How to get started investing in the stock market
Unless you’ve been living under a rock, you’ve probably heard about the stock market. In this post, I want to show you the different ways you can invest in it. I will focus in particular on ETFs, which I favor in my own portfolio.
There are basically three main ways to invest in the stock market:
- Pick and purchase individual stocks.
- Invest through active funds.
- Invest through ETFs (Exchange Traded Funds) and Trackers.
Why should I invest in the stock market?
Because past long-term performance has been pretty good.
I can already hear you saying the famous phrase “Past performance doesn’t predict future performance”. And this is definitely true in the short term (~10 years), but in the longer term (~25 years) we can start seeing some interesting patterns.
A Forbes article shows that if you pick any 25-year rolling period from 1925 to 2011 and compare stocks (tracking the S&P 500 index) to bonds, stocks win in performance every time 1. Besides, from 1802 to 2002, the stock market average compound inflation-adjusted rate of return has been 6,8%.
“A 6.8% annual rate of return means that if all dividends are reinvested, the purchasing power of stocks has doubled, on average, every ten years over the past two centuries.” Historical Record Of Stocks And Bonds, Investopedia
Thanks to compound interest, a long-term investment increases in value enormously.
The risk of investing and not investing in the stock market
Of course, there are risks. Individual shares can quickly lose 50% of their value, and even the market as a whole can lose more than 50% of its value.
But hey, not investing is a risk too. If inflation is higher than the interest on your savings account, you are basically losing purchase power every year.
How to invest in stocks
There are many ways of investing and all of them have their advantages and disadvantages.
Pick and buy stocks individually
There are many ways to invest in the stock market directly: daily trading, trading based on “indicators”, long-term investment by reviewing annual reports, medium/long-term investment using algorithms, etc. The subject is vast.
I am not a fan of daily trading, mainly because it requires a lot of time, attention and expertise. Also, who wants to spend every day in front of the screen looking at stocks going up and down? Not me! Let’s take a look at the other types of investments:
- Investing in companies that are truly disconnected from their intrinsic value. This is called “value” or “deep value” investment. But for this to work, you have to choose shares that are not studied by the professionals who do this all day long… and that you can understand (not everyone can read a financial report in Vietnamese). This means that you have to focus on small US companies.
- Investment in quality companies over the long term, and if possible at a fair price. To simplify, let’s say it’s the Warren Buffett investment. It is less risky than the previous method, but it requires a minimum of skills.
- Investment in companies with growing dividends. It’s a variant of Warren Buffett’s strategy. It’s suitable if you like dividends.
- Investment through algorithms, according to rules that have been academically identified. Setting up the programs that run the algorithms is not an easy task, however.
- Random investment. It may sound strange, but yes, it works. In 1973, Burton Malkiel, in his book A Random Walk Through Wall Street, explained that a monkey choosing stocks by throwing darts would do as well as the experts.
The advantages of picking individual stocks
- We are really co-owners of the company. We are part of the adventure!
- We are interested in the life of companies, and therefore in the economy, and therefore in society.
- We can select companies that we like because we like their products or for ethical reasons (or exclude them).
The disadvantages of direct investment
- Less diversification.
- Good luck studying hundreds if not thousands of companies in order to find the best to put your money on!
Invest in the stock market through an active fund
An option if you don’t want or don’t have the time to do your own analysis is to delegate it to a professional. There are many active funds, each with its own style. The idea of an active fund is that a manager picks stocks in order to beat the market.
The advantages of “active” funds for investing in the stock market
- Diversification. Funds allow for real diversification, which greatly reduces risk. A fund is generally managed by several well-trained managers. They can review a large number of companies around the world and manage portfolios with dozens or even hundreds of stocks.
- We don’t need to do anything!
- This gives the opportunity to do better than the market… theoretically.
The disadvantages of “active” funds
- It’s not cheap. From Investopedia 2: “The average expense ratio for actively managed mutual funds is between 0.5% and 1.0% and typically goes no higher than 2.5%, although some fund ratios have gone higher. For passive index funds, the typical ratio is approximately 0.2%.
- Some active funds are anything but! They’re very close to the index they’re following. So yo’re basically investing in a passive fund with fees.
Invest in passive funds, also known as index funds, trackers or ETFs
These funds can be listed on the stock exchange, and are then called ETFs (Exchange Traded Funds) or trackers. ETFs track the performance of an index such as the S&P 500 or the FTSE 100.
The advantages of investing in the stock market with index funds and ETFs
- They’re usually cheap. The typical expense ratio is 0,2% as we saw above.
- They follow the collective intelligence of the market. They have a performance of more than 80%-95% of actively managed funds!
- You can diversify easily with little effort.
- They are very transparent, we clearly know what is in the index it follows. And the ETF manager cannot change strategy.
- There are no entry fees and they are easily available in all banks, as they are listed on the stock exchange.
- No need to be a financial expert.
The disadvantages of investing in ETFs and Trackers
- Less choice than with active funds. “As of 2015, the number of exchange-traded funds worldwide is over 4000” 3. Even so, there are fewer choices than with active funds. Not that more choice necessarily means better. But hey, why not? If you want to find a super specific niche, you might only be able to do it with an active fund.
- We can’t exclude companies we don’t like
- We don’t own the companies directly.
- In short, yes, it is less interesting than direct investment, and moreover, we do not have the hope of having a crazy performance! It’s a little boring.
Conclusion: how to invest well in the stock market?
It seems to me that investing in an ETF portfolio is what provides the best risk/return ratio over time.
Individual stock picking is intellectual more challenging and interesting, but it requires you to educate yourself and to spend time on it in order to avoid mistakes.
There are many books on the subject, but I would suggest that you start with Benjamin Graham’s “Intelligent Investor”. It’s not the easiest book, but if you can’t even get through it, then maybe you shouldn’t be picking stocks.
Sometimes we want to put our trust in a manager because we find him inspiring or we believe in him. Also, sometimes, as there are many more active funds than ETFs, we have to go through active funds.
However, choosing a good fund is not easy. I am talking about funds that will outperform in the future and not funds that have outperformed in the past.
For me, there’s only one serious option for the long-term investor, and that is ETFs.
Recommendation for investing successfully
Manage your money and build your wealth in one place. Sign up with M1Finance, the web’s #1 free and automated investing solution. In addition to managing your investments in one place, you can create a target asset allocation and your deposits will be automagically invested to maintain it.
One of the coolest things about M1Finance is that they support fractional shares. You don’t have to worry about your money sitting idle in your account without being invested. Every dollar you add will be allocated. Finally, there are no management or commission fees, so every dollar you invest adds to your future wealth.
The Oracle of FI is a middle-class guy working as a software developer. His goal is to achieve full financial independence by the age of 40.
He started this blog in 2019 in order to share his tips and techniques on investing, saving money and making the most out of life.
He has a cat and lives in France.