Stocks rock. Generally speaking, that is. More specifically, we’re referring to average annual returns over long periods of time. On that measure, stocks have historically outperformed every other asset class (bonds, Treasury bills, cash).
The key words here are “long-term outperformance.” Because, oof — the short-term ups and downs can be brutal. If you’re trying your hand at stock investing for the first time, know that stock trading tips based on anything but long-term results will expose you and your money to frequent bouts of agita. But don’t let that stop you.
Yes, most investors are best served by keeping things simple and investing in a diversified mix of low-cost index funds. That said, earmarking a small sliver of your investable assets (a low single-digit percentage) to buy individual stocks online can, at best, be profitable and fun. And at worst? As long as you don’t use money you can’t afford to lose, it’s just a temporary diversion that leads to limited losses and lessons learned.
If you’ve already got your cursor hovering over the “buy” button, we’re glad you’re gung-ho, but first let’s get one thing out of the way. A confession.
Trading vs. investing: What do you want to do?
We fully acknowledge that the headline of this article — just the “trading stocks” part — may be a little misleading to a certain kind of investor. “Trading stocks” is often used as shorthand for “active trading,” which refers to day traders (the folks who play hot potato with stocks, holding onto them for very short periods).
If that’s your thing, cool. Allow us to point you to our roundup of the best online brokers and platforms for day trading. But in this article, we’re focusing on the buy-and-hold investor (who will be best-served by these highly ranked online brokers for beginning investors).
Although technically long-term investors are indeed “trading stocks,” the intent behind the action is very different. You need to figure out if you’re going to be a speculator or an investor.
- Speculators concentrate on short-term price movements. The most extreme of them disregard the underlying business and simply base trades on whatever ticker symbol pops up on the screen (often of companies they’ve never heard of), or on rumors and fads they pick up on penny stock trading forums. These short-term traders are betting (aka, gambling) they can make a few bucks in the next minute, hour or few days. This strategy relies on trying to time the market, seeing if the marble lands on red or black.
- Investors buy businesses that they have researched until they understand the operations inside and out. They expect to be rewarded (via share price appreciation, dividends, etc.) over years or even decades. Time, not timing, is an investor’s superpower. Investors know that buying an investment at its all-time low and selling it at its all-time high is luck, and they don’t need luck. Through thoughtful research, a solid investing plan and patience, they’re able to identify companies that will deliver handsome long-term returns to contribute to their future financial freedom.
It’s pretty obvious which approach we’re advocating here. With that in mind, let’s get your illustrious stock investing career started.
8 tips that will make you a better investor
1. CHECK YOUR EMOTIONS AT THE DOOR
“Success in investing doesn’t correlate with IQ … what you need is the temperament to control the urges that get other people into trouble in investing,” said someone you should probably know: Warren Buffett, chairman of Berkshire Hathaway, oft-quoted investing sage and basically The Man when it comes to long-term, market-beating, wealth-building returns.
The urges Buffett refers to are things such as overreacting to short-term events, focusing on share price instead of company value, feeling like you need to do something when no action is warranted, and generally letting your gut, not your head, run your portfolio.
You need to cultivate the temperament needed to not bail at the first sign of trouble or take the bait when the crowd is lining up for the IPO of iSnapOogleAzonDotCom.
2. DEFINE YOUR TIME FRAME
Part of how Buffett keeps his cool is that he knows he’s got time to let his investments recover from those short-term jags that tend to stir up emotions. You can do that, too, by setting parameters for the money you’re using to buy stocks:
Set financial goals. What are you earmarking this money for? The majority of people are investing for long-term wealth accumulation so they’ll have money for retirement, a small child’s future college tuition, or other off-in-the-distance financial goals.
Identify your investing time horizon. How soon will you need to use the money? Any money you need in the next five years (or longer if you are risk-averse) should not be invested in stocks. During shorter time frames there are natural, inevitable stock market swings. Investing your near-term money in stocks is akin to putting your most vulnerable soldier on the front line.
