DISCLOSURE: THIS POST MAY CONSTAIN AFFILIATE LINKS,MEANING I GET A COMMISSION IF YOU DECIDE TO MAKE A PURCHASE THROUGH MY LINKS, AT NO COST TO YOU. PLEASE READ FULL DISCLOSURE HERE
Investing in stock market is a great way to grow your wealth passively. The earlier you start, the more you can capitalize on the power of compounding. So, how do you get started investing in stock market as a beginner?
Learn The Basics
What is the first thing you should do to get started in investing in stock market?
No, it is NOT opening a brokerage account.
What you should do first is to first learn the basic knowledge about investing and stock market.
- What is stock market?
- What are the instruments that are being traded on stock market?
- What makes stock price go up and down?
- Understand the important terms and concepts such as dividends, market cap, bull/bear market, market indices, PE ratio, portfolio, diversification, compounding and etc
Here are some good books to read:
- “The Intelligent Investor” By Benjamin Graham
- “The Essays of Warren Buffett: Lessons for Corporate America”
- “Value Investing: From Graham to Buffett and Beyond”
- “The Little Book of Common Sense Investing: The Only Way to Guarantee Your Fair Share of Stock Market Returns “
- “One Up On Wall Street: How to Use What You Already Know to Make Money in the Market”
What Type Of Investor Are You?
There are two types of investors, active investor and passive investor.
Here’s how to find out what type of investor you are.
Ask yourself these two questions:
- How much time are you willing to spend on stock investing
- How much interest do you have in stock market investing
If you don’t want to spend a lot of time analyzing and picking stocks and have little interest in doing it, then you are a passive investor. Your best option is to invest in stock market passively through ETFs or mutual funds.
If you have a strong interest in stock market investing and want to adopt a more hands-on approach, then you are an active investor.
The best way to become a good and profitable active investor is to find people who have achieved what you want and follow what they do.
For example, everyone knows Warren Buffet is one of the greatest investors.
His investment strategy is value investing.
And it has been already proven to work.
Follow his proven strategy, then you too will make money from investing.
How To Pick Stocks
I am a strong believer in value investing.
So, we will be talking about how to pick stocks based on value investing strategy.
The essence of value investing is to buy good businesses when they are undervalued.
Simple as that.
Now, the question becomes, how do you identify good businesses and how do you tell it’s undervalued?
What defines a good business?
A good business is a business if
- it generates consistent profits over the years
- it has positive cash flow year after year
- it has an endurable competitive advantage over its competitors
- it generates high return on capital employed with little debt
- it is scaleable
One trick is to think like a business owner.
Do you think it will give you better return if you re-invest the profits back in this business?
If yes, then it’s worth putting your money in this business.
Because you won’t get a higher return on your money elsewhere.
Next, how to tell it is undervalued?
There are a few common valuation methods:
- Asset-Based Valuation
There are two ways to approach it.
- Total Asset Value minus Total Liabilities
- All the cash received after liquidating the company
- Discounted Cash Flow Analysis
The idea behind discounted cash flow analysis is that the value of a company is the net present value of ALL FUTURE CASH FLOW of that company.
- Multiples method
How it works is that you value a company based on market valuation multiples.
For example, if you are going to use P/E multiple to value the company. First, you look at what P/E multiple is used for a comparable company in the same industry. Next, you apply the same P/E multiple to the company’s earnings to arrive at a valuation.
Common Sense Investing
Even if you don’t know any valuation method, you can use common sense when you are looking for undervalued good businesses.
I still remember my ex fund manager boss told me a story about a man who managed to put all his 3 children through medical school in the United States with his investment profits.
He does not have any sophisticated valuation models. He does not have any finance background. He does not even actively trade the market.
What he did was simply combining common sense with value investing principles.
During 2008 market crash, people were all panic selling.
But, he knew some fundamentally sound companies were oversold. Value investors always look for irrational behavior in the stock market because it