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- Stocks 101
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Table Of Contents
Investing in stocks is the most accessible way for the average person to participate in the growth of the economy. For more than 100 hundred years, the stock market has outperformed other asset classes like bonds, commodities, and real estate. Yes, there are thousands of stocks available to investors, and investing can be complicated – but it really doesn’t have to be. There are very simple ways to invest, and you can get started with relatively little capital. If you find the idea of buying stocks daunting, the following step by step process will help you get started.
1. Decide on your investing strategy
Your first step is to decide on an investing strategy, as this will help you decide on the best broker for your needs. If you plan to use a hands-off approach like buy and hold, passive, or value investing you will be making very few trades, so the commission you pay won’t have a big impact on your account. You also won’t need a very sophisticated platform to execute trades, though access to some research may be helpful.
On the other hand, if you plan to adopt a hands-on investing style, like momentum or growth investing, you will be trading more often, and your trading commissions will add up. So, the commission rate will be an important factor in choosing a broker. You may also need a platform with more features, and access to up to date research.
It’s also important to make a distinction between investing and trading. If you are investing, you are concerned with the value of a stock, whether the value will increase, and how much the stock price differs from its value. Your timeframe will typically be from one to five years, and you will not react to short term price movements.
Trading is all about the short term, supply and demand and price action. Traders have much shorter timeframes, ranging from minutes to months. Traders often use leverage to improve their returns too.
Trading can be very profitable but comes with more risk and is a lot more time consuming. If you plan to trade actively, you may want to choose a broker that gives you access to a margin account or derivatives too.
2. Choose a broker
To buy shares in a listed company, you will need an account with a stockbroker. Strictly speaking, it is possible to buy shares in other ways, but it’s a lot easier with a trading account at a broker. Stockbrokers are firms that are members of exchanges and are responsible for sending your buy order to the exchange where it will be matched with a sell order from a client of another broker. Stockbrokers are also responsible for settling the trade after it has matched.
In this day and age, online brokers are almost always the way to go. Commissions are lower and in some cases free, and online trading platforms give you a lot of control over your orders. If you are prepared to pay more, you can open an account with a full-service broker, allowing you to place orders over the phone and ask for advice.
Several brokers even offer commission-free accounts now, though you may need to pay other fees to maintain the account.
When choosing a broker, you will need to consider commissions and other fees, the platform, tools, and research they offer, and the level of support you can expect. Try to find a few independent reviews on each broker to find out what their strengths and weaknesses are. You should then be able to make a decision on the right broker for your needs.
A broker that we recommend is Firstrade.
3. Open and fund your account
Once you have decided on a stockbroker, you will need to open an account. Most brokers make this as easy as possible. You will need to provide a few personal details, and a few documents to prove that you are who you say you are. The entire process shouldn’t take more than a few minutes.
Once your account has been verified and approved, you will be able to fund it. A wire transfer is typically the fastest way to get money into your trading account, but you can also fund your account by check.
4. Learn how to use the trading platform
Typically, an online broker will allow you to open a demo account. This is an account with fictitious money in it, but with access to live prices and all the same tools as a live account.
The main reason for demo accounts is for active traders to practice trading, also known as paper trading. This is more relevant to short term traders than to investors, but it also gives you an opportunity to get to know the platform. You can practice entering orders, set up a watchlist, and find out which tools you may want to use in the future.
When you are entering ‘practice orders’ it’s important to ensure that you have in fact logged into your demo account, and not your live account.
Before you get started, it’s worth knowing the following terms which will come up often:
- Bid – A bid is an order to buy stock.
- Bid Price – The price of the highest bid is the market bid price.
- Offer – An order to sell a stock is an offer. The price of an offer is the ask price.
- Ask Price – The price of the lowest ask/offer is the market ask price.
- Spread – the spread is the difference between the market bid and ask price, also known as the ‘bid-offer spread’. The bid and ask price are also known as the ‘double.’
- Market order – A market order is executed immediately at the current market price. A market order to buy will be executed at the ask price, while a market order to sell will be executed at the bid price.
- Limit order – a limit order is an order to buy or sell a stock at a specific price, or limit. Limit orders are only executed when a corresponding order at the limit price is entered into the market.
- Stop-loss order – A stop-loss order is executed if the price crosses a threshold level. If you buy a stock you can enter a stop-loss order to sell if the price falls below a certain price. This is done to limit losses.
- GTC – Good till canceled orders remain in the market until they are canceled.
- GFD – Good for day orders remain in the market for the remainder of the trading day.
- FOK – Fill or kill orders are automatically canceled if they are not filled immediately.
5. Create a watchlist of stocks
A watchlist is a list of stocks, or other securities, along with their prices -either live prices or daily closing prices. All online brokers give you the ability to set up a watchlist. Besides the price, you can add other columns like volume, bid price, ask price, and daily percentage price change to your watchlist.
You should also add a few indexes to your watchlist so that you can compare the performance of each stock against the performance of the overall market. The important indexes to watch are the S&P 500 and the Nasdaq 100. If you can’t add the index itself to your watchlist you can add an ETF that tracks the index instead. The performance of the SPY (S&P 500) and the QQQ (Nasdaq 100) ETFs will be just about identical to the indexes they track.
The stocks on your watchlist are those that you will track and learn more about, but not necessarily buy. Start with companies you like and admire – because these are the companies you probably know a little about.
Once you have a handful of stocks on a watchlist you can begin to compare their performance to the market. You should also start learning more about the companies and how well they are doing. Find out whether their revenue is growing and how profitable they are compared to similar companies. While you do this research, you will probably come across other stock’s worth investigating, and you can add these to your watchlist too.
