How to Invest in Stocks

It’s no coincidence that many wealthy individuals invest in the stock market. While investing can come with risks of loss, it's still one of the best ways to achieve financial security, independence, and build wealth. Whether you’re just starting to save or already have a retirement fund, the money you earn should be used effectively, just as you actively earn it. However, to succeed in investing, it's important to understand how stock investments work. This article will guide you through the investment decision process and the right path to becoming a successful investor. It will also specifically cover stock investments. For trading stocks, you can check out the article 'How to Trade Stocks.' For investing through mutual funds, refer to the guide on deciding whether to buy stocks or fund shares.

Create a list of what you want. To set your goals, you need a clear idea of what experiences or assets you need to achieve your desired amount of money. For example, what kind of lifestyle do you want after retirement? Do you love to travel, buy new cars, or enjoy fine dining? Or do you have more modest needs? Use this list to help you define your objectives in the next step.

• This list also helps if you're saving for your children's future. For instance, do you want to send them to private high schools and universities? Do you wish to buy them a car? Or would you prefer to send them to public schools and use the extra funds for other purposes? Having a clear idea of what matters most to you will help set the goals for your savings or investment plans.

Set Financial Goals. To build an investment plan, the first thing you need to do is understand why you want to invest. In other words, what are your financial goals, and how much do you need to invest to achieve them? The more specific your goals, the better you will understand what you need to do to reach them.

• Common financial goals typically include buying a house, paying for children's education, creating an emergency fund, and saving for retirement. Instead of having a broad goal like 'owning a home,' be more specific. For example: 'I need to save $63,000 for a down payment on a $311,000 house.' (Most mortgage loans require a 20%-25% down payment to secure the best interest rates.)
• Most investment advisors suggest saving at least eight times your highest salary for retirement. This enables you to receive 85% of your pre-retirement income as pension payments. For example, if you want to retire on $80,000 per year, you need to earn $64,000 annually in the years before retirement.
• Use a student-oriented financial calculator to estimate how much you need to save for your child's college expenses. Factor in any financial aid your child might receive and calculate your contributions based on your net income for those large costs. Keep in mind that expenses can vary significantly by location and the type of school (public, private, etc.). Also, note that college costs include not only tuition but also room and board, travel, books, and other miscellaneous expenses.
• Consider the time factor when setting your goals. This is especially relevant for long-term goals like retirement funds. For example: Nam starts saving at age 20 using an Individual Retirement Account (IRA) with an 8% annual interest rate. He saves $3,000 per year for the next 10 years, then stops contributing but continues to invest. By the time Nam reaches 65, he will have accumulated $642,000!
• Several websites provide 'savings calculators' that estimate how your investments will grow over time with a given interest rate. While these tools can't replace professional financial advice, they offer a great starting point.
• Once your goals are set, you can determine how far you are from achieving them and calculate the necessary annual return rate.

Assess Your Risk Tolerance. Investment returns often come with risks. Risk tolerance consists of two key components: your ability to handle risk and your willingness to accept it. There are a few crucial questions you should ask yourself:

• What stage of life are you in? Are you far from or nearing the peak of your potential income?
• Are you prepared to accept more risk in exchange for higher rewards?
• What is the time horizon for your investment goals?
• How much liquidity do you need (assets that can be easily converted to cash) for short-term goals and to maintain an emergency reserve? Don’t invest in stocks until you have at least six to twelve months of living expenses saved up in case of job loss. If you find yourself needing to sell stocks before a year to meet liquidity needs, you are speculating, not investing.
• If an investment’s potential risk exceeds your tolerance, clearly it is not a suitable option. Walk away!
• You should allocate investments based on your age. For example, when you're young, you can allocate more into stocks. Similarly, your job will influence your allocation. If you have a stable, high-paying job (like bonds), your income is steady, and you can invest more in stocks. Conversely, if your job is more like stocks, with unpredictable income (e.g., sales or brokerage), allocate less to stocks and more to bonds. While stocks may grow wealth faster, they also carry higher risks. As you get older, you can gradually shift toward more stable investments like bonds.

