How to start investing? How to make money on the stock market? If you ever wanted to start investing but didn’t really know where to start, this is the article for you. In this article I will explain how you can start investing without prior knowledge and how YOU can use the stock-market to your advantage. Don’t have that much time? No problem, there is a strategy for people with lots of time and with no time at all.
Introduction to Investing
There are mainly two types of investing strategies: Active investing and Passive investing. For those of you with less time, passive investing is the best strategy. If you have more time you want to spend on investing, perhaps active investing is something for you. In the end, it doesn’t matter that much which strategy you choose but do not become an active investor if you have too little time.
First, some basic investing terminology. Stocks are tiny pieces of ownership in a company that often also give you voting rights in that company. Just like an owner of a company you earn the profit that the company makes. Dividend is the piece of profit the owner of a stock receives. In the long run, what really matters is reinvested dividends and not share price increases. So always make sure you reinvest your received dividends! Next to stocks there are also bonds. Bonds are tiny pieces of loans to companies. Just like with normal loans, companies pay variable or fixed interest (called a coupon) and need to pay back the loans at some point. Bonds are generally paid back all at once and the amount of the loan outstanding is called the principal. The money difference between the money you use to buy a stock or bond and the total amount of money you get back at the end (when the bond principal is paid or when you sell your stock or bonds) is called your return on investment.
It’s important to know a little more about risk when we talk about investing. Investing may look like gambling but its not, you can actually increase or decrease your risk of losing money. When a company declares bankrupcy the first people that get paid are suppliers, employees, banks and bond holders. At the end of the line are the owners and thus the stock owners. Everybody before the stock owners must first be paid back in full before the stock owners can divide what’s left – and generally that is not much. This makes bonds (first in line) a safer investment than stocks (last in line). You can probably also imagine that companies that are not doing well financially need to pay higher interest on loans because less people are willing to lent money to a company that is in danger of going bankrupt. Higher interest rates can, however, make it more appealing to people who want to invest in bonds. If more people want to buy a bond, the price of a bond will thus rise. Because of the higher risk of stocks, the price of a stock is much more volatile than that of a bond. If bad news about a company comes out, people will want to sell their stock quickly to avoid losing all their money. This results in the stock price to decrease. The good news is, if you buy a simple stock you can never lose more money than the value of your stock.
Now you know the basic terminology and concepts! Let’s have a look at the two different strategies.
As the name suggest, passive suggesting is a strategy that does not require a lot of work or a lot of knowledge but it does require a lot of time and patience. This strategy is best summarised as “buy and hold”. Ideally, a person would like to buy every company in the country (or the world) in equal proportion to its contribution to the economy. That way, if the economy goes up so does your investment. This means that when all these politicians are talking about wanting to grow the economy, you know you are making money. It also reduces the risks of losing your money. Companies can go bankrupt, but the chances that all companies in a country go bankrupt is almost non-existent. That means you can lose a percentage of your money, but never all of it. Passive investing is also a long-term strategy and the economy always recovers after a while which means your investments, in the long run (10+ years) always make a profit. In summary, passive investing has 2 important principles.
The first once is the concept of diversification. Investors generally don’t invest in only one company or stock, they spread our their investment in their investment portfolio. Diversification allows you to spread the risk associated with investing. You invest in different companies from different business sectors in different countries in order limit the risk to a minimum. This means that if one country, industry or company is struggling the other are not and only a small percentage of your investment will suffer. You can diversify stocks and bonds but you can also diversify the ratio of stocks and bonds in your portfolio. Depending on how much time you want to spend investing you can choose to buy different stocks yourself or you can buy pre-diversified bundles of stocks and bonds. Mutual funds are examples of a financial products that bundle several stocks and bonds. Mutual funds are managed by fund managers, which are people who study the financial market and invest accordingly. They have one disadvantage, you need to pay for they services. Generally its small fixed fee and a small percentage of the yearly return on your investment. A special type of mutual funds are index funds. Index funds follow certain preset rules so that the fund can track a specified basket of underlying investments. Examples of index funds are the S&P 500, Dow Jones, MSCI World Index. These indexes are often based on the value of companies. The S&P 500 for example, follows the 500 biggest companies in the US and the MSCI World Index follows the large and madcap companies in all developed countries. Index funds generally have lower cost than mutual funds because they are not actively managed but and in the long run (10+ years) outperform mutual funds. The famous investor and financial analyst John C. Bogle analysed the S&P 500 and multiple other mutual funds and realised that over the course of 50 years the S&P500 outperformed every other mutual fund. In the first few years that difference didn’t seem that obvious but the longer the period, the more mutual funds fell behind. Even the most famous investor and the 3rd richest person on earth (2020), Warren Buffet, had to admit to his investors that his investment company can’t compete with the S&P500 anymore.
