Most software engineers get introduced to world of stocks the second they get their first job.
At the same time, most software engineers know very little about finance in general and the stock market specifically.
You get a good portion of your compensation in stocks yet most engineers don’t know how to properly invest in the stock market.
In this in-depth article, I will show you step-by-step everything you need to know before you start investing.
When I was a beginner myself and I wanted to invest in the stock market, I was very intimidated. I thought this is something that only the smartest and wealthiest people could do. I thought I needed to read tons of books and articles before I invest my first dollar.
I was very wrong!
Even though I absolutely needed to educate myself about various topics, it wasn’t really as hard as I thought it would be.
I have to warn you, this is a long article. But I can promise you one thing. I promise you that after you read this article, you will be able to understand 90% of the investing and stock market news, articles, and conversations that were once very hard to understand.
Alright, let’s begin!
How much money should I have before I start investing? [Not a lot]
There is a big misconception that investing is only for the wealthy.
Investing in general (whether in the stock market or not) helps you accumulate wealth. So investing results in wealth not the other way around.
However, you obviously can’t invest if you’re broke. It is important to make sure that your financial situation is in great shape before you start investing in the stock market or any other sort of investing for that matter.
The first rule of thumb is to be consistently earning more than you’re spending.
Afterwards, you have to make sure that your emergency fund is in good shape.
What’s an emergency fund?
An emergency fund is a sum of cash that you save in your bank account. Experts advise that this fund should cover 3-6 months of expenses in case of an emergency. For example, if you suddenly got laid off from your work, your emergency fund will help you with your expenses until you find another job.
I absolutely wouldn’t recommend any type of investing before you fill up your emergency fund first.
The reason why you need to have a cash emergency fund before investing is because emergencies happen unexpectedly. And when they happen, you might need to have an immediate access to cash to deal with the emergency.
For example, Real Estate investment is very illiquid. If an emergency occurs, it will be almost impossible to immediately convert your real estate investments into cash.
Stock market investments on the other hand are relatively more liquid than real estate but they still have their own problems.
First, if an emergency happens while the market is in a downturn, you will be forced to sell your stocks and endure losses. You don’t want that!
Second, it usually takes a couple of days after you sell your stocks before you have access to your cash. If immediate access to cash is required, then selling your stocks will not help you.
Only after your emergency fund is filled up that you start thinking about investing.
Always make sure your emergency fund is in good shape before you start investing.
At what age should I start investing? [The power of compounding]
You probably heard about the power of compound interest, haven’t you?
Compounding is THE thing that makes investing so appealing.
It essentially means that your money will grow exponentially with time under the assumption that you reinvest the gains. This is super powerful because it means that you don’t need to start with a large amount of money. You can start small and wait… just let compounding works its magic.
OK let’s have some concrete examples.
Assume the average annual gains on your investment is 5%.
Let’s take a look at some cool scenarios and then try to draw some important conclusions:
Scenario 1: If you invest $10,000 at the age of 20, and do absolutely nothing else, your money will grow up to $70,400 by the time you’re 60. That’s a whopping 7x your initial investment!
Scenario 2: If instead you invest $30,000 at the age of 45 (three times the money you invested in scenario 1), and do nothing else, your money will grow up to $62,367 by the time you’re 60. Notice that in this example, even though you started with larger money, your investments just doubled in value. (compare that to the 7x increase of scenario 1)
Scenario 3: If you had invested the same $30,000 at the age of 20 instead of 45, you will have $211,199 by the time yo’re 60.
Mathematically, the more time you let your investments grow, the more exponential gains you accrue. It is really time (and the average annual return) that makes compounding magical.
Now all of these assume you put some money into an investment once and you let it grow on its own. You never add money to it. You never withdraw any money. And you always reinvest the gains.
This is not what happens in real life. In real life, If you have a job, you earn more than you spend, and your emergency fund is in good shape, you’ll be able to consistently invest more money (not just once). This is a one sure path to eventual wealth.
Investing late in life is not as powerful as investing early. Compounding needs time to work its magic. Don’t miss the train. Start early!
Besides starting early, there is also another thing that I want you to completely internalize.
I want you to respect, appreciate, and genuinely understand the power of the effective rate of return on your investment.
A 3% annual return is FAR MORE superior than a 2.5% annual return. For the inexperienced, these little differences are easy to ignore. But because of the power of compounding, these small variations significantly make a huge difference over the long term.
If there is one thing I want you to take away from this article, it is just that! Because everything else follows naturally.