Explore the Market. Take time to immerse yourself in the world of the stock market and the economy. Listen to expert analyses and forecasts to develop a deeper understanding of macroeconomic conditions and spot promising stocks. Classical investment books will provide you with a solid foundation:

• The Intelligent Investor and Security Analysis by Benjamin Graham are excellent introductory books on investing.
• Interpreting Financial Statements by Benjamin Graham and Spencer B. Meredith. This concise guide teaches you how to read financial reports effectively.
• Expectation Investing by Alfred Rappaport and Michael J. Mauboussin. This easy-to-read book offers a fresh perspective on stock analysis and fills in gaps left by Graham's works.
• Common Stocks and Uncommon Profits (and other essays) by Philip Fisher. Warren Buffett once mentioned that he learned 85% from Graham and 15% from Fisher. This book illustrates Fisher's influence on Buffett's investment style.
• "The Essays of Warren Buffett" is a collection of Buffett's annual letters to shareholders. Buffett has built a massive fortune through investing, and his letters offer invaluable advice for anyone looking to follow in his footsteps. These letters are available online for free at: www.berkshirehathaway.com/letters/letters.html.
• The Theory of Investment Value by John Burr Williams is considered one of the best books on stock valuation.
• One Up on Wall Street and Beating the Street by Peter Lynch, an outstanding financial manager. Both books are easy to read, filled with useful insights, and sprinkled with humor.
• Extraordinary Popular Delusions and the Madness of Crowds by Charles Mackay and Reminiscences of a Stock Operator by William Lefevre. These books use real-world examples to demonstrate the destructive effects of excessive emotions and greed in the stock market.
• You can also enroll in basic or beginner investment courses online. Occasionally, you can find free courses from companies like Morningstar and T.D. Ameritrade. Many universities, including Stanford, offer online investment courses as well.
• Community centers and adult education centers also provide finance-related courses. These courses often have low or no tuition fees and offer a general overview of investing. Check online for local courses in your area.
• Consider practicing “virtual trading.” Simulate buying and selling stocks, using the daily closing prices. You can practice on paper or use free online accounts provided by sites like How the Market Works. Practicing allows you to hone your investment strategy and knowledge without risking real money if you incur losses.

Build Your Market Expectations. Whether you're a seasoned professional or just starting, this step can be the toughest as it blends science with art. This process requires you to develop the ability to analyze large financial datasets to understand how the market operates. You also need to build a "market sense" to interpret what the data reveals and what it doesn't.

• This is why many investors buy stocks of products they are familiar with and use. Pay attention to the products around you, from furniture in the living room to items in your refrigerator. You have firsthand knowledge of these products, allowing you to easily compare them to similar ones.
• For household products, try to imagine the conditions that would make you stop buying it, buy more of it, or purchase less.
• If others are also purchasing products that you know well, you could consider this a strong investment assumption.

Focus on Your Thought Process. As you work to develop general expectations about the market and identify companies that could thrive based on current or forecasted economic conditions, making predictions becomes crucial in areas such as:

• The trends in interest rates and inflation, and how they might impact fixed income or equity acquisitions. When interest rates are low, consumers and businesses can easily access capital. Consumers have more money to spend, leading to higher consumption. As a result, companies generate more revenue and may expand their operations. This often drives up stock prices. Conversely, high interest rates can lead to lower stock prices. Higher rates make borrowing expensive and difficult. Consumers tend to spend less, and businesses have less money to invest. This can lead to stagnant or declining growth rates.
• The business cycle of an economy from a macroeconomic perspective. Inflation is the increase in prices over time. Moderate or “manageable” inflation is seen as beneficial for the economy and stock market. Low interest rates paired with moderate inflation usually have a positive impact on the market. High interest rates and deflation tend to push the market down.
• Study which industries benefit from macroeconomic conditions. Some industries perform well during periods of economic growth, such as automotive, construction, and aviation. During prosperous times, people feel optimistic about the future and spend more. These types of businesses and sectors are known as “cyclical” sectors.
• Other sectors continue to perform well even when the economy is poor or in a downturn. These industries are generally unaffected by economic volatility. For example, utility and insurance companies are rarely impacted by consumer confidence, as people must still pay for utilities and health insurance regardless of economic fluctuations. These companies are classified as “defensive” or “counter-cyclical” sectors.

Start with Asset Allocation. In other words, you need to decide how much money to allocate across different investment channels.

• Research and determine how much you will invest in stocks, bonds, riskier options, and how much you will keep in cash or cash equivalents (such as certificates of deposit, treasury bills, etc.).
• The goal here is to create a starting point based on your market expectations and risk tolerance.

Select Your Investments Carefully. Your "risk and return" objectives will help you weed out the unsuitable options. As an investor, you might choose individual stocks like Apple or McDonald's. This is the simplest form of investing. A bottom-up approach involves buying and selling stocks based on forecasts for price and dividends in the future. Direct stock investment helps you avoid management fees that come with mutual funds, but it requires more effort and research to create a properly diversified portfolio.