Depending on your risk appetite, how much risk you are willing to take, you diversify between stock and bond indexes. If you have a low risk appetite, consider investing 70% in bond indexes and 30% in stock indexes. If you have a high risk appetite, you can invest 70% in stock indexes and 30% in bond indexes. You can of course also decided to invest 100% in stock indexes or 100% in bonds indexes but this is generally not recommended unless you are very young and your money has time to sit out the economic recessions.
The second important principle is compound interest. Albert Einstein rightfully called it the 8th Wonder of the World. Compound interest is summarised as “interest over interest”. If you put 1.000 in an account once and you earn 10% interest on your investment that means at the end of the first year you will have 1.100 dollar. The second year you will have 1.210 dollar and so on. This seems like peanuts but let’s take a look at the long run. At the end of 10 years you will have 2.590, at the end of 20 years you have 6.720 dollars and at the end of 50 years you will have 117.390 dollar. You have received more than 117 times your investment back! Most people don’t save once, they save monthly. Now imagine that instead of saving 1.000 dollar once, we save that amount every year. That means we have around 15.000 after 10 year, around 57.000 after 20 years and 1.1 MILLION in 50 years. As you can see, compound interest matters.
But wait, where do you get a 9% rate of return nowadays? Well definitely not in your savings account. However, have a look at the S&P500 discussed before. The average annualised total return for the S&P 500 index over the past 90 years is… 9.8%. The total return consists of the stock market increases and the dividend that you kept reinvesting. Remember the important lesson about dividends, in the long run dividend reinvesting and compound interest together is what is going to make you rich. Unfortunately, there is a catch to the benefit of compound interest investing.
That catch is costs. Participating in the stock market costs money. Buying stocks and bonds costs money and sometimes so does reinvesting dividends. As Albert Einstein already states in its quote, you can earn compound interest or pay it. Every dollar spend on fees is not a dollar that will earn you money. Just as earnings grow exponentially so do costs, they take up a growing proportion of your possible earnings. The less you trade, the less costs you make and the more money has time to compound. Hence the concept of passive investing: you invest and then let the market run its course. Ups and downs, recessions and economic boom, you don’t touch your money and it will generate a profit for you. This is also why we prefer low-cost index funds over other forms of mutual funds. The more a manager of a mutual fund is shifting around in the fund, the more costs you make and thus the less profit. The manager doesn’t care, they get their fee anyway. The best fund is therefore a low-cost index fund and among the index funds the S&P500 and MSCI World Index are one of the best once. The inventor of low-cost index funds created Vanguard and this company is still one of the biggest investment agencies in the world. The vision of Vanguard? Decrease the costs of holding a broad index fund so the participants in the fund get the most value for their money. Vanguard is not a for-profit company, although it does make profit. Although their portfolio has been expanding and they have been adding more mutual funds, they still generally provide the lowest cost S&P500 index fund. Another company that provide low-cost index funds is iShares. In most countries, the expense ratio needs to be shown for investments. For example, have a look at one of the Vanguard SP500 index trackers.