A tiny variation in your effective annual return will result in a huge difference in your gains over the long term
Good! Now you have the essential fundamentals that will help you with any type of investment you make. It’s time now to focus on the magical world of the stock market.
What is a stock?
It all starts when a company decides to go public.
But what does going public mean?
So when you hear that Snapchat has gone public, this means that now the company can be owned by the general public.
The main reason why companies decide to go public is to raise money and expand.
Corporations go public through a process called initial public offering (IPO). They hire an investment bank (aka the underwriter) which helps them with the process.
During IPO, the ownership of the corporation is divided into some number of shares. Each one of these shares represents a partial ownership of this corporation. For example, if a company is divided into 100 shares during IPO, each share represents 1% ownership of the company. This means that you, as an owner of the share, are entitled to 1% of the company’s assets and earnings. Pretty sweet, right?
The number of shares to be issued, the price per share, and when to bring these shares to market are all decisions made by the underwriter.
Some of the popular underwriters are Goldman Sachs, JPMorgan Chase, and Deutsche bank. You probably heard these names before and you probably didn’t know what these banks do. Now you do!
So what happens after IPO?
After IPO, all the shares of the corporation that were issued are then freely traded in a stock exchange. So when you buy a stock, it’s a transaction between two investors and the corporation is not involved whatsoever with this transaction.
Pros like to use the word equity to refer to ownership. For example, the equity market is the same thing as the stock market. Equity investing means investing in stocks. Don’t be intimidated by the lingo!
So to summarize the three main points here:
1- During IPO, the corporation sells the shares to investors (this is called the primary market)
2- After IPO, investors trade these stocks amongst themselves through a stock exchange (this is called the secondary market)
3- equity = ownership
Now let’s get to the part that excites you and me the most. Making money from stocks.
How can I make money with stocks? [two ways]
Well, there are multiple ways you can make money with stocks.
Some of these ways are pretty risky. But done right, and with a little bit of luck, you can make some real money (and you could also lose all your money).
But since you are a beginner, you don’t really need to overwhelm yourself with unnecessary risky methods for now.
Let’s talk about the basic, most essential ways investors make money with stocks.
There are two ways:
- Appreciation: This means that you make money when you sell the stock at a higher price than your buying price. Very straightforward. For example, when Google became a public company in 2004, its share price was $85. In 2017, Google’s stock price was hovering around $1000! This article explains exactly how much money you would have today if you had invested in Google in 2004.
- Dividends: The other way you can make money with stocks is through dividends. Remember that you, as a shareholder, are entitled to a portion of the corporation’s profits. If the company makes profit, and has no plans to reinvest the money in the business, then the profit is distributed among the shareholders. This is essentially what a dividend is.
Even though theoretically, a stock of a specific company can make you money through both appreciation and dividends. In real life, usually the majority of the money you make from a specific stock comes from either appreciation or dividends.
The reason for that is very straightforward.
Corporations in general fall in one of two categories: they’re either well established, usually big, corporations that consistently make fixed profits and have no plans for further expansion (because they can’t or because they have already saturated the market) or they’re corporations that are still in the process of expanding and trying to increase their future income.
The first type of corporations (think Coke or AT&T) don’t need to reinvest their earnings, so they pass on the earnings to their shareholders as dividends.
The second type of corporations (think Google, Facebook, or Snapchat) are trying to grow. They need to reinvest their earnings to expand their business or to venture into uncharted territories that would potentially bring more money in the future (think self driving cars or VR).
Google and Facebook never pay dividends to the shareholders. If you own shares of these companies, the only way you are going to make money is if these companies actually grow and the stock price increases.
On the other hand, if you own an AT&T stock, as long as AT&T exists and their profit margin doesn’t fall, it is safe to assume that you will be making roughly 5% in dividends every year.
Time for some lingo!
If you read more advanced articles, you might come across these two terms:
- Income investors: these are investors who rely on a stock’s dividends to make money
- Growth investors: these are investors that rely on a stock’s price appreciation to make money
You don’t have to classify yourself though.
At the end of the day, an increase in the value of a stock you own or an increase in your bank account is an increase in your net worth.
What matters is, how much this net worth increase is? and how much risk you’re willing to take for it? (returns vs risk)
Growth stocks are definitely riskier than income stocks. If the company fails to grow. You end up with an overpriced stock that probably never paid you any dividends. But, if the company succeeds, then you can make some eye-popping returns.
Dividend stocks on the other hand are safer but your returns maximum potential is limited.
You will observe this relationship between risk and returns over and over again.
Now I know you’re rolling up your sleeves and you’re ready to go ahead and buy some stocks. Don’t get carried away. There is a lot yet to cover 🙂
How can I buy stocks?