Assess the flexibility of your plans. Time for some visioning exercises. What if the market is in a down cycle when you had planned to start selling and drawing income from your investments? How would that affect your plans? Could you modify your plans (e.g., push back your retirement date, delay buying that B&B) until the market inevitably recovers? If a goal is not flexible, then you should consider a more conservative mix of investments or a most conservative strategy, such as moving out of stocks and into safer havens sooner than you planned.
3. PICK COMPANIES, NOT TICKER SYMBOLS
It’s easy to forget that behind the alphabet soup of stock quotes crawling along the bottom of CNBC, behind every jagged-lined graph and jargon-filled analyst commentary, is a business run by actual human beings whose job it is to build a thriving enterprise that ultimately delivers value to shareholders.
Don’t let stock picking become an abstract concept. Heed Buffett’s advice, this gem from a 1974 interview in Forbes magazine: “Buy into a company because you want to own it, not because you want the stock to go up.” (We told you the guy was quotable.)
Business owners ask different kinds of questions from business traders. And if you’re considering going into business with the people who run a company, you’ll be more inclined to do thoughtful and thorough research before you shake hands and buy shares.
4. DO YOUR RESEARCH AND ASK THE RIGHT QUESTIONS
Research involves looking at publicly available information on the company, including annual reports, quarterly earnings reports, financial filings, research from outside analysts and whatever the Securities and Exchange Commission has on it. Then there’s all the more-technical stuff, like calculating the company’s growth rate and comparing its P/E ratio to similar companies. Much of this information will be on your broker’s site. (Enter your initial account balance and what kind of research and tools you need, and we’ll compare discount broker deals to find the best fit for you.)
There’s an overwhelming amount of information out there. But it’s easier to home in on the right stuff when wearing your “business buyer” hat. You want to know how this company operates, its place in the overall industry, its competitors, its long-term prospects and, of course, how the company fits into the portfolio of businesses you already own (exposure to smaller companies? international flavor?). Some questions to ask:
- Does this company have a competitive advantage (something about it that makes it difficult for others to imitate, equal or eclipse)?
- What are the main drivers of the business? For example, what operational metrics should you keep an eye on to check the company’s health? (For more guidance see beginners’ tips for evaluating stock performance.)
- Will this company be around in 20 years?
- How big of a personal stake do the company’s managers have in the company they run, and is a portion of their salaries tied directly to company performance?
- Lastly, what change in business would drive you to sell your shares in the company? Here we’re not talking about stock price movement (especially not short-term), but fundamental changes to the business that affect its ability to grow over the long term.
If you feel like all this talk is sucking the fun out of picking stocks, we’ve got a surprise for you.
5. PULL THE TRIGGER! THAT’S RIGHT — BUY A (SINGLE SHARE OF) STOCK RIGHT NOW
Invest on a whim? Heck, yeah. The best investing education is the hands-on experience of actually owning a share or two of a company — becoming a bona-fide shareholder (or, if you prefer sportsball-speak, “putting some skin in the game”).
The cost of tuition is the price of a single share (and any trading commissions). As a shareholder you’ll experience firsthand what owning a stock is like. You’ll get updates on quarterly performance and annual shareholder meetings. By following along you’ll start to get to know the rhythm of the company’s operations. (Added bonus: If you buy stock in a company involved in retail or restaurants, you can waltz in and announce, “Shareholder alert!” and see if it gets you and your appalled party service any faster.)
Of course eventually — or even right out of the gate — the market is going to do its short-term market thing (bounce around) and your single-share portfolio might get swept up in the chaos. You’ll take a look to see whether the price movement is based on actual fundamental things happening with your company, random headline news, or which side Jim Cramer parts his hair on that day.
That can be harrowing for the first-time investor who is 100% invested in a single share of a company. On the bright side, what you have here is a classic “teaching moment” — the opportunity (albeit an uncomfortable one) to test your investing temperament. The experience may turn you off to buying individual stocks for a while or even altogether. That’s OK.
The point of this exercise is to dip your toe in the water in a low-commitment way and see what investing in stocks is really all about … and whether you enjoy it.
