The 5 Step Guide to Getting in the Stock Market
Create future opportunities for yourself through investing
I remember investing my first thousand dollars into the stock market. It was the most exciting thing I’ve ever felt until it wasn’t… That is, when I started losing money.
Risk? Diversification? I had no idea what any of that was... I only knew one thing — I wanted to get rich. This meant chasing investments that could triple my money. What I didn’t realize was that this meant I also had a higher chance of losing money.
I learned over the years (painfully in some cases) that investing can be a powerful way to build wealth, if done correctly. It requires patience, a long term mindset and a thorough understanding of investing. What you’ll find in this article are practical steps to start investing and a lesson on fundamental investing concepts.
To show you why investing is important, I’ll give you two scenarios:
Scenario #1: Say you invest $10,000 into the stock market and contribute an additional $1,000 each year. Your total capital will grow to ~$476,302 at the end of 40 years (assuming you earn the stock market average return of ~8% per year).
Result: Your total investments of $50,000 will have grown over 9x.
Scenario #2: You invest $0 into the stock market and contribute an additional $0 each year. Your total capital will have grown to ~$0 by the end of 40 years.
Result: Your investment will have grown by a grand total of 0.
Investing creates future opportunities. It helps you save for big purchases (e.g. house, car), gives you the option to retire earlier or creates an additional income source. Now, why should you invest? To create opportunities, build your wealth and so you don’t end up in scenario 2.
The goal of this article is to set you up to purchase your first investment. Here we go through 5 fundamental points that will help you succeed:
- Understanding your investment horizon
- Choosing a portfolio allocation
- Finding the investment type that fits you best (ETFs vs mutual funds vs stocks)
- Deciding how much money to start with
- Picking a broker
1. Understanding your investment horizon
The investment horizon is the amount of time an individual expects to hold an investment before cashing out. i.e. if you’re planning on buying a house in 5 years and expect to pull your money out for a down payment, 5 years will be your investment horizon. This is an important decision that will impact the types of investments you buy and the level of risk you take.
Stocks are highly volatile and markets are prone to sudden crashes that could take years to recover. It might not be a smart decision for someone looking to retire in 2 years to put all their money into risky investments. For example, in 2007, the stock market crashed and lost over 50%. It took over 3 years before the market recovered to its pre-crash value.
What is your investment horizon?
Short-term horizon period (1–3 years) — These investors are better off putting their money in lower-risk investments with a larger portion in guaranteed assets (e.g. low yield bonds, high-interest savings accounts, certificates of deposits, or lower risk bonds and stocks).
Medium-term horizon period (3–10 years) — These investors can afford to choose investments with higher risk (e.g. bonds and stocks).
Long-term horizon period (10+ years) — These investors can afford to put their money into bonds and stocks with a higher allocation towards stocks.
PRO TIP: You should look to sell part of or all of your investments before the end of your investment horizon period. It’s often good practice to sell your riskier investments, which has greater short-term price changes, even earlier.
2. Choosing a portfolio allocation
Portfolio allocation is the process of spreading your investments across different investment types. This diversifies your portfolio and spreads out your risk amongst various asset classes. Unexpected events (e.g fraud, pandemics, natural disasters) can impact companies at random. Diversification is the only way to protect your portfolio from these unexpected events.
Two of the most common investment types accessible by everyday investors are stocks and bonds:
Stocks (equity) are an investment that represents ownership units in a company. These units are called shares and they can be bought and sold on the stock market.
Stocks are known to provide investors with higher risk and potentially higher returns.
Bonds (fixed income) are a type of loan made to a borrower (i.e. business) that can be bought and sold by investors. A bond will pay the investor the original loan amount (i.e. money you invested) at the end of the loan date along with regular interest payments.
Bonds are known to provide investors with lower risk and potentially lower returns.
The most common portfolio allocation recommended by financial advisors is the 60/40 portfolio, putting 60% of your investments into stocks and 40% into bonds. However, this recommendation does not take personal circumstances into account (i.e. investment horizon and risk tolerance).
Not sure what your allocation should be? Here’s a simple rule to decide: Take 110 and subtract it by your age. This number will be the amount to put in stocks, i.e A 30-year-old would invest 80% of their investments into stocks (110–30 = 80). As you get older, your bond portfolio should slowly grow.