Stocks are traded in stock exchanges.
For example, the biggest stock exchange in the US is the NYSE (New York Stock Exchange)
Stock exchanges existed a long time before the internet.
It was a very interesting world before the age of internet.
Let me tell you how investors bought stocks back in the day.
First, You would need a stock broker.
Second, you would get the stock prices from the business section of a newspaper. Real-time stock prices that we now take for-granted weren’t available back then.
If you wanted to buy or sell a stock, you’d call your broker, and someone would literally stand out on the floor of an exchange and get your order filled.
If you are a history buff, I really suggest you watch a documentary about the history of stock exchanges. The story dates back to the 1600’s and it’s surprisingly entertaining!
Nowadays, the process of buying and selling stocks is very different.
It has become way easier to buy and sell stocks.
Now we have online brokerages. We can simply open an account online at any one of them and immediately start trading stocks NOW.
Some examples of these online brokers are E-trade, TD Ameritrade, and Fidelity.
How do I read a stock quote?
Stock quotes are the alphabet of the stock investing language.
But what is a stock quote?
A stock quote represents the stock price at at the last transaction that happened between a stock buyer and a stock seller. This price will be changing dynamically based on the mechanics of supply and demand.
Besides the stock price, a stock quote will also show you some other important information about the company.
With practice, you should be able to easily and comfortably look at the stock quote of any company and quickly get all the information you need.
In fact, it’s insanely easy to pull out the stock quote of any company instantaneously. Just google the name of the company and put the word “stock” next to it.
For example, if I want to get the stock quote of Nike, I would just type “Nike stock” on Google and in 0.52 seconds I have all the information I need. This is how the stock quote on Google looks like.
Now, I am going to teach you everything you need to know to be able to quickly decipher a stock quote and get all the information you need.
Let’s start by pulling out the Apple stock quote on e-trade. The reason I am not using google is because there is more information on e-trade that I want to cover.
If you already feel intimidated, it’s ok. I agree it’s not the most visually appealing thing to look at. But it’s also not as complicated as it seems.
Let’s start with the most important thing. This is where the eyes of every investor look at first. The stock price.
As you can see, the price of the apple stock in the last transaction was $150.5
Now let’s take a look at some of the other interesting information in the Apple quote.
Open: Stock Exchanges (where stocks are traded) are not open 24/7. For instance, in the US, the New York Stock Exchange and Nasdaq are open from 9:30 am to 4 pm Eastern time. They’re closed during weekends. ‘Open’ refers to the share price of Apple’s stock when the stock exchange opened on that particular day (Nasdaq in our case because this is where Apple’s stock is traded).
Pro Tip: The more seasoned investors will say “the market is open” or “the market is closed” to refer to the stock exchange
Previous Close: This is the price of Apple’s stock the last time the market closed.
52-week-range: this is the range of prices that Apple’s stock had in the last 52 weeks. The minimum price in the last 52 weeks was $104.08. The maximum was $164.94
Avg Volume: This is the average daily number of apple stocks that are being traded (averaged over 10 days). The higher this metric is, the easier and faster for you to sell or buy this stock. In other words, a high volume is a good indicator of liquidity.
Shares Outstanding: This is the total number of shares owned by the stockholders. Apple has 5.2 billion shares outstanding.
Market Cap: Mathematically, the market cap is the number of shares outstanding multiplied by the share price. Conceptually, this represents the market value of the company. In other words, this is how investors (the market) valuate Apple.
Dividend Yield: This is the dividend you get per share (annually) divided by the share price. It is worth noting that Apple is one of the few technology companies that give out dividends. The Tech sector in general does not give out any dividends to the shareholders.
Pro Tip:The dividend per share is declared by a company each quarter. For example, the board can declare $1 per share as dividends. This amount will not change again until the next quarter. What this means is that the dividend yield fluctuates all the time as the stock price fluctuates. Lower stock prices means higher dividend yields and vise versa.
There are still two very interesting metrics that are related to Apple’s earnings that I haven’t discussed yet:
EPS: Earnings-per-share, is a metric that indicates a company’s profitability (either on a quarterly or annual basis). It can be calculated by dividing the company’s net income by the total number of shares outstanding (it could be more complicated than that but let’s ignore it for now).
Quiz: Just by looking at the stock quote, can you tell how much profit Apple made in the last year?
PE: This is called the Price-to-Earnings ratio. It is one of the most popular metrics used by investors to value a company. PE is calculated by dividing the stock price by the earnings-per-share. Math aside, Let’s see why this metric is useful.
