17 Things You Need to Know Before Investing in Stocks
Finally, you can enter the investment world of Wall Street with confidence.
It’s not always the smartest option
“Over many decades, the investment that has provided the highest average rate of return is stocks,” says financial adviser Brian Saranovitz, president of Your Retirement Advisor. If you owe money on a credit card and are paying 18 percent interest, though, you should pay off that debt before investing. By sending the money to the credit card issuer instead of Wall Street, you’re effectively making 18 percent on your money. That type of high-paying investment—let alone a sure thing—would be hard to find in the stock market. Don’t miss these 11 money tips from people who managed to retire early.
Learn the lingo
If you can’t talk the talk, don’t try to walk the walk. Not knowing the difference between EPS (earnings per share) and ETF (exchange-traded fund) could cost you a small fortune. Did you realize the much-touted Dow Jones Industrial Average is based on only 30 stocks? Websites such as MoneyTips can help you learn the vocabulary of Wall Street. Most importantly, understand what investing in stocks means: that you own a small piece of a business.
It’s not all “buy low, sell high”
“Stock ownership provides multiple ways to profit—not only price appreciation, but also dividends,” says Saranovitz. With a dividend, you get paid simply for owning a stock.” A recent Hartford Funds study shows that dividend-paying stocks tend to beat the market over the long term and yield far better returns for investors than stocks that don’t pay dividends. Check out other easy ways to earn extra income.
Decide what kind of help is best for you
Back in the day when the Dow Jones Industrial Average was below 1,000, investors had to rely on licensed brokers who garnered large commissions with every trade. Not only has the Internet driven sales commissions way down, but new technology also allows people to rely on robo-advisers (computer algorithms) or to make their own stock-picking decisions without any human interaction. It’s wonderful that you can trade stocks in your underwear—until you lose your shirt!
“My mother has always said, ‘Life is 20 percent what happens to you and 80 percent how you react to it.’ With your financial life, you might not always have the right know-how or frame of mind if the going gets tough,” says Lynn Toomey, co-founder of Your Retirement Advisor. “A financial adviser can provide the behavioral coaching that you can’t do on your own or with a robo-adviser platform. When the market drops, an adviser can help you focus on your long-term goals instead of hitting the panic button.” With so many good stock-pickers in the industry, picking your own portfolio is a financial risk, she says.
Consider the long-term
“Trading stocks isn’t like a long weekend in Vegas,” warns Toomey. “You’re not trying to cram a ton of action into a few nights. Commit to being a long-term trader, and the odds of coming out ahead turn in your favor.” Your stocks might dip for a little while, but with the patience to ride it out, you’ll earn in the long run. Learn 26 more secrets rich people won’t tell you about their money habits.
Don’t try to time the market
When investing in stocks, try the buy-and-hold strategy as opposed to day trading. Nobel Prize-winning economist Paul Samuelson wrote, “Scores of documented statistical studies attest that not one in ten ‘timers’ ends up getting back into the market at bargain prices lower than what they sold at earlier.” In fact, you might end up doing worse damage, says Saranovitz. “Many traders panic and sell stocks too late, after a large drop,” he says. “That could be the worst time to sell.” It’s hard to calculate exactly when to sell a particular holding, but signs include a high price-to-earnings ratio, stagnating or dropping sales, and decreasing profit.
Don’t invest more than you could afford to lose. Like any investment, there are risks, especially in the short term. What if you had invested in early February, right before the market suffered through the biggest one-day drop in history? Stocks won’t go up all the time. You also need to recognize your own risk tolerance. Consider your age: The closer you are to retirement, the less time you’ll have to make up for a large loss. Saranovitz, who counsels people on controlling their risk as they get closer to retirement, says, “We’ve witnessed many people throwing caution to the wind due to the stock bull market we’ve had since April 2009. We’ve witnessed people very close to retirement wanting to keep high stock exposure in their portfolios. We recommend age-appropriate portfolio allocations to assure one is properly invested in the event of a major stock market correction or potential bear market, either of which could be on our horizon.” Use this timeline to show exactly how much to save for retirement.
Start with exchange-traded funds, index funds, and mutual funds
Buying exchange-traded funds (ETFs), index funds, and mutual funds are popular ways of buying stocks without having to choose individual stocks. Many are automatically diversified (so one event won’t ruin all your investments), have low fees, and are rated for risk tolerance. Target-date funds, which assume investors will retire in a certain year, adjust their asset allocation to get more risk-averse as one approaches retirement age. However, one study shows that most participants in these “set-it-and-forget-it” end up taking money out to actively invest in their own stock picks, despite its risks. Don’t miss the answers to your top retirement savings questions.