In short, the strategy of passive investing is simple: buy and hold. Just because this strategy is simple, doesn’t mean it’s easy. If every other trader is running around screaming BUY or SELL or RECESSION or OPPORTUNITY you will have to sit on your hands and wait, sometimes years, before your point is proven. You will have to resist a lot of social pressure and yes some people, just like with the lottery, will strike the jackpot. However, for the large majority of people this strategy remains the one solid way to earn a solid profit in a complex stock-market. For a beginner, it is the best way to start and if you manage to stay patient long enough you can be sure to outsmart the majority of people and even some of the best investors in the world. As mentioned before, even the most famous investor and the 3rd richest person on earth (2020), Warren Buffet, had to admit to his investors that his investment company can’t compete with the S&P500. This is also the reason why I am in favour of passive investing. However, if you want to try your luck and see if you cán beat the market, have a look at the Active Investing strategy below.
As you might have noticed on wall street, most traders are running around like crazy. These are active investors. They want to buy low and sell high and do that as much as possible. These traders are short-term investors and often trade daily but sometimes their horizon is a bit longer. They basically try to predict and beat the market. Sometimes people succeed, like George Soros. He bet against the Bank of Engeland and won, profiting around $1 billion. However, most traders, both beginners and seasoned traders, lose money. According to stock trading platform eToro, 80% of day traders lose money in a year. The the median loss for these traders was 36.3%. Hence a fair warning, active trading is risky and the chances of you joining the 80% are significant. In that sense, active trading is most of the time a bit like gambling and the odds are stacked against you. If you are still interested its best to at least learn the basics.
As we mentioned at the beginning of this article, the most commonly trades items are stocks and bonds. Bonds from stable countries like US Savings bonds or US Treasury Bills are considered the safest financial products but they consequently also have the lowest return. Stocks, index funds and Mutual funds can be risky depending on the industry. Index funds and stocks of companies that make necessary consumer goods (P&G, Nestle, Unilever, Shell) are generally considered relatively safe. Valuable metals like gold and silver are commodities that are considered fairly stable too and are often used as “safe heavens” as they tend to keep their value.
The most common reason why active investors lose money is because they forget how much costs they make and they don’t understand the financial product their using. Even if brokers do not ask for a commission there are always other fees like transfer fees, stock fees, mutual funds fees and option contract fees. These all depend on the broker so make sure you match the broker you use with the active investment style you have. Another point is not understanding the financial products you are using. Financial products all have their own risks associated with them and many an economic crisis has been made worse by them. Take this into account when you read about the financial products below. There are many financial products and I will not go through them all. I have selected some of them that are common and some of them that are advertised a lot but are very risky.
An option is a contract in which you agree sell (put option) or buy (call option) an underlying security (stock, index, bond, interest rate, currency, or commodity) at a preset price (strike price) before a certain date. This can be used to speculate on the downfall or rise of a security. For example, in the corona crisis you can speculate that pharmacies will be doing well and their stock price will rise. You can then make a call option to agree to buy at the the current strike price before a certain date. If your guess is correct, you can buy the stock at the strike price decided before and sell it for the actual increased price.
It is important to know that call option buyers have a right to buy the shares covered in the option contract at the strike price but he/she is obliged to do so. You will of course lose the money to buy the option contract! Put option buyers have the right to sell shares at the predetermined strike price but not the obligation. Again you will lose the money to buy the option contract.
On the other hand, option sellers are obligated to transact if a buyer decides to execute a call option to buy or put option to sell the underlying security. Buying put options or call option contracts is therefore less risky than selling option contracts.
Options are risky and more of a gamble. You need to have a lot of feeling or understanding with a particular industry in order to grasp in what direction the market will be moving. Make sure you choose a limited amount of industries or just one and become an expert at that industry. Also be aware that you as an outside trader are almost always at a disadvantage. Insider trading is forbidden but you are fighting against huge companies that have studied industries for year and have an in-dept understanding of certain industries. You can know something they don’t but it is very unlikely. Make sure you read up on market leaders in the industries, the seasonal patterns, what drives the market and what big investment companies tend to do in that market.
