and use a PEA which is a tax-efficient investment account that allows me to not pay capital gains tax if I keep my money on the account for 5 years or more. Similar accounts are likely to exist in your country as well.
In a Nutshell
Decide on a feasible fraction of your income that you can save. Regularly invest that amount on a set date in a predefined asset allocation of ETFs with low fees. Make use of tax-efficient investment accounts. Then just be patient and let the compound effect grow your investments exponentially.