• Choose stocks that align with your needs. If you're in a high tax bracket, don’t need money in the short or medium term, and can tolerate higher risk, consider growth stocks: these typically pay little or no dividends but offer a higher-than-average growth rate.
• Passive index funds usually have lower fees than actively managed funds. They tend to be more reliable because they track indices. For example, an index fund might follow a benchmark like the S&P 500, purchasing most or all of the stocks in that index to replicate the index’s results (though not outperform it). This is considered safer, but less exciting. Active investors typically don't favor this approach. However, index funds are an excellent starting point for new investors. Buying and holding index funds with minimal thought, low costs, and using a dollar-cost averaging strategy has historically outperformed actively managed mutual funds over long periods. Choose index funds with the lowest expense ratios and track their performance. For those with under $100,000 to invest, index funds are great for long-term growth. If you have more than $100,000, self-directed investing may be better than mutual funds, as these funds charge fees based on asset size. Even a low-cost index fund may charge a 0.05% fee, which can add up. For example, assuming an average return of 10%, a 0.05% fee on an initial investment of $1,000,000 would accumulate to $236,385 over 30 years! (Compare this fee to a balance of $31,500,000 after 30 years.) Read the article "Should You Self-Trade or Invest in Mutual Funds?" to determine which approach suits you best.
• Exchange-Traded Funds (ETFs) are a type of index fund and investment certificate that trade like stocks. ETFs usually consist of unmanaged portfolios (stocks that aren't bought and sold frequently like actively managed funds) and are traded without commissions. You can buy an ETF based on an index, sector, or commodity like gold. ETFs are also a good choice for beginners.
• Another option is to invest in actively managed funds. These funds pool money from investors to buy stocks and bonds. Individual investors purchase shares of the fund's portfolio. Fund managers often create portfolios based on certain criteria or goals, such as long-term growth. However, because actively managed funds (where managers buy and sell continually to achieve the fund’s objectives) incur higher fees, these costs can reduce returns and delay your financial goals.
• Some companies offer specialized portfolios for retirement investors. These are "asset allocation" or "target-date" funds that automatically adjust your portfolio holdings based on your age. For instance, your portfolio might be stock-heavy when you're younger and gradually shift to fixed-income securities as you age. Essentially, these funds manage your portfolio as you get older. Keep in mind that these funds typically charge higher fees than standard index funds or ETFs due to the added service they provide.
• Considering investment costs is crucial. Fees can significantly lower your returns and profits. Make sure you understand the costs associated with buying, holding, or selling stocks. Common transaction fees include commission charges, bid-ask spreads, expected price spreads, SEC 31 fees, and taxes on capital gains from selling securities. For funds, costs may include management fees, sales charges, purchase fees, exchange fees, account fees, 12b-1 fees, and operational expenses.

Determine the intrinsic and fair value of each stock. Intrinsic value refers to the price of a stock determined based on the company's fundamentals, differing from its current market price. The fair value is calculated in proportion to the intrinsic value, considering a margin of safety (MOS). MOS can range from 20% to 60%, depending on the uncertainty in estimating intrinsic value. Several stock valuation methods are outlined below:

• Dividend Discount Method: The stock's value is the present value of all future dividends discounted to the present. Hence, the price of a stock = dividend per share divided by the difference between the discount rate and the dividend growth rate. For example, if Company A pays a dividend of $1 per share and is expected to grow 7% annually, with a capital cost (discount rate) of 12%, the stock of Company A would be valued at 1/(.12-.07) = $20.
• Discounted Cash Flow (DCF) Model: The stock value is the present value of all future cash flows discounted to the present per share. Hence, DCF = CF1/(1+r)^1 + CF2/(1+r)^2 + ... + CFn/(1+r)^n, where CFn is the cash flow for the period n, and r is the discount rate. A typical DCF model will calculate the annual cash flow growth rate (calculated as operating cash flow minus capital expenditure) over 10 years at a fast growth rate and long-term growth rate to determine the projected terminal value, then sum up to get the DCF value of the stock. For instance, if Company A has a current FCF of $2 per share, the expected FCF growth rate is 7% for the next 10 years, and 4% thereafter, using a discount rate of 12%, the growth value of the stock would be $15.69, with a terminal value of $16.46, making the total value of the stock $32.15.
• Comparable Company Method: This method values a stock based on the price of each stock relative to its earnings (P/E), book value (P/B), revenue (P/S), or cash flow (P/CF). It compares the current stock price ratios to a relevant benchmark and historical average price ratios to determine the possible selling price.