A future contract works a bit like an option. You make a contract that obliges you to sell or buy an asset at a later date at an agreed-upon price. Futures are often used by companies who want to secure a certain price for their goods, like farmers for their crops that are still on the field. Other companies may want to buy their raw materials at a pre-set price in order to be able to determine their costs and profit for the production of their products. For investors it is used to speculate. For example if you expect the price to rise, you can decide pre-set the price at the current rate and buy them at the contract date. If the price rises you can sell the product again for the new, higher, value. Futures are generally for large amounts of money which make them risky when prices do not behave as expected. Just like options, futures are a lot like gambling so be sure to study the industry you are investing in!
Now lets look at some of the dangerous financial products.
Reverse convertible bonds
The bonds are often short-term investments for one year and they generally have a high coupon payment (interest!) because of their risk. These type of bonds allow an investor to redeem a bond for cash or stock at the end of the period. Whether you receive cash or stock depends on the share price. If the stock price falls, you receive a pre-determined amount of stocks. If the stock price rises, you receive 100% of the value of the bonds. Investors can thus lose money if a company’s share price falls or a company declares bankruptcy, since in both cases the reverse convertible bonds will become stocks.
Stocks trade for less than 5 dollars are called penny stocks. They are cheap and therefore quite interesting for beginning investors with less money to invest. Although cheap, they are not without danger. Because of their value people speculate heavily with them and that sometimes results in so-called “pump and dump” schemes. Frauds buy large amounts of one penny stock, inflating the price, at which point they sell them.
Credit Default Swabs (CDS)
This financial product allows you to protect yourself against defaults on bonds. It became famous after the 2008 crisis as it is considered one of the causes of the financial collapse and is considered a very risky instrument and certain types are even banned by the European authorities. Generally, they are considered to have to small of a benefit for too much of a risk.
A turbo (or speeder or sprinter) is a derivative and a highly speculative financial instrument. With a turbo you can increase your profit or loss multiple times. With a stoploss, a threshold at which point the turbo is automatically sold, banks limit the amount of money you can lose as a security measure. A turbo is based on the value of an underlying security such as a stock, commodity, valuta, bonds or index. A turbo long increases in value when the value of the security increases. A turbo short increases in value if underlying value decreases. When you buy a turbo you don’t buy the whole security but only a part, the other part is financed by the bank. Over the part that is financed by the bank, you pay a high interest in return. This makes turbo’s very interesting for the bank and also a reason why they do not like governments restricting the practice. If the value of the underlying security increases and you sell the turbo, the full value minus the value the bank paid is yours. For example, you buy a turbo for 5 with an underlying security value of 30. The bank finances 25 and you pay an interest (often around 10% on a yearly basis) over that amount. If the price of the security increases to 35 and you sell the turbo you get 35 minus the 25 invested by the bank, so 10. You have doubled your initial investment! Of course there are also buy and sell costs and interest you need to deduct from that amount. This is a positive example but it can also go terribly (and expensively) wrong. If your stoploss is determined to be 27.50 and the security value reaches that point, the bank will automatically sell the underlying security. You get 27,5 minus the 25 invested by the bank back, or 2,50. If you invested 5 that means you just lost 50% of you investment. Again this is a very risky and very speculative financial instrument that resembles gambling.
In short, Active Investing is fighting against your odds. In the short term there are ways to make some money but in the long run most people, again 80%, make a loss. Remember that you generally only hear about the people who succeeded, not the thousands that lost everything. You can limit the amount of risk and loss as an active investor by being patient, with diversification and making use of compound interest. Although I have tried to teach you the basics I am a passive investor myself with a low-risk appetite and I did want to warn instead of stimulating people to become active investors.
Please note that this article is for informational purposes and not professional investment advice. I do not take or have any responsibility as a result of actions taken based on the information provided in the article. Past investment returns are no guarantee for future returns.