Dear Lifehacker, I've saved a decent amount over the years and I'm ready to start investing some of it. I've heard I should put some in the stock market, but all I really know is how to look up a company's symbol. How do I get started investing? What do I need to know? Thanks, Lost Exchange
You've already made a good move by asking first. While it's certainly possible to make money investing in the stock market, it's also possible to lose really quickly if you don't know what you're doing. Before you take any action, do your research and wait until you're ready to dive in. To set yourself up for that, let's go over the basics of how individual stocks work and how you get returns on your investment.
Learn Some Basic Terminology
Most people are aware of a stock's price. Investors and analysts talk about a company's price going up or down on the market in a given day. However, out of context, a stock price gives very little information about the health or value of a company. To truly understand how well a stock is doing, you need to look at a variety of factors. For that, we need some definitions.
Outstanding Shares - This refers to the total number of shares of a company held by all its investors. This number is used to calculate other key metrics like Earnings Per Share and Price to Earnings ratio.
Dividends - Once a company reaches a certain level of stability and profitability, it can choose to start paying dividends. During a growth period, profits are usually reinvested in a company so it can grow more (which also benefits investors), but once growth stabilises, a company can choose to pay dividends to shareholders. Shareholders can then choose to reinvest those dividends to get even more shares of stock.
Earnings Per Share - This is the amount of money that a company earns per share of stock. It's calculated as a company's net income minus dividends on preferred stock divided by the average outstanding shares. So, if a company makes $50 million and there are 18 million shares outstanding, then one share is worth $2.78 worth of the company's income.
Market Capitalisation - Market cap is the current share price multiplied by all outstanding shares. This gives you a general idea of the size of a company. While getting the absolute value of a company is a bit more complicated than just looking at the market cap, for most basic research, comparing two company's market caps can help you get a better sense of scale than a share price will.
Price to Earnings Ratio - Put simply, price to earnings (or "P/E") is a company's current share price divided by its EPS. This amount will show you about what investors are willing to pay per dollar of earnings. It can also be used as a metric to determine how much a company is over or undervalued.
How To Pick The Right Companies
OK, so now you're at least a little bit more prepared to handle the flurry of financial words that are flying at you. That still doesn't help you decide on a company to invest in, though. What should you even be looking for?
When you're choosing which stocks to invest in, most strategies can fall into one of two categories (and an ideal investor will have both in their portfolio): growth stocks and dividend stocks. (The examples we're using below are US companies, but the same principles apply in the Australian market.)
The basic idea behind a growth stock is that you want to buy it when it's not worth much and then sell it when it's worth a lot ("buy low, sell high"). Chances are these are the types of stocks you've heard people discuss when talking about buying or selling a stock because they're the most interesting and see the most change on a daily, quarterly, or yearly basis. As eHow puts it:
A growth stock investment strategy attempts to find companies that are already experiencing high growth and are expected to continue to do so into the foreseeable future. To investors eager to capitalise on this momentum, rapid growth means a fast and sustained increase in the stock price, which leads to a faster accumulation of wealth.
In general, growth stocks aren't a bad idea. If you had invested in, say, Netflix (NFLX) around this time in 2009, you would have seen a 660% increase in your investment. Putting in $US100 back then would leave you with $US660 now. Not bad for doing nothing for three years! This is what investors hope for when choosing growth stocks: companies that have room to expand, grow and provide a return on their investment solely based on the value of the company.
Growth stocks can also be among the most volatile. When you hear about someone losing all their money playing the stock market, it's typically because they over-invested in a risky company. This happened a lot during the dotcom bubble, but it continues happening today. Groupon, for example, started selling stock to the public in November of 2011, starting at $US20/share. Within four months, it dropped below that price for the last time and has yet to rise above $US20 again. It also currently has an EPS of -0.15, meaning the company is losing money per share. The mad rush to buy Groupon before the stock could prove itself on the marketplace ultimately proved to be a bad bet for early investors.