EPS tells you how much money a company made in profit per share. You can use EPS to know if a company is more profitable than previous years (just by comparing EPS values)or you can use EPS to know the total earnings that a company made (by multiplying the EPS by the shares outstanding).
What EPS doesn’t tell you though is if the stock price is high or low? Is the company overvalued or undervalued? How is the company doing relative to its competitors?
Assume there are two companies in the same industry with EPS $0.5 and $0.3 respectively. Assume they both have the same number of shares outstanding (say 1 million shares). If the share price of the first company (company A) is $10 and the second one (company B) is $4.5. Which company would you be more willing to invest in?
Well, there are too many variables here.
On one hand, company A has a higher EPS than company B. On the other hand, the price of company A’s stock is higher.
So how do you compare these two stocks?
To be able to compare these two stocks, let’s see how much income does each company generate per $1 of its market value.
Company A is valued at $10 million. It was able to generate $500,000 in profit (EPS x shares outstanding). So in other words, for every dollar of its market value, company A was able to generate $0.05
Company B is valued at $4.5 million. It was able to generate $300,000 in profit. So, per each dollar of its market value it was able to generate $0.067.
Now, it is clear that company B is a better investment even though the EPS for company A is higher because company B can generate more income per dollar of its market value than company A.
But wait? where is the Price to Earnings ratio here?
Good question. The PE is simply the inverse of these numbers above.
The PE for company A is 20 (1/0.05) and that of company B is 15 (1/0.067). The lower PE, the better a company is at generating income for each dollar of its market value.
Here I would like to stress some points that are very important. PE is by no means the only way to compare companies but it’s one of the most effective and quickest ways.
Another thing, PE is used for comparisons. It should be used relative to the PE of another stock in the same sector or industry. It should never be used separately to measure how good an individual stock is. It also shouldn’t be used to compare two stocks that belong to completely different industries.
Fun Fact: For a corporation to be listed on the New York Stock Exchange, a company must have issued at least a million shares of stock worth $100 million and must have earned more than $10 million over the last three years.
Congratulations! With this knowledge, you are now well-equipped to dive deeper into more interesting subjects.
So far we talked about how you buy or sell a share in company. If you want to invest in multiple companies, you would need to buy at least one share for each of the companies you want to invest in.
Wouldn’t it be nice if you could buy one share that would allow you to instantaneously invest in multiple companies at the same time?
Indeed you can! Let me introduce you to Mutual Funds and ETFs
What are Mutual Funds?
Imagine a man called Andy.
Andy learnt about stocks and the stock market and he was so fascinated by it.
He learnt how to invest in good stocks. He learnt how to avoid bad stocks. He gained years and years of experience.
Then one day Andy came up with a great idea!
“I can use my experience to invest other people’s money, and I think people will be willing to pay me if I do all the hard work on behalf of them”, he thinks to himself.
He starts his new business idea by telling his friends.
His friends trust him so they give him their money to invest.
Andy is getting more and more popular because his investments are doing very well so more and more people give him their money to invest.
Andy now is managing a large pool of money (this is what the mutual fund is).
Andy’s now a fund manager.
In fact, mutual funds are not exclusive to stocks as fund managers might choose to invest in other types of investments as well (bonds or real estate).
Investing in a mutual fund is a GREAT way to start investing in the stock market without having to be an expert investor.
Among other benefits that we’ll talk about later, fund managers are experienced investors who are going to be in charge of picking stocks, trading stocks, and allocating the fund in a way they see fit. This means you’re essentially delegating the management of your investment to a third party, the fund manager.
In this day and age, there are many people like Andy.
What I am going to do now is that I am going to show you some real examples of mutual funds. We will look at the mutual fund table (similar to a stock quote) and try to decipher it. Let’s begin!
How to Read a Mutual Fund Table?
Mutual funds themselves are also divided into shares like traditional stocks.
In our example above, if Andy is managing a $1 million fund, he can divide the fund into 1 million and each share would be $1.
Let’s take a look at two examples of popular mutual funds to make our discussion more practical and less abstract.
Our first example is the Vanguard Total Stock Market Index (VTSMX).
This mutual fund is provided by Vanguard. One of the largest providers of mutual funds in the world.
VTSMX is a type of a passively managed mutual fund.
A passively managed mutual fund means that the fund requires little to no management. This is because usually these types of funds try to mimic a market index (an already predefined set of stocks like S&P 500) . This means that managers are not really required to pick individual stocks and hence the name “passive”.
The screenshot above is from Morning Star. Morning Star is an investment research company that you will probably be using a lot especially if you are researching mutual funds.