Purchase stocks. Once you've identified a suitable stock, it's time to buy it. Open an account with a brokerage firm that meets your requirements and place the order.

• You can choose a discount broker who will only execute buy and sell orders for you. Alternatively, you may opt for a full-service brokerage, which is more expensive but will provide additional valuable information and advice. Check reviews and advice online to find the best brokerage firms. You should first research commission fees and other costs. Some brokers offer free trading if your portfolio meets a minimum balance (e.g., Merrill Edge Preferred Rewards) or if you invest in certain stock groups that they will cover the trading fees for (e.g., Loyal3).
• Some companies offer direct stock purchase plans, allowing you to buy without a broker. If you're planning to buy and hold or dollar-cost average, this could be a great option. However, check online or contact the company of the stocks you wish to buy to see if they offer this. Be mindful of their fee structures and choose the program with the lowest or no fees.

Build a diversified portfolio with 5 to 20 stocks. Diversify across sectors, industries, countries, market sizes, and investment styles ("growth" or "value").

Hold long-term, for five to ten years or longer. Avoid making impulsive sales when the market drops for a day, month, or year. Over the long-term, stocks tend to rise. On the other hand, avoid selling when a stock has risen by 50% or more. As long as the company's fundamentals remain solid, hold on (unless you really need the money). You should only sell when the stock's price exceeds its intrinsic value (see Step 3 of this section) or when the company's fundamentals have changed drastically since your purchase, and the company may no longer be as profitable as before.

Invest regularly and systematically. Dollar-cost averaging is a simple and effective strategy for buying low and selling high. Set aside a portion of your salary each month to buy stocks.

• Remember that a bear market is a great opportunity to buy. If the market drops by at least 20%, allocate more funds to stocks. If it drops by 50%, use all your idle cash and sell bonds to purchase stocks. This may sound crazy, but the market always recovers, even from the Great Depression of 1929-1932. The most successful investors often wait for "discounted" stocks.

Set clear standards. Establish criteria for evaluating and measuring the performance of your stocks in comparison to your expectations. Define standards such as how much growth is needed for you to continue holding them.

• Typically, standards are based on market indices. These indices help you gauge whether your investment is performing as well as the market or better.
• This might seem counterintuitive, but understand that a stock that rises in price is not necessarily a good one, especially when similar stocks have risen more. On the other hand, a stock that is falling is not necessarily bad (if other similar stocks are falling even more).

Compare your actual investment performance with your expectations. You must compare the returns from your stocks during each period with your expectations to determine whether to sell or hold on. This comparison should also apply to other asset allocation decisions.

• If investments do not meet your expectations, consider selling and investing elsewhere. However, hold on if you believe your expectations will be realized.
• Be patient. One year or even three years is a short time frame for long-term investing. The stock market is often emotional and volatile in the short run, but in the long term, it is a very accurate tool for assessing stocks.

Be cautious and update your expectations. After purchasing stocks, you need to regularly check the performance of your portfolio.

• Circumstances and perspectives may change. This is part of investing. You must evaluate new information and adjust your decisions based on the guidelines from previous steps.
• Assess whether your market predictions are accurate. If not, why? Use the following evaluations to reassess your expectations and portfolio.
• Is your portfolio within the risk tolerance you set? Stocks may perform well but be more volatile and riskier than you anticipated. If you can’t bear this risk, it might be time to change those investments.
• Have you met your goals? If your investments are performing within acceptable risk levels but are growing too slowly to meet your targets, consider exploring new investment opportunities.

Resist the urge to trade frequently. After all, you are an investor, not a speculator. Additionally, every time you make a profit, you are taxed on the gains. On top of that, each trade comes with brokerage fees.

• Avoid insider tips or ‘pump and dump’ schemes. Do your own research and don’t pay attention to insider information from people within the company. Warren Buffett says he throws away all stock recommendations. He points out that these sellers are paid to speak positively about stocks so that the company can raise capital or make money.
• Don’t get overly focused on market hype or short-term stock price movements. Stay focused on your long-term investment goals (at least 20 years) and don’t let short-term fluctuations distract you.

Seek advice from brokers, bankers, or consultants when needed. Always be learning and reading as much as you can from books and articles written by successful investors in your field of interest. It’s also important to explore literature on managing emotions and psychology when investing, to help you control the emotional swings that come with participating in the stock market. Even after making the best possible choices, you must be prepared to face potential losses.