Fortunately, growth in a company's overall value isn't the only way you can make money.
A safer way to make money on stocks is to invest in a company that pays dividends. Some companies have reached their plateau in terms of growth. You might see some increase over time, but the real advantages of these stocks are their stability and dividends.
For instance, you can probably assume that McDonald's isn't going to go out of business any time soon. Since the company makes enough money to reinvest and still have some leftover, it pays dividends. In other words, the company pays you money for being an investor. Investopedia explains the benefits:
Because many dividend-paying stocks are lower risk, the stocks are an appealing investment for both younger people looking for a way to generate income over the long haul, and for people approaching retirement - or who are in retirement - who desire a source of retirement income.
Using McDonald's as an example again, let's say you'd purchased $US10,000 worth of MCD on 31 March 2006 (about 291.03 shares). In dividends alone, the company would have paid you around $US4600 since then (assuming no dividend reinvestment program, which we'll get to in a second). That's in addition to the value of the stock which, as of 20 September, would be worth around $US28,200. If growth were your only factor, your investment would only have gone up 182% in seven and a half years. Including dividends, though, you're closer to a 329% increase.
Of course, these numbers aren't entirely representative of real life because many investors will reinvest their dividends. This means that you can buy more shares with the dividends that your company just paid you. The more shares you have, the more money you'll get back in dividends and the more your total investment will be worth.
Research Companies To Build A Portfolio
A vital point: you shoudn't put all your eggs in one basket by buying into just one stock. Investing in a single stock is one of the quickest ways to financial ruin. Even a healthy company can have its problems. Netflix, for instance, had major problems in 2011 and 2012 when it pushed up its pricing and tried to spin off its DVD service. If you had invested in 2009 hoping for a lot of growth and had to sell in 2012, you would have seen some growth from it, but not nearly as much as if you still had that stock today.
There are several lessons that can be learned from this scenario:
Don't invest solely in one company. This is an amateur mistake that can cause a lot of problems. An ideal investor will have a diversified portfolio. This means you'll have money in a variety of stocks with different goals. There's no need to choose between growth and dividend stocks. Buy both.
Even healthy companies will go down in value. Netflix was in no danger of going out of business when its stock price fell in 2011. The company lost 810,000 subscribers when it raised its prices, but still had 23 million left. Today, the company has 37.6 million subscribers and produces valuable original content. Yet the stock still fell by 60 per cent in just a few months. The market will often be volatile and irrational, even for companies that are doing well.
Buying for the short term is much more dangerous than long-term investing. Netflix' stock has had a wild ride over the last few years. Long-term investors have seen a good return, but if your goal was to make a quick buck -- or if you couldn't stomach that big dip -- you would be faring much worse. If you can't handle the thought of a volatile stock price, don't invest in growth companies.
You can learn these lessons from any company that's done well because it's the same story over and over. Apple is another stock that has historically done very well but still saw a substantial price drop following the death of Steve Jobs and subsequent product releases. That being said, despite the negative hype, the company's price is still higher now than it was at the start of 2012, and it has started paying dividends. Always be sure to research the health of a company before buying and, when you do, be sure you're ready to stick it out for the long term.
Renowned investor Warren Buffett provides a sage tip (among many others):
"I try to buy stock in businesses that are so wonderful that an idiot can run them. Because sooner or later, one will."
Ultimately, this mentality can help drive all your investments. Do you have reason to believe that a particular business can make money? Is it serving a need that the world will continue to have in the future? Is there room for the company to expand to new markets (or is it paying dividends on consistent earnings)? If so, you may have a company that you should add to your portfolio. Don't be in a hurry to buy, though. Take your time to thoroughly research and consider a company.
When you know what you're doing and don't hurry to make risky investments, the stock market is safer than you might think. While nothing is guaranteed 100 per cent of the time, the basic principle is that when a company makes money, you make money. And many publicly traded companies are very good at making money. It's just a matter of figuring out which ones.
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