Let’s take a look at some of the information in the mutual fund table.
The first thing we’ll talk about is NAV (net asset value). This is essentially the price of a share of the mutual fund. Much like the stock price in the stock quote.
So by looking at the mutual fund table above, we know that the price of a share of VTSMX is $62.36
Another important piece of information is the Total Assets, which is the total amount of money that makes the fund. As you can see, VTSMX has $603.6 BILLIONS in assets.
Now let’s look at what I believe is the most important piece of information in the fund table.
That is, the expense ratio.
In the table above, the expense ratio is 0.15%. But What does that mean? What is the expense ratio?
The expense ratio is a fee that you pay annually for having your money managed by the fund manager.
It’s always a fixed percentage of the fund assets and it essentially covers management fees among other things (marketing the fund, etc). You can essentially think of management fees as the salary of the fund manager(s).
So back to our example, if you have $10,000 invested in VTSMX, you will be paying $15 annually as an expense fee.
The reason why expense ratio is important is that you will need to deduct these fees from your annual return to estimate your actual effective return on investment.
In other words, a mutual fund that consistently generate more returns than another one is not necessarily better if the fees are much higher.
Expense ratio is the most important piece of information in a mutual fund table. Don’t ignore it.
Now let’s take a look at a different mutual fund. A mutual fund that is “actively” managed.
This means that the fund manager will be in charge of conducting stock research, analyzing data, picking, selling, and buying individual stocks.
In this example, we will be studying American Funds Growth Fund of America (AGTHX).
American Funds is a collection of mutual funds provided by the Capital Group.
Unlike VTSMX, this fund actively managed.
Similar to VTSMX, we can gather the following information.
The share price is $48.95.
AGTHX has $167.9 billions of assets.
But now let’s take a look at the most important piece. Remember? yes, those nasty fees. Let’s take a look at the expense ratio.
It is a whopping 0.66% (4.4 time the expense ratio of the passively managed VTSMX)
Here is what I want you to know.
you will always find passive mutual funds to have less fees than actively managed ones.
Another difference between passively managed funds, and actively managed ones is the expectation from each.
Usually investors who invest in passive funds are just trying to match the returns of the market index that the fund is tracking whereas investors who invest in actively managed funds expect more returns. That’s the only justification of paying higher fees.
We will come back to Mutual funds later when we discuss fees in more detail but for now, let’s talk about Mutual Fund’s close cousin, exchange-traded funds or ETFs.
What is an ETF?
Now that you understand the basics of mutual funds, it will be SUPER EASY to explain ETFs.
They are VERY similar to index mutual funds. ETFs stand for Exchange-Traded Funds and they mean exactly that. They are funds that you can sell and buy in traditional stock exchanges.
The difference between ETFs and Mutual funds is that they are traded similar to individual stocks. You can open an account on e-trade or fidelity or any of the popular brokerages and start buying and selling shares of ETFs immediately. So when you buy or sell an ETF share, you are making a transaction with another investor. For mutual funds, your transaction is always with the fund manager.
Also, in general, ETFs tend to be cheaper than index mutual funds because they require less active management. However, because they are traded like individual stocks, you incur commission fees when you buy or sell ETF shares.
When you go shopping for ETFs, you will find different ETFs for various sectors, countries, or investment strategies (e.g. growth vs dividend stocks). You should look carefully at the trading volume of the ETF before you buy because some ETFs have small volumes which means selling them back can be problematic. You should try to steer clear from low volume ETFs.
Before finishing this section, I also want you to be familiar with the biggest names in ETFs so that if you see these names later on, you will understand what they are referring to. This site has a list of the most popular ETFs by trading volumes. Skim through the names once or twice. You will most likely see these names again.
Understand the Importance of Diversification
“Don’t put all your eggs in one basket” is what describes best what diversification means. Diversification means to hold a variety of uncorrelated investments. For example holding stocks in Microsoft, Google, Facebook, and Netflix is not a diversified strategy (even though they are still different stocks) because they all fall under the technology sector so they are not strongly uncorrelated.
Harry Markowitz, a popular American Economist, coined the principle of diversification in his classic paper “Portfolio Selection” in 1952 and his book “Portfolio Selection: Efficient Diversification” in 1959. An idea very simple to conceptualize and understand nowadays, stirred a lot of controversy back in the days when investors were busy investing in individual stocks.
In fact, diversification was so important that Harry Markowitz won the Nobel prize in Economics in 1990.
Putting the mathematics of diversification aside, practically diversification would imply investing in different sectors of the stock market, bonds, and real-estate.