6. NAIL DOWN YOUR INVESTING THESIS
Now that you are a bona fide stock investor — a shareholder, thankyouverymuch — it’s time to get back to work. This is an important tip for all investors, pros and novices alike. It’s time to write your vows and a prenup, aka your investing thesis.
Why I’m buying: Your vows include the reasons you’re making a commitment to the company (the opportunity you see); what needs to happen for the company to succeed (your expectations and what metrics you’ll use to judge its progress); and the “in sickness/in health” part (potential pitfalls that will prevent your beloved stock from reaching its full potential over the long term).
What would make me sell: The prenup spells out what would justify a breakup and drive you to sell the stock. Maybe the company loses a major customer, the CEO’s successor starts taking the business in a different direction, a major viable competitor emerges, or your investing thesis doesn’t pan out after a reasonable period of time.
Your investing thesis serves as an accountability buddy when your stocks start bouncing around and anxiety about market noise threatens to overtake the calm, cool demeanor you’ve cultivated.
7. BUILD UP YOUR POSITION
After you decide that a company is worthy of a place in your portfolio, it’s time to commit.
This is that terrifying moment when an investor has to slap down a wad of cash. This is when all the “what if” and “should I” questions get real: “What if the share price drops five minutes after I buy?” “Should I wait to see if I can buy shares cheaper tomorrow, next week, after Labor Day?” “Is this the right time to buy this stock?”
Good news: You don’t have to commit a bunch of dough all at once and you don’t have to worry about buying at the “wrong time.” Here are three ways to build up a position:
Dollar-cost average: This sounds complicated, but it’s not. Dollar-cost averaging means investing a set amount of money at regular intervals, such as once a week, twice a month or whatever your preference. Spreading out your purchases means your set amount buys more shares when the stock price goes down and fewer shares when the price rises. It smooths your investment returns over time and evens out the average price you pay for shares. (Discount brokers enable investors to set up an automated schedule and dollar amount to make this happen.)
Buy in thirds: Like dollar-cost averaging, “buying in thirds” helps investors avoid the morale crushing experience of bumpy results right out of the gate. Here you settle on the amount of money you’re going to use to buy shares and then, as the name implies, divide that by three and pick three separate points to buy shares. The “when” is up to you and can be regular intervals (e.g., monthly or quarterly) or even based on performance or company events (e.g., buying shares before a product is released and then if it’s a hit putting the next third of your money into play). And if it looks like the company is not going to reach milestones you set in your investing thesis, you can divert the remaining money elsewhere. Since buying in thirds typically requires fewer transactions than dollar-cost averaging, another bonus is that you’ll save on commissions.
Buy “the basket”: Can’t decide which of the companies operating in a particular space will be the long-term winner? Buy ’em all! Buying a basket of stocks takes the pressure off picking “the one.” Over time a lot can happen: companies fail, are acquired, establish their dominance and save the world. Having a stake in all the players (that pass muster in your analysis) means you won’t miss out if one takes off, and you can use gains from that winner to offset any losses. This strategy also will help you identify which company is “the one” so you can double down on your position if desired.
8. WATCH YOUR STOCKS, BUT NOT TOO CLOSELY
How often should you check on your stocks? Once a quarter is just fine. Companies release earnings reports each quarter, making it the ideal cadence for investors to check on how things are going.
Yes, investors should stay up to date on holdings. And when the market overreacts and punishes a company’s stock price (which will happen), they should investigate to see if underlying business reasons triggered the price movement or if it’s simply “the market” overreacting. But rarely is short-term noise (blaring headlines, temporary price fluctuations) relevant to how a well-chosen company performs over the long term. The caveman part of our brains translates noise into an urge to take action. And action — overactivity — is what often leads to people hurting their own investing returns.
Temperament, friend, temperament and time. That’s Buffett’s secret to being a successful investor — and yours too.
Dayana Yochim is a staff writer at NerdWallet, a personal finance website: Email: dyochim@nerdwallet.com. Twitter: @DayanaYochim.
This post has been updated. It was originally published Sept. 30, 2014.
Image via iStock.
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