Stock investing is probably the most reliable way to grow your wealth over the long term. Investing in stocks has also become more accessible to individual investors thanks to lower fees and the tools and information now available.
This is an introductory guide for anyone who wants to start investing in stocks. In this guide we have tried to include all the basics you should know before you buy your first stocks. In further articles we will build on these topics in more detail.
- Why invest in stocks?
- What do you need to get started investing in stocks?
- What is a stock?
- 6 Ways to categorize stocks
- Are you investing, trading, or speculating?
- Should you invest in equity funds or make direct stock market investments?
- Active vs. passive stock investing funds
- Stock investing strategies
- When should you buy a stock?
- When should you sell a stock?
- Key stock investing ratios and metrics to know about
- 5 Tips to help you get started investing in stocks
Why invest in stocks?
Stocks, which are also known as shares or equities, are an asset class – the other major asset classes being bonds, commodities, real estate and currencies. Apart from a few isolated periods in history, stocks have always outperformed these other asset classes. A recent study by Deutsche Bank showed the following real returns (after inflation) for major asset classes in the US from 1920 to 2020.
As you can see, stocks have consistently outperformed the other asset classes. There is a very simple reason for this. Companies can reinvest their cashflows to grow, thereby compounding their profits. A company’s shareholders are the ultimate owners of those profits. In addition, companies are exposed to economic growth and inflation, which act as tailwinds for stock values and prices.
Investing in stocks has proved to be the most reliable way to generate wealth with the savings you already have. There are other ways to invest – real estate and private equity for example – but they tend to carry more risk and require specialist skills. This is why stock investing should be at the core of most people’s strategy to grow their wealth.
What do you need to get started investing in stocks?
To start buying and selling stocks, all you really need is a trading account with a brokerage and a few hundred dollars (or any other currency). A brokerage account typically gives you access to a trading platform, with real time stock quotes and lots of tools to help you make investment decisions and manage your portfolio.
However, to make money reliably by investing in stocks you will need more than just a brokerage account. You will need a strategy and you will need to develop your knowledge of the stock market. There is a fine line between investing wisely and gambling – and a strategy will help you stay on the right side of that line. A strategy can include an approach to investing, a system, or a process that you follow to decide which stocks to buy and sell, and when.
InvestOpen exists to provide educational content, insights, and resources to help investors make educated investment decisions. Before we discuss investment strategies and tactics, we will cover some of the basics that you’ll need to know before beginning your stock investing journey.
What is a stock?
A stock or share is a share of ownership of a company. Technically, the relationship between a company and its shareholders is quite complicated, but the most important element is the rights that shares give their owners. Unless otherwise stated, we are referring to common shares here. The exact wording may vary from one country to the next, but typically a share gives its owner the following six rights:
- An equal claim on the company’s assets in the case of liquidation. However, common shareholder claims come after those of creditors, bondholders and preferred shareholders.
- The right to receive an equal share of any dividends the company pays.
- The right to vote on important company issues.
- The right to transfer ownership of the share.
- Access to company information.
- The right to sue the company in the case of wrongful action, or in the event that these rights are violated.
These six legal rights are what you technically are entitled to when you buy stocks. But you are really buying a share to make a profit, either in the form of dividends or a capital gain. From an economic perspective, when you buy a share, you are buying a share of the company’s future cash flows.
Cash flows are either paid out as dividends or reinvested in the company. If they are reinvested, they increase the cash generating capacity of the business – i.e., future cashflows. Thinking about stocks in terms of cash flows is the key to understanding the valuation of a stock, and whether you are likely to make a profit when investing in stocks.
6 Ways to categorize stocks
Stocks can be categorized in various ways, which is useful as there are tens of thousands of listed companies in the world. By categorizing stocks, you can decide which one’s interest you and specialize in certain segments of the market. And if you know the different ways to categorize stocks, you can use stock scanners like the FINVIZ stock screener to easily find the shares you want to own.
The easiest way to divide the market up, is by market value. Historically, the market was divided into three categories – small, medium and large cap stocks. Over the years, the list has expanded to about six categories. There are no official rules, but the following categories are commonly referenced:
- Mega Cap: $200 billion +
- Large Cap: $10 to $200 billion
- Mid Cap: $2 to $10 billion
- Small Cap: $300 million to $2 billion
- Micro Cap: $50 to $300 million
- Nano Cap: less than $50 million
Larger companies are usually more stable, and their shares are more liquid and less volatile. Small cap stocks should be regarded as risky, and micro and nano-caps as very risky. The term “penny stock” is often used when referring to small, micro and nano-cap stocks.