It shouldn’t come to you as a surprise that diversification minimizes risk. It is likely that an investment falling in value will be compensated by another one that is rising. So as long as the general trend of you portfolio of investments is going up with a good rate of return, then you are in good shape!
You should also be aware that minimizing the risk always indicates reducing the expected returns. This is one of the basic principles of investing.
You can mix and match your portfolio to fit your risk appetite which is usually correlated to how much money you have available for investing, and your age.
Don’t put all your eggs in one basket. Diversify!
Should I Invest in Individual Stocks, Mutual Funds, or ETFs
With all available options (Individual Stocks, Mutual Funds, ETFs), perhaps the biggest question in your mind is: where to start? should I invest in individual stocks, mutual funds, or ETFs?
Before I answer your question, I really just want you to completely understand the consequences of each investing decision you might make.
Based on that, I will tell you what my favorite way. However, it is much better to understand first what to expect for each case.
ETFs vs Mutual Funds
Let’s start with ETFs and Mutual funds since they are very similar and they share most of the advantages and disadvantages (remember that ETFs are essentially mutual funds that can be traded in stock exchanges)
The greatest appeal of both ETFs and Mutual Funds is that they offer you a very convenient way for diversifying your investments, and accordingly mitigating your risks.
This is crucial because efficient diversification and risk management are not easy. They require a lot of research and a ton of experience across many different companies and sectors. You probably don’t have the time or experience to do that yourself.
ETFs however have cheaper costs than Mutual funds because most ETFs track a market index so they don’t require active management, hence they are cheaper.
Since ETFs are traded like stocks, the fees incurred are commission fees when you buy or sell ETFs. It is not complicated and very easy to understand.
Mutual fund fees on the other hand, are complex, and not super easy to understand. We will talk more in depth about fees later in this article but for now, you just need to know that the cost structure is completely different between ETFs and mutual funds. It is very important to do your research and compare fees before you start investing.
For example, if you want to invest in the S&P 500 index, you will be able to find ETFs and passive mutual funds that achieves this objective. In such case, your choice should be based on the costs that you will incur, which is related to how frequent your trading is going to be and how much money you are investing.
(ETFs and Mutual Funds) vs Individual Stocks
Now the question is, how is investing in individual stocks different?
Let me start with the biggest advantage of investing in individual stocks: a potential high return on your investment.
When you invest in mutual funds or ETFs, the instant diversification inherent in these investments lowers your risk and your potential gains.
If you invest in individual stocks, you increase the potential of your gains and your risk.
If you had invested $1,000 into Apple in 2002, your investment could be worth more than $174,000 today, including dividend reinvestment. However, if you had invested the same money in a company that didn’t do well, you could lose all your investment money. Always keep in mind that the Apples and Facebooks of the world are the exceptions, not the common case.
Another thing is, picking individual stocks require a lot of research and experience that you probably don’t have. It is a full time job and some professionals spend their whole lives working with stocks trying to beat the market and they still can’t.
One thing you could do is to stand a middle ground between ETFs/MFs and individual stocks. You could possibly pick a diversify portfolio of individual stocks to decrease the risk factor, yet maintain gains that are potentially a little higher than passive ETFs.
Although this is a very valid point assuming that you are willing to spend the time and energy to do all the required research, it is still easier said than done.
Let’s talk about why this is not a very good idea, especially for beginners.
Most experts agree that a basket of 20 company stocks is good enough for a well diversified portfolio. Because individual stocks have different prices, you will need to buy different number of stocks for each company to achieve the diversification weights that you are trying to achieve.
It is not as simple as buying one stock for 20 different companies. This actually means that you will need a lot more money to invest to have this well-diversified portfolio. On the other hand, just one ETF stock has diversification built-in. Even mutual funds generally have a minimum investment that is going to be smaller than what you will need to build your own diversified portfolio of individual stocks.
My 2 Cents
Based on all the previous discussions, I suggest that you should go for ETFs or mutual funds (whatever’s cheaper).
Even if you are not a beginner, I haven’t heard of any professional who can consistently beat the market in the long term. So the odds aren’t in your favor that you will get higher gains if you individually pick your stocks.
If you are a beginner, it is completely unwise to invest in individual stocks. If you have a strong gut feeling that a specific company is going to be the next Apple and you really really want to invest in it, don’t put all your money in it. Put only money that you are comfortable completely losing. The bulk of your investments should be in ETFs or mutual funds though.
Understand the Difference between Investing and Trading
First, let’s discuss the difference between investing and trading. What investing and trading have in common is that both are ways to make money. Conceptually, investing and trading aren’t limited to the context of financial markets.