3. Finding the investment type that fits you best (ETFs vs stocks vs mutual funds)
Investors can get exposure to stocks by investing directly in stocks, exchange-traded funds (ETFs) or mutual funds. In this section, I go through the different options, explain what they are and decide what the best option is for you.
⚠️ Caution: New investors should get a good understanding of investing before diving into more advanced investment types (e.g. options, forex, cryptocurrency, futures). These are highly complex investments that require a deep understanding of finance and investing.
Understanding Equity ETFs
Exchange-Traded Funds (ETFs) is an investment that contains a basket of different investments (e.g. stocks and bonds). Like many other investments, they can be bought or sold on the stock market. Most ETFs are considered a passive investment that is designed to be bought and held for a longer period of time.
ETFs have several benefits that make them great investments:
- Diversification… By buying an ETF, you spread your risk amongst multiple companies or bonds — this protects your portfolio even if one company fails.
- Low annual fees… In most cases, ETFs have a lower fee than mutual funds, a similar investment product.
- Low maintenance… Investors can often hold an ETF for a long period of time without actively managing the investment.
- Simple… Investing in ETFs are much simpler than choosing stocks. Investors can buy a diversified basket of stocks without having to spend time individually choosing a portfolio of stocks.
ETF Example
The SPDR S&P 500 ETF ($SPY) is one of the largest ETFs in the world. This ETF gives the investor exposure to the 500 largest companies in the United States. Buying the SPDR S&P 500 ETF is the same as owning a tiny percentage in each of the largest 500 companies in the US. This ETF trades under the stock ticker symbol “SPY”.
Did you know: Stock ticker symbols are unique letters given to each company that helps investors identify the company. Investors can use these symbols to ensure they’re buying the correct stock. Many investors mistakenly buy the wrong company with a similar name or similar ticker symbol.
Investors pay a 0.09% annual fee for holding the S&P 500 ETF. Someone who invests $1000 will pay 90 cents per year in expenses. 0.09% is considered low as some fees can reach as high as 1.5–2% while the average is around 0.5% to 0.75%.
The chart below shows the price of the SPDR S&P 500 over the past 20 years. Just like a stock, investors can buy and sell shares of the ETF and watch its value go up and down over time.
Understanding mutual funds
Mutual funds are very similar to ETFs. They both invest in a diverse basket of stocks and bonds, require minimal maintenance and have low annual fees. Mutual funds are actively managed by fund managers who watch over the fund and select the investments that are bought and sold overtime. Mutual funds typically have a higher annual fee compared to ETFs.
Mutual funds offer an even more simplified approach to investing in the stock market than ETFs. There are several mutual funds that will build a complete portfolio of stocks and bonds. On the other hand, ETFs usually invest in one type of asset (stocks or bonds). Those that invest in ETFs will have to choose separate ETFs for stocks and a separate ETF for bonds.
The Income Fund of America (AMECX) is an example of a mutual fund that holds stocks and bonds.
Understanding stocks
As defined above, stocks represent percentage ownership in a company. By investing in stocks, you expose yourself to two different types of risk:
- Market risk (systematic risk)… This is a type of risk that will impact all companies in the market (e.g. recession, pandemic, natural disaster).
- Specific risk (unsystematic risk) … This is the risk related to an individual company that includes operational, financial and regulatory risks (e.g. a company running out of cash, being sued).
Buying ETFs and mutual funds eliminate specific risk (unsystematic risk) from an investors’ portfolio. Even if one company were to go bankrupt, ETFs and mutual funds are diversified enough that the impact will be minimal.
On the other hand, if an individual chooses to invest in 2 different companies for their portfolio, a bankruptcy in one company will have a significant impact. Investors can avoid this by investing in multiple companies. There isn’t a right number of stocks to hold but it is common practice for investors to hold 10–30 different companies at once. If you have less time to manage your portfolio, it may be better to invest in the low number of that range — this gives you more time to focus and understand every single company you invest in.
Market risk on the other hand is unavoidable. These types of risks affect a whole industry (e.g. a pandemic will affect most companies). However, investors can lower this type of risk by diversifying even further through investments in other countries (recommended for more advanced investors).
Now that you understand what ETFs, mutual funds and stocks are, it’s time to decide what to invest in…
Based on your time constraint, risk tolerance and interest in finance, you will fall into one of the following categories:
🐷 Mutual Fund Piglet
- Little time to invest… “Struggling to find time to even sit down and read this article.”