If you are unsure about picking individual stocks, you could consider ETFs. An ETF, or exchange-traded fund, is a basket of stocks that can be traded just like a stock. You can learn everything you need to know about them from our in-depth series of articles on the ETFs.
6. Decide how much to allocate to each stock
Investors are rewarded for taking risks, but that risk needs to be managed. Regardless of how much research you do, you can never be sure of the future. The most important step you can take to manage risk is to make sure one bad investment doesn’t wipe out your portfolio. Diversifying your investments across a portfolio of stocks is the equivalent of making sure you don’t have all your eggs in one basket.
There are two rules of thumb you can use to decide how much of your portfolio to allocate to each stock. The first is that a properly diversified portfolio should have at least 15 to 20 stocks in it. That means you shouldn’t invest more than 6.7% of your account in each stock.
The second rule of thumb is that you shouldn’t risk more than 2% on each stock. That implies that if you are prepared to lose up to 20% of the value of a single stock, you should limit that stock to 10% of your portfolio (20% of 10% comes to 2% of the portfolio). This approach is more appropriate for active traders who use stop losses.
To further reduce risk, you should spread your investments across a few different sectors. Stocks in each sector tend to be highly correlated, so your risk is higher if all your stocks are from the same sector. An even simpler way to diversify is to invest the bulk of your portfolio in an ETF. That way you will be spreading your risk across the entire market. You can still keep 20 to 40% of your account for individual stocks you really want to own and invest the rest in an ETF.
7. Decide which stocks you will buy and when you will buy them
By now you should have a good idea of the stocks you want to own or may want to own in the future. Rather than rushing out and buying these stocks, you should formulate a plan. Your plan should be based on your reasons for buying the stock, and your time horizon.
Very broadly speaking, there are three approaches you could use:
- Long term investments in blue-chip stocks
Blue chips stocks are the stocks of very high-quality companies with long track records and relatively predictable earnings. They are usually leaders in their industries with a distinct competitive edge. The prices of these stocks don’t typically appreciate a lot each year, but compound steadily over the long term. Buying blue-chip stocks should be a long-term commitment of 10 years or more.
If you are buying blue-chip stocks to hold for a long time, there is little to gain by trying to time your entry. If you don’t want to buy them in one go, you could stagger your buying over a few months – but ultimately your objective is to own the stock for a long time, and there is no point overthinking your entry price.
- Buying growth stocks and stocks with momentum
The stocks that tend to appreciate the most over shorter periods are those of rapidly growing companies. Often, the price momentum alone will attract more buyers causing the momentum to continue. Buying these types of stocks requires a more hands-on approach as the momentum is unlikely to continue forever. If the price is too high, the long-term return is unlikely to be very good, and the stock price may fall substantially.
If you are buying growth and momentum stocks, you need to weigh up the company’s earnings growth, the valuation, and the stock’s price momentum. Often, you will need to buy the stock when the price is already in an uptrend. If the price stops rising, you will need to pay close attention to the company’s growth and valuation to decide whether you will remain invested.
- Buying after a stock price correction
The best time to buy most types of stocks is after a market crash or a sharp correction. This is when the entire market will be ‘one sale’. This is the best time to buy shares in any company with a good business model and not too much debt.
Individual stocks may also offer an opportunity when their stock falls out of favor with investors and the stock price declines substantially. But not every stock recovers, so you should carefully consider the company’s long-term prospects. It’s also a good idea to wait for the price to stabilize before buying – prices can fall a lot further than you might think they can.
Before you actually buy a stock, you should also decide on the criteria you will use to exit the stock. Having a plan before you buy the stock will prevent you from making impulsive decisions later.
Your exit criteria should also be related to your reasons for buying the stock in the first place. If you buy based on price momentum, then you may want to exit if the momentum stops. But, if you buy based on the company’s fundamentals, then you should only sell if those fundamentals change, not because of the price action.
8. Enter your first buy order
Sooner or later a stock will meet all your criteria for investing and it will be time to make your first investment. The first thing to do is to calculate the number of shares you will buy. You have already decided how much you are going to allocate to each share, so you just need to divide that amount by the share price. Making sure you are dividing a dollar amount by the dollar price and not the price in cents.
Before you enter your buy order, you will need to decide whether you’re going to use a limit order or a market order. Usually, a limit order is safer. A market order might result in paying too much if the bid-offer spread happens to widen when you enter your order. But, if the market is moving very fast, a market order may be more appropriate.
Decide on a reasonable price given the trading range for the last few days and for the current day. This will be the limit price for your order. In most cases, your limit will be a price that you think has an 80% chance of being filled.
A higher limit price will give you more chance of your order being filled – but will eat into your profit.
A lower limit price will give you less chance of the order being filled – and this may result in you having to then pay an even higher price. However, if your time horizon is short and you are looking to turn a quick profit, you may need to aim for a lower price.
Now that you have bought your first stock, you need to manage the position according to the criteria you used to buy it. You may begin to doubt your decision if the stock price falls. You may also be tempted to sell if the price rises and you find yourself with a profit. Remember to keep your long-term plan in mind and stick to it – the price will rise or fall each day, but that doesn’t mean you need to act.
Now that you have bought your first stock, you can carry on slowly adding new stocks to your portfolio. There should be no rush though – investing is a long-term game. You should also keep learning and reading as much as you can about investing and stocks. Start out with ETFs and blue-chip stocks and add slightly riskier stocks later. Keep your long-term plan in mind and avoid impulsive decisions – the market rewards patient investors.
Richard Bowman is a writer, analyst and investor based in Cape Town, South Africa. He has over 18 years’ experience in asset management, stockbroking, financial media and systematic trading. Richard combines fundamental, quantitative and technical analysis with a dash of common sense.