To draw an analogy in the real estate world, investing would be buying some real estate in a promising location where you expect the value of your real estate to grow. Trading would be similar to flipping houses. Buy a house when it’s listed at a low price and sell when you can make the desired profit.
Usually when people talk about investing vs trading, they are talking about the act of investing or trading in the financial markets specifically (stock market, bond market, mutual funds, etc..).
Although both ways can result in financial gains, it is extremely important to understand the expectations from you before you choose which way you want to go.
If you are an investor, you goal is to slowly build wealth through the act of buying and holding on to financial assets that you believe is going to increase in value in the long term. “Long term” is THE investor’s mindset. This can be years or even decades. Investors don’t care about short-term fluctuations of the price of the asset they are holding on to as long as the asset is valuable in the long term.
On the other hand, traders are concerned a lot about the short term. They are consistently involved in the act of buying and selling stocks because their goal is to make profit from small fluctuations in the stock’s price. For instance, day traders are a type of traders who buy and sell stocks on the same day.
It is very obvious that trading is a full-time job. You can’t have a different job and be a trader at the same time since making profit from short-term fluctuations requires continuous market monitoring, to say the least. However, the buy and hold strategy followed by investors is ideal for people who want to still benefit from the market but they don’t have the time or energy to continuously observe and monitor the market like traders do.
Educate yourself about Taxes
Tax-Advantaged Investment Accounts
Every year when I file my taxes, I find myself spending a whole day trying to educate myself about all the available deductions I can use.
I am sure you might have done that yourself. It is overwhelming!
We love to pay less taxes, umm legally, if we could but sometimes it is just not that easy.
However, Uncle Sam encourages you to invest for your retirement by offering you deductions on the money that you invest!
So if you make an annual income of $10,000 and invest $1000 in your retirement account, you are only taxed on $9000!
These are some of investment accounts that have tax advantages:
All of the above accounts allow you to invest a portion of your income and get some tax advantages doing that!
However, there are some rules that you should be aware of for each of these accounts. For example, in a 401k if you want to withdraw your money before the age of 59.5, you incur a penalty that is 10%. This is a huge penalty.
It is wise to educate yourself about these rules before you start investing in any of them.
How are stocks get taxed?
You want the values of your stocks to increase because this is how your money grows.
But after that, Uncle Sam demands his shares.
Capital gains are the taxes you pay when your stocks increase in value. But you only pay taxes AFTER you sell.
If you don’t sell, your gains (if any) is called unrealized gains and you never pay taxes on unrealized gains.
If you sell, your gains are now called realized gains and you have to pay Uncle Sam his fair share.
But how much does Uncle Sam demand?
Well, this is the interesting part. The taxes you pay on capital gains depend on how long you held to your investment!
Of course the law can change but in 2017, there are two types of Capital Gains taxes: Short-term (less than a year) and Long-term (more than a year).
The taxes you pay on a short-term capital gain is the same as your income tax rate. For example, if you are in the 35% tax bracket, you pay 35% of your capital gains as taxes.
So say you buy a stock at $100 and you sell it at $200 after 6 months (short-term), you pay $35 in taxes leaving you with $165.
For long-term capital gains, it is lower than that. If you are in the 35% tax bracket, you only pay 15% in taxes for your capital gains.
In the scenario above, you will end up with $185 instead of $165.
Don’t underestimate this difference. These taxes are eating at your effective annual return and we have discussed before that the smallest difference in your effective annual return will result in a huge difference in the long term (because of the compounding effect).
Watch Your Fees
Similar to taxes, fees are another monster that eats at your effective annual return.
From your perspective, they should be treated similarly. Both are this hungry pac-man that is slowly munching away at your returns.
The only difference is that taxes are paid to the government whereas fees are paid to an individual or a broker.
To be honest with you, The ONLY thing that separates a smart investor from the average joe is that smart investors pay a great deal of attention to both the fees associated with their investments and the tax implications.
Remember that a tiny decrease in your returns significantly impacts the exponential growth of your money in the long term.
The SEC office of Investor Education and Advocacy published a chart showing how an investment with a 4% annual return over 20 years looks like when the fees are 0.25%, 0.50% or 1%. Notice how the gap between your the different gains becomes exponentially bigger as time passes.
You won’t be able to completely eliminate fees but you should still do your homework, shop around, and educate yourself about the different types of fees that can hit you.
What I am going to do now is that I am going to teach you about the basic fees associated with each investment type that we covered.