Country and region
The stock market is becoming increasingly globalized, and a lot of companies are listed in several countries. But it’s still worth paying attention to the country in which each company does most of its business. Countries and regions have different types of economies and demographic profiles which affect the companies located there. Besides individual countries, stocks can fall into various regional groups. These are some of the common regional groups:
- Global excluding US
- Emerging markets
- Asia excluding Japan
- EMEA (Europe, the Middle East and Africa)
The third way to categorize stocks is by sector. There are various ways to classify companies which results in between 8 and 11 market sectors. The most widely used classification system, the Global Industry Classification Standard (GICS) lists the following 11 sectors:
- Communication services
- Consumer discretionary
- Consumer staples
- Information technology
- Real estate
Sectors can be further divided into industries. The GICS actually divides sectors into industry groups and then into industries. For example, the communication services sector is divided into the following industry groups and industries:
- Telecommunication Services:
- Diversified Telecommunication Services
- Wireless Telecommunication services
- Media and Entertainment
- Interactive Media and Services
In total there are 24 industry groups and 68 industries. Some industries are further subdivided into subindustries. The GICS framework is designed to change as the economy changes.
Stocks can also be classified according to investment themes and narratives. Examples include EVs (electric vehicles), renewable energy, cloud computing, blockchain, metaverse and cannabis stocks. Themes like these can include stocks from several sectors and industries.
Marketing departments and the financial media love these themes because it’s easier to sell a story than the financial attributes of an investment. This means that themes go hand in hand with hype and sentiment – and tend to come and go like fads and fashions.
Investors often focus on companies with certain investment attributes. The following six attributes are commonly used:
- Growth stocks belong to companies that are growing their profits rapidly or operating in new growing markets.
- Value stocks are shares that are trading at attractive prices relative to their intrinsic value.
- Cyclical companies belong to industries that are closely tied to the business cycle and to changes in interest rates.
- Defensive companies are less sensitive to the business cycle and have more predictable cash flows.
- Dividend stocks pay higher than average dividends which allows investors to generate regular cash flow.
Of course, any of these categories can be combined. So, you invest in small cap growth stocks, mega cap tech, biotech penny stocks, or EMEA utilities.
Other types of stocks
The term stock or share is usually used to refer to a company’s common stock that is listed on a stock exchange. You are likely to also encounter a few other types of company shares, including:
- Preference shares or preferred stock issued by a company are a hybrid equity/bond. They usually pay a fixed dividend and in the case of liquidation they are paid out before common stock holders.
- SPACs, or special purpose acquisition companies, are listed companies that are set up to acquire unlisted companies. They speed up the listing process of the acquisition target.
- OTC, or over-the-counter, stocks are shares that are traded, but are not listed on stock exchanges like the Nasdaq or London Stock Exchange. OTC stocks are traded on OTC exchanges, but are not subject to the same scrutiny as publicly listed stocks – so they carry more risk.
- REITs, or real estate investment trusts, are listed companies that invest in real estate, primarily to generate rental income which is distributed to shareholders as dividends.
- ETFs, or exchange traded funds, are listed investment vehicles that own shares or other assets. ETFs typically mirror the constituent companies or assets of an index to replicate the performance of the index.
Are you investing, trading, or speculating?
Before you buy a stock, it’s important to decide whether you are investing, trading or speculating. These three terms are often used interchangeably, but there are some differences. When you invest in a company, you are primarily concerned with the company’s ability to generate cashflow, and to reinvest any retained earnings profitably.
You will be looking for the share to increase in value due to increased profitability over time. You will probably also consider both the share price and the intrinsic value of a share. Investors generally invest in companies with proven business models and have a long-term time horizon.
Stock trading is all about price, supply, and demand. Traders anticipate changes in price that will be caused by changes in supply and demand over the short to medium term. These changes may be caused by news events, sentiment changes or technical factors.
Speculating means investing or trading based on a theory or the hope that something will occur. If you buy a stock because you think the company will make a positive announcement, you are speculating. If you invest in an unprofitable company with an unproven business model, you are speculating.
This distinction is important as beginner investors often speculate without appreciating the risk they are taking. Speculation is driven by media hype and FOMO – the fear of missing out, and often results in investors buying too many risky stocks and not enough high-quality stocks.
Should you invest in equity funds or make direct stock market investments?