Try dollar-cost averaging
“Many people are introduced to stocks through an employer-based retirement program such as a 401(k) plan, where you get to choose your preferred investments from several options,” says Toomey. “Take full advantage of these programs, since many are tax-deferred and have matching components. They also make it easy to use dollar-cost averaging.” In this investment technique, you buy a fixed dollar amount of stocks regularly, such as every pay period. That means you’re buying more shares when the price is lower and fewer when the price is higher, removing the worry about when to buy.
Diversify in every way
“A good money manager will purchase 20 to 30 stocks to diversify a portfolio,” says Saranovitz. Not only should you pick different industries, such as consumer staples and technology stocks, but you should aim to have different countries, and both mega-corporations and small companies, he says. In mastering how to invest money, your overall investments should be diversified, too. Stocks should make up a part of your portfolio, but not all of it. “We recommend bonds and fixed-indexed annuities to our clients as well,” says Saranovitz.
Expect realistic returns
With cryptocurrencies like Bitcoin increasing by 1,000 percent or more in a year, investors might have unrealistic ideas about what to expect from stocks. In a 2016 study, investors expected an 8.5 percent return over inflation, but financial advisers said less than 6 percent was more realistic. While 2017 was a great year for stocks, the market could go down in any given year. “Remember, past performance is no indication of future results,” says Saranovitz. Check out 16 money mistakes millennials don’t realize they’re making.
The more you pay in fees, the less you’ll get to take home. You’ll pay fees to an adviser, and the funds you’ll buy have management fees that will eat into your returns. If you’re the do-it-yourself type, compare prices of online brokers, and try to get in on a new-customer promotion. If you’re using an adviser, make sure you understand the fee structure that can include custodial fees, trading costs investment management fees, adviser fees, as well as other expenses. Learn the 23 secrets your financial advisor won’t tell you.
Use 5 percent of your holdings to experiment with company shares
Owning individual company shares is higher risk than investing in funds; be prepared to lose 100 percent of your investment. Still, if you have insight and knowledge of a particular industry or use products of a company you admire, feel free to buy some shares. Watch out for red flags, such as companies that recently cut dividends or have never earned a profit.
Avoid penny stocks, options, and hot tips
In a pump-and-dump scheme, a group will buy stock in a small company, and then email thousands of people touting the company. They’re trying to get the gullible ones to invest; when the price goes up, the senders sell at a profit, and the price drops back down. If stock tips were truly based on insider knowledge, then trading on them would be illegal. Beginners should also avoid penny stocks, which are sort of like the lottery: little money down, but little chance of profit. Investing in options—the right to buy or sell a stock for a certain price within a certain time—can be inexpensive, but it’s also easier to lose all your investment when options expire.
Leave emotions at home
“The raging bull market since 2009 has made investors feel impervious to the inherent volatility of the stock market. February’s market dip could be a quick market correction or the beginnings of the next bear market,” says Saranovitz. “But my research shows that you have to keep a cool head when times get tough. Since 1950, the Standard & Poor’s 500 stock index fell by 3 percent or more on 100 days. In the ensuing year following those drops, the S&P 500 generated a 16.8 percent investment return average. Too many people sell after drops because they fear losing even more.” As noted investor Warren Buffett puts it: “Be fearful when others are greedy and greedy when others are fearful.”
Don’t celebrate unrealized profits
When you learn how to invest in stocks, you could become a paper millionaire—but until you sell your holdings, the profits aren’t yours. On the other hand, don’t mourn unrealized losses, either. You can’t count your profits or losses until you sell.
Don’t forget the taxman
When you do sell a stock for a profit, Uncle Sam will want his share in the form of a capital gains tax. If you hold a stock for more than a year, your tax situation should be more advantageous than flipping a stock within a year. Investing in stocks in a retirement plan such as a 401(k) can help your investment grow in a tax-free environment. In addition, if you sell a stock for less than you paid for it, the resulting capital loss could lower the tax you’ll pay on your gains. Consult with a tax professional for how to keep more of your stock market gains. Don’t miss these other 32 things a tax accountant won’t tell you for free.