Part 3. Investing basics: Investing in stocks

PART 3. INVESTING IN STOCKS

As we have told before, stocks (we have called them also shares) have been the most profitable investment in the history. Considering this knowledge, one should still start investing right now. Still it is important to remember, that nothing ensures that such rate of return will continue in the future.

When to buy and when to sell

If you are a long-term investor – maybe you keep your investments for a very long period without selling them, then the type of assets you are buying becomes decisive. Allegedly, 90% of the investment return depends on whether to invest in shares, bonds or keep the money at the bank deposit. The remaining part has less importance.

Why to invest in shares?

  1. It’s all about risk. It is generally believed misconception that shares are riskier than bank deposits and bonds. The risk hereby means that the possibility to lose money is present. If the risk is higher, more rate of return (interest) is also required for that. When investment is made in one company, i.e. the shares of this company are to be bought, the risk maintains that this company will not be successful and the price of its share at the stock exchange will decrease.
  2. It’s all about diversification. So when to buy the shares of several companies, the risk disperses and this is already called investment portfolio. This is important information for the beginner and as the name of our website says, we draw major attention to that the beginning investors would make right investment decisions in as early phase as possible.
  3. It’s all about growth. The share means one part of the company. A company is like an organism created to grow. Each company has owners. If we talk about stock exchange, the entrepreneurs have decided that they share a part of the company for the general public. The share means one part of the company. A company is like an organism created to grow. It is natural that companies grow. Owners wish that their money invested would grow in time and their risk would be covered. I do not know a company which aim is to fade.

The growth of value

The companies making profit grow as the profit earned remains in the company, unless it is not paid out as dividends. If the company receives more profit and money, the volume of assets of the company grows – the number of clients has increased, more goods are acquired for resale, more cash is remaining etc. If the company continues growing and is successful. And guess what! Investors are also ready to pay more for this company in stock exchange market and the share price is about to increase.

Investment risks and the time horizon

It is summer 1929, positive mood is dominant at the stock exchanges. Analysts give purchase recommendations for majority of shares. America is currently living through powerful economic growth period.

One well-known manager of a listed company gives his tips and suggests to put 15 dollars into shares each month. He promises that the value of the portfolio in 20 years will be 80,000 dollars. The annual rate of return is approximately 24%.

The stock index Dow Jones reaches the level of 381.17 points in September of the same year which is a recent record. But few weeks later the unbelievable stock exchange crash is present where the shares are in freefall. By July 1932 only 41.22 points is left from the value of Dow Jones index. The whole decade passes and Dow Jones reaches the pre-crisis level in 1945 at last.

The analysts who recommended the shares just before stock exchange crash became the objects of ridicule.

But still, what happened and was the idea of investing in stocks with small amounts still wrong?

Investing is related to emotions and it is clear that investors were very insecure within the first months and years after the crash and they experienced financial loss. Everyone was in panic and regret.

Everything depends on whom we compare ourselves with. But here is the truth! If we had invested at that time in small amounts, as we were suggested, our wealth would have been bigger already in four years than the one of those who would have kept the same amount in the bank deposit. Yes, in the midst of deep economic crisis.

In the middle of stock market boom, it is recommended to stay in cash or invest small amounts. It is difficult to find the value investments anyway.

To put it into numbers. The value of stock portfolio in already 20 years would have been 9,000 dollars and 10 years later 60,000 dollars. This is not very much, but compared to investment crowd that lost billions, it is still an excellent result – in average 13% annually.

Yes, it is the magic of diversification and investing in stocks over long period of time!

Investing with small amounts is an efficient way to decrease the risk, as thus it is possible to diversify the purchase of shares in time. This is called dollar cost averaging and is one of the main investment methods recommended to the beginners.

Thus dollar cost averaging enables to get a head start through diversification and investing in stocks with small amounts before bonds and bank deposits also during really difficult times.

Decreasing risks

  1. The diversification of share purchases in time means the continuous investing in stocks with small amounts instead of one big purchase. When buying shares each month for buying equal amount, you will buy more shares in pieces when the prices are low (market falls) and less when the prices are higher (market goes up).
  2. The diversification of portfolio between many different shares helps to achieve the same expected rate of return with the considerably lower risk. There is no such thing as the best stock, share, company or investment.

No investment is risk free!

Investment is not risk free. Something happens to each company sooner or later. The single event is as complicated to predict. It is almost impossible to forecast future.

There is famous old saying “Do not put all eggs into one basket”. We call it diversification or portfolio theory. Economist Harry Markowitz introduced modern portfolio theory in 1952 and got Nobel Prize for that in 1990.

I will talk more about the diversification principles later in my blog, but the general approach is that the portfolio consisting of 30-50 shares is necessary to achieve decent diversification.

If you do not have enough funds to diversify the portfolio between 20-30 stocks, I also I recommend the beginners to buy Exchange Traded Funds (ETFs). For those who are interested to learn more, there are lot of ETF websites and the background of ETFs are well defined in Wikipedia. And here are the arguments supporting investing in ETFs:

– the expenses of index funds are usually much lower of the regular share funds. More than 70% of equity funds in the whole world remain each year below the return of indices.

– it is often very complicated to understand the investment strategies of regular equity funds. Often, the overrated “piglet in a sack” is sold to the client. The long-term rate of return of index funds is better predictable.

  1. Investments should be diversified between sectors and countries. If we look back in time, certain economic sectors boomed at different times. Japan and biotechnology in the 90-ies, internet shares in the year 2000, the East European region in the years 1997-1998.

If we invest only in our favourite shares, for example in technology or internet companies, we are connected with very serious and unnecessary risk that everything goes once down the hill, including the money invested by us.

Thus one’s world view should be broadened. One should invest in different companies, different economic branches, countries and districts. Once again it is most simple and cheapest to do it through ETFs. The advanced investors can establish such portfolio consisting of different districts independently.

Today it is easy to buy indices covering different countries and economic branches. In addition to the latter single shares can be always added.

  1. Be continuously involved in investing, stay at the stock market

If you have followed the diversification principles recommended by me, there is one more important and unpredictable risk. This is a panic of stock exchange. My recommendation – do not invest all your available means into shares, keep liquidity. In my section of articles I teach in more detail how to invest in shares in a reasonable manner. I teach value investment principles and when to buy and sell shares, how to buy cheap and sell expensively.

The experienced and successful investors have two main choices for the protection of occasional events:

  • to hedge whole or part of the portfolio
  • or stay in cash and avoid making large investments during unstable and volatile times

By following my above provided four simple rules it is quite probable that investor earns money at the stock markets. As a disclaimer it can be stated that investor makes his transactions still independently and I cannot assume liability that the recommendations made on the given information of the past ensure future success for the investor.

Choose the right broker

What to do when there is not enough money to invest in the company and the transaction costs take a too large part of the amount to be invested? First I recommend using quality brokers or the bank you are currently keeping your cash. I am active investor and I need to keep transaction costs as low as possible. As I am active investor and low fees and reliable software is very important, so I am using OptionsHouse.com (by E-Trade company) for buying options and stocks.

« Part 2. Achieving adequate rate of return go back, or continue Part 4. Start investing now »