If you don’t want to invest in individual stocks, you can invest in ETFs and mutual funds. But which approach to stock investing is better? If you have no interest in the stock market or in companies, then you should definitely stick to funds, or leave your investments to an advisor. If you don’t find investing in companies interesting, you’ll struggle to put in the work it takes to be successful at stock investing.
However, if the market does interest you, there are good reasons to invest in both stocks and funds. Investing can be a very rewarding hobby, and there is no reason that individual investors can’t build an investing edge over time. If you are unsure, the sensible approach is to start with funds like ETFs, and add individual stocks as you learn more about stock investing.
Active vs. passive stock investing funds
Investment funds are either managed actively or passively. If a fund is actively managed, the fund manager decides when to buy and sell stocks based on their analysis of each company. Most actively managed funds are mutual funds, but there are a growing number of active ETFs too.
Passively managed funds are designed to track an index like the S&P 500 or MSCI world index. These funds mirror the holdings of the index to ensure that the performance tracks the index performance. Most passively managed funds are ETFs that can be traded just like any other stock.
Actively managed funds charge higher fees as they require more resources to manage. In theory, actively managed funds can deliver better performance than funds that merely track an index. However, in reality most actively managed funds underperform their benchmarks. For this reason, most investors hold a mix of ETFs and individual stocks in their portfolios.
Stock investing strategies
At its heart, investing is about buying stocks that will appreciate in price and value, or that will pay you a growing stream of dividend income. But how do you go about selecting stocks, deciding when to buy them, and if or when to sell them? Do you buy the stocks everyone’s talking about, or the stocks that have gained the most in the last year? Or do you buy the stocks that have fallen the most in the last year? How about buying stocks in companies that you buy products from?
There are lots of different ways to make money from stock investing and each investor will develop their own process using techniques that make sense to them. The following are the most basic investing strategies to know about.
- Buy and hold investing is self-explanatory, you simply buy a stock and hold it indefinitely. This is a good strategy if you believe a company will be around for a very long time and has top notch management.
- Value investing is all about buying a stock at a good price relative to its intrinsic value. If you can buy a stock at a discount to its value, your downside should be limited, and you benefit if the intrinsic value increases or when the market realizes the stock is undervalued. Value investing requires a solid understanding of stock valuation and accounting methods.
- Growth investing is focused on growing companies. Growth investors are more concerned with a company’s ability to grow and compound their profits than they are with the valuation. The shares of growing companies usually trade at a premium, so you need to be certain that the company can grow enough to justify the premium and still generate a decent return.
- Momentum investing is a strategy based on buying the stocks with prices that are rising the fastest. Momentum investing is a surprisingly effective method of stock investing, but is also very risky. Momentum stocks tend to rise the most during bull markets, but decline the most during bear markets.
- Income investing is concerned with generating cash flow. You can do this by investing in stocks with above average dividend yields or yields that are increasing steadily. There’s a lot more to dividend investing than picking stocks based on their yield – you also need to make sure that the company’s cash flows are sustainable so it can keep paying dividends.
The five strategies listed above are popular and simple approaches to making money from stock investing. Other more advanced strategies include quantitative investing, factor investing and penny stock investing. In addition there are countless methods of trading and speculating.
When should you buy a stock?
Your decision to buy a stock should be guided by your strategy and your time horizon. If you are buying a stock because you think the company will continue to grow for a very long time, the exact timing of your investment will make little difference to the overall return.
You could buy the stock as soon as you decide it’s a company to own, or you could wait for a dip in the share price. If you are following a specific strategy, then you should let that strategy dictate when you buy a stock – rather than letting news and events dictate your stock purchases.
When should you sell a stock?
The decision to sell a stock should relate to the reason you bought the stock. It’s important to avoid the trap of investing in stocks for one reason and then selling them for another reason. If you buy a stock when you believe it is “cheap”, you should only sell it when you think it’s “expensive”.
If you buy a momentum stock, you will look to sell it when the momentum fades. If you are investing in stocks because you believe in their growth potential, you should sell them when you no longer believe in the growth potential.
Key stock investing ratios and metrics to know about
There is more to investing in stocks than the brand, the media hype and narrative that goes with a company. To deliver a return, a company needs to be profitable or on a path to profitability, and you need to pay a reasonable price. The following ratios will give you an idea of what you are actually buying when you invest in a stock.
