If you spend enough time watching financial news media, you may begin to feel like the stock market is one of the major pro sports in America. Stock prices flash on the screen like football scores, analysts discuss their favorite companies and trades, and someone like Jim Cramer is usually yelling for no particular reason.
When viewed from this framing, it’s hard to imagine the stock market as anything more than the giant casino for the rich. You put down your chips on certain stocks and spin the wheel, right? Well, not really. The financial media might make it seem like every trading day is an NFL Sunday at the sportsbook, but public markets aren’t meant to be viewed this way. When we invest, we aren’t gambling—we’re giving ourselves access to a piece of a public company’s future earnings. Let’s dive into this guide on investing in stocks for beginners to better help you understand how the process works.
If you’re looking for assistance in managing your investments or creating a personalized investment strategy, speak with a CERTIFIED FINANCIAL PLANNER™ professional at Good Life Financial Advisors of NOVA today!
Debt vs Equity
When a company wants to raise money on public markets, it has two primary choices—debt or equity. Debt is issued as bonds, which are basically loans from investors to the company. Like loans, bonds are repaid with interest, which makes it a beneficial arrangement for both the seller and buyer. The company gets cash now and the investors are promised their money back plus interest later.
The other option is equity. A company might issue shares of stock in order to raise money, which means they’re actually breaking up and selling little pieces of the firm. When we buy stocks, what we’re really buying are little stakes of ownership. Now, owning shares of stock doesn’t mean you’ll be getting invited to board meetings or conference calls, but it does entitle you to a portion of the company’s future profits in the form of dividends and stock price appreciation.
Buying and Selling Stocks
Stocks usually aren’t purchased directly from the issuing company. Instead, shares are bought and held on an open market called an exchange (ie. the New York Stock Exchange). Since everyday investors don’t have direct access to these exchanges, a broker is required to facilitate buying and selling. Brokers used to charge commissions for stock purchases, but most online brokers like TD Ameritrade and Charles Schwab are completely commission-free now.
“Don’t put all your eggs in one basket” is advice everyone has heard from parents or grandparents, but it’s sound wisdom when it comes to stocks. Buying an individual stock can be risky. If the company issuing the shares performs poorly or becomes suspected of fraud, the shares could fall rapidly. For most investors, a strategy of diversification is the key to avoiding the risks presented by investing in singular stocks.
Investment products like ETFs and mutual funds are great tools for diversification since they offer exposure to entire sectors or markets in one convenient package. Of course, all ETFs and mutual funds are not the same, and they have their own drawbacks and opportunities as well. We’ll talk more about ETFs and mutual funds in a future article.
Key Factors and Ratios to Look for in Stocks
Investing in stocks is a long-term game. Most Wall Street pros struggle to beat market averages over time, let alone in short periods where volatility could be high. With a long time horizon, you can ignore the day-to-day volatility of the stock market and focus on the fundamentals of the underlying companies. Remember, we aren’t buying lottery tickets, we’re buying into an operating business. Here are a few key factors to keep an eye on when researching stocks:
- Sales Growth. The ultimate barometer of success or failure in any company will be sales. How much product is the company selling and is the rate of those sales increasing? Investors often look for year-over-year sales growth to measure how quickly a company is becoming a successful enterprise.
- Net Margins. A growing company isn’t always primed for success if the cost of doing business increases faster than revenue. Increased costs can put pressure on net margins. This often serves as the canary in the coalmine that a company’s business and past results are unsustainable.
- Price-to-Earnings Ratio. The Price-to-Earnings Ratio (P/E) is used to judge how cheap or expensive a stock is relative to its peers. P/E is found by dividing the company’s current stock price by earnings-per-share (EPS). High P/E stocks aren’t necessarily bad investments, but you will be paying a premium for that future profit growth.
- Debt-to-Equity. Too much debt can crush even the most innovative and promising public companies. The Debt/Equity ratio is a sound, quick measure if the burden debt is currently levying on a company. To find Debt/Equity ratios, you simply divide the total outstanding company debt by the value of the equity held by all shareholders. If a company has twice as much debt as shareholders' equity, it could create a scenario where future costs will rise and profits will be spent paying off creditors instead of rewarding shareholders.
Are Individual Stocks Right for You?
We’ve covered some of the basics of what stocks are, how to buy stocks, and a few key ratios to look at when considering investing. In my experience as a financial advisor, the most important question to ask is not how to invest in individual stocks or what to look for when choosing a stock.
The most important question is this—is investing in individual stocks the right thing for you?
For instance, do you have the time to research the company and follow the company’s operating results over time? Do you understand the ins and outs of the business? Are you interested in getting into the weeds, or are you just excited about the prospects of finding the next big thing? What do you hope to achieve by investing in individual stocks? How does the investment fit into your overall plan?
The bottom line is that investing in individual stocks can be a great way to grow your wealth over time, but it is not for the faint of heart. It takes plenty of time and work to do correctly.
If you decide that the individual stock approach is not for you, fear not. There are still ways to access the stock market and participate in the fortunes of terrific businesses. Mutual Funds and ETFs offer access to markets without the rigors of an individual stock approach.
We hope this guide on investing in stocks for beginners assists you. If you have any questions, an experienced, truly independent financial advisor from Good Life Financial Advisors of NOVA can help you get started. Contact us today!
The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individuals.