Individual Stock Fees
For individual stocks, there is a commission fee. You pay the brokerage a fixed amount of money with every transaction you make.
For example the e-trade commission fee is $6.95 so if you make a buy or a sell transaction, you pay $6.95 to e-trade. It’s that simple.
Commission (or transaction fees) are fixed. They are not a percentage. It doesn’t matter if you are selling one stock or 1000 stocks. You pay the same fee.
Minimizing these fees means minimizing your transactions. Buying 100 stocks of company A in a single transactions is much better than two buy- transactions of 50 stocks each which is also much much better than four buy-transactions of 25 stocks each.
So how about Mutual Fund fees?
Mutual Fund Fees
I glanced over mutual fund fees earlier when I covered the expense ratio.
Unfortunately, this is not the only type of fees that hit you when you invest in mutual funds.
In general, there are two types of fees when it comes to mutual funds.
First: Ongoing Fees
These are the fees represented by the expense ratio that I discussed earlier.
They include various items but mainly the management fees (read: salaries) and fund marketing fees.
Second: Transaction Fees (loads):
Loads are another type of fees that is not ongoing. These types of fees are transaction based.
Sales Loads: These are very similar to the commission fees of individual stocks. The main difference is that, unlike individual stocks, they are not fixed. They are a percentage of your investment. These fees are eventually paid to the broker (not the fund manager) when you buy or sell the shares of the fund. There are two types of sales loads: Front-end loads is the fee you pay when you purchase the fund. Back-end loads (or deferred sales charges) are paid when you sell the fund shares. There exists also no-loads mutual funds which means you don’t incur these fees.
Redemption Fees: These fees are paid to the fund manager (not the broker) when you sell the fund shares. This is separate from the back-end load that you pay to the broker.
Purchase Fees: These fees are paid to the fund manager (not the broker) when you buy the fund shares. This is separate from the front-end load that you pay to the broker.
Loads information is also available in the mutual fund table. Go back to the two mutual funds that I covered. Can you spot the Loads information? Does it make sense?
So what about ETFs?
ETFs are unique because they have a dual nature.
They are essentially mutual funds but they’r also traded in traditional stock exchanges similar to individual stocks.
This dual nature is what makes ETFs appealing.
However, this dual nature means that not only you pay commission fees when you buy or sell ETFs (similar to individual stocks), but also you pay the fees associated with mutual funds (e.g. expense ratio)
For instance, e-trade commission fees for trading ETFs is the same as individual stocks, $6.95.
Also don’t let this dual nature of fees intimidate you. It doesn’t mean that ETFs will cost you more because as I mentioned earlier, the expense ratio of ETFs is very small (especially if the ETF is passively tracking a market index )
Read Reliable High-quality Content
if you want to dive deeper into the amazing world of investing , there are a lot amazing sources of information out there.
It is important to keep an open mind and read different sources and get exposed to different opinions. And trust me, you will come across different and sometimes conflicting opinions.
Here is a list of my favorite sources. This list is by no means comprehensive or complete. I will update the list whenever I come across a new valuable addition.
1- The Intelligent Investor by Benjamin Graham: One of the classics. Written by the “father of value investing”. Warren Buffett’s pick as the greatest investment book of all time, and it really lives up to that review!
2- The Little Book of Common Sense Investing: Written by John Bogle, the founder of Vanguard. An essential book for beginners.
3- Principles of Corporate Finance: If you are a nerd like me and you like to learn everything about finance. I highly recommend this 1000-page book. Not for the faint-hearted but surprisingly very enjoyable to read.
Best Paid Sources
1- Financial Times: One advantage of FT is that it covers financial issues beyond the US which can be very useful if you want a broader understanding and insights.
2- Wall Street Journal: This one is more US centric and also covers politics so it is not solely dedicated to financial news.
3- The Economist: I know for sure this is the one subscription I will never git rid of. I rely on the economist for all sorts of news, not just the financial ones.
Barron’s and Bloomberg are very high-quality publications.
The Economist, Barron’s, and Bloomberg’s businessweek are weekly magazines (unlike WSJ and FT which are daily). This is good because that way they avoid all the gibberish articles that daily publications have.
Best Free Sources:
1- Investopedia: This one is my favorite. They always provide high-quality content. Investopedia is not just for news but it also has a ton of educational material.
2- MarketWatch: It is a very comprehensive website to keep you updated. The only downside is that it can be too much!
Best News Aggregators:
Aggregators basically aggregate news from all the previous resources I mentioned (and more) so that you can get everything in one place
1- Vesty Waves: This is my favorite aggregator.
2- RealClearMarkets: Another good aggregator