The price/earnings ratio, or price multiple, of a share is calculated by dividing the share price by the earnings per share over the last 12 months. This tells you how many years it would take for the company to earn profits equal to the price you paid if the earnings remained static. P/E ratios are useful when comparing different stocks, or when comparing a stock’s current valuation to its historical valuation. The higher the P/E ratio of a stock, the more earnings growth is required to justify the price.
If you are considering investing in stocks that are not yet profitable, the P/E ratio will be meaningless. In this case, you can use the price/sales ratio (share price/revenue per share) to compare similar stocks.
Revenue growth and earnings growth
The objective of investing in stocks is to invest in companies that are increasing in value. To do this, a company needs to grow its earnings per share. To increase earnings per share, a company can either improve its profit margin, or increase sales. To understand how well a company is growing earnings and revenue you can consider the growth rates over 12 months and 5 years. This will indicate whether growth is slowing or accelerating, and give the valuation some context.
Three different profit margins are typically referred to for a company: the gross margin, the operating margin and the net margin. Of these, the operating margin is probably most useful as it reflects the profitability of the core business and excludes one-off expenses and income.
If a company has an operating margin of 20 to 30% or more, it indicates the company is probably a market leader with pricing power. An operating margin of 5% or less indicates that the company operates in a very competitive industry, or is not yet benefitting from economies of scale.
Stocks with negative margins can turn out to be great investments – but they can also turn out to be terrible investments. If you are investing in companies that aren’t profitable, you should be very confident that they can become profitable, or you should treat them as momentum investments.
A company’s ROE or return on equity is another measure of profitability. The ROE is calculated by dividing the net income by the equity value of the company. The ROE will give you an idea of the return the company is generating on its equity (assets less liabilities). A ROE of 15% or more is considered good.
Debt to equity ratio
Finally, the debt-to-equity ratio reflects a company’s use of leverage. Debt can be a useful way to increase returns, but can also get companies into trouble. Ideally a company should have a debt-to-equity ratio below 0.5 – however some industries have much higher ratios.
Before investing in stocks, its worth comparing the debt-to-equity ratio to similar companies to get an idea of the potential risk. When you are investing in stocks, it’s very seldom that you will find the perfect company at the perfect price. Instead, you will need to find a balance between valuation, profitability and growth.
5 Tips to help you get started investing in stocks
- Start with a low-risk portfolio
- Experiment with paper money
- Pick a strategy that fits your personality
- Leverage your skills and strengths
- Develop a process
1. Start with a low-risk portfolio
Start out by investing at least 50 to 80% of your portfolio in ETFs that track broad based indexes like the S&P500 or the MSCI World index. This will give you diversified exposure to the equity market. You can then invest in a handful of individual stocks, investing no more than 2-3% of your portfolio in each. When you start out, stick to blue-chip stocks, i.e. profitable companies with reliable cashflows and strong brands and leadership.
2. Experiment with paper money
Now that you have some money in the market, you can learn and experiment by paper trading with a demo account. Have a look at our article on paper trading and backtesting to find out how to get the most out of a demo account.
3. Pick a strategy that fits your personality
Use an investing strategy or method that makes sense to you and matches your personality. If you are contrarian by nature, value investing may be a good fit. On the other hand, if you struggle to go against the crowd, growth or momentum investing will be a better fit. You will find it a lot easier to stick to your plan if you aren’t fighting against yourself. Have a look at this post on finding your niche in the market to get a better idea of how to pick an investing style that matches your personality.
4. Leverage your skills and strengths
Outperforming the market requires an edge of some form. When you start investing in stocks, the easiest way to develop an edge is by using skills you already have. If you have domain knowledge in a particular industry, you can build an edge by focusing on companies in that industry. If you are an accountant, you may be able to build an edge by digging into financial statements. Any knowledge you already have could be a starting point for your own investing process.
5. Develop a process
Consistency is an essential element of successful stock investing. There are lots of ways to make money in the market, but jumping from one approach to another seldom works. Developing a process will help you maintain consistency.
Successful investors borrow and adapt ideas from other investors, but ultimately develop their own methods and techniques. To do this you need to be realistic about your capabilities and the amount of time you want to spend on your investing.
Conclusion: Getting started with stock investing
Investing in stocks is both a lifelong hobby (or career) and a lifelong learning curve. Even Warren Buffett is still learning and still makes mistakes. The good news is that you can make money along the way, as long as you don’t allow anyone investment to wipe out your portfolio.
This guide is intended as a starting point for anyone wanting to learn how to invest in stocks. In future posts we will go into more detail on each of the topics we have covered here. If you have any questions on stock investing, please let us know in the comments below.