- Highly risk-averse… “Won’t even step foot in a casino.”
- Put to sleep by finance… “Price/earnings ratio? Bull market?… Just stop right there!”
🐻 ETF Lovin’ Winnie
- Moderate amount of time to invest… “Willing to put a couple hours a week into research.”
- Comfortable taking some risk… “Makes $20 after 4 hours at the casino.”
- Interested in learning more about finance… “Finance isn’t so bad.”
🐯 Stock Trading Tigger
- Lots of time to invest… “Willing to spend 10–20+ hours/week on research.”
- Risk loving… “Able to stomach big gains as well as big losses.”
- Excited about finance… “Can’t get enough of investing!!”
4. Deciding how much money to start with
Before zero-fee trading was introduced, it would traditionally cost $5 to execute a purchase or sell an order on a brokerage platform. The higher the trading fees, the higher your profits must be to cover the cost of trading. Say you were buying an individual stock worth $10. The stock will have to double to $20 to cover your trading fees ($5 to buy and $5 to sell).
What investing looks like today for the retail investor:
The introduction of zero-commission trading fees completely changed the game for everyday investors. That $5 fee that you had to pay for trades dropped to $0. This made it much more profitable to trade with a lower amount of starting capital. One can easily sign up for a brokerage account and dive into the stock markets with the equivalent of their lunch money.
So how much money should you start with? Investors can start with as little as $5. I encourage starting with a smaller amount to familiarize yourself with the market before putting more money in.
There’s no limit to how much you can start with but there is a limit to how much you should invest into the stock market.
Never invest 100% of your money
With every investment, there is the risk of your investment going to zero. The odds of this happening will vary for each investment.
Take our SPDR S&P 500 ETF as an example. The only way for you to lose the entirety of your investment is if the value of all 500 companies in this index drops to 0. I’m talking about the largest 500 companies in the US including Apple, Facebook, Netflix, etc. The likelihood of this happening is not impossible, but extremely unlikely.
On the other hand, investing in a single company exposes you to a greater set of risks. Anything could happen to that company. Fraud, natural disasters, pandemics, etc., could all put that company on the path to bankruptcy.
Risk cannot be avoided in investing, it can only be controlled and the best form of control is diversification.
Never invest more than you’re willing to lose.
Start small, get comfortable and slowly build your portfolio size up
Professional investors spend months researching and understanding a potential investment before hitting the buy button. You probably don’t have months to spend on one investment but resist putting 100% of your money into the first company you find.
- Phase money into the stock market by dividing up your purchases over time.
- Take the time to research and understand what you’re buying.
5. Picking a broker (US edition)
The first step into your investing journey, choosing a broker. This will be the tool you use to access the stock market to buy and sell your investments. The largest brokerages offer very similar services, fee structures and security features. However, they all have slight differences that may make one a better choice for you.
There are a couple of key considerations that new investors should focus on. Below I prioritize them from the most important to the least along with some recommendations. These recommendations are all reputable, secure and low cost with zero-commission trades on stocks and ETFs.
What should you consider?
How much experience do you have with investing? Certain brokerages provide basic educational resources, glossaries and access to support staff.
- Best for beginner investors: TD Ameritrade, E*TRADE, Merrill Edge
What types of investments will you be buying? Different brokers are known for certain investment types (equities, ETFs, options, commodities, etc).
- Best for stocks/bonds/ETFs (recommended for new investors): TD Ameritrade, E*TRADE, Charles Schwab, Fidelity, Robinhood
Will you be trading on your mobile phone or desktop? Each broker offers a different web or mobile interface that may make it easier or harder to place trades.
- Easiest to use on either device: TD Ameritrade, E*TRADE, Robinhood
Putting it all together
At this point, you should have a couple things checked off on your list:
- Understanding your investment horizon
- Choosing a portfolio allocation
- Finding the investment type that fits you best (ETFs vs stocks vs mutual funds vs stocks)
- Deciding how much money to start with
- Picking a broker
This information sets you up to begin investing and the next step is selecting your first investments. In later posts, we dive into the selection process and how you can purchase your first investment.
This is the first part of our Investing for The Average Joe series. Subscribe here for updates on future releases.
This post is a collaboration between The Average Joe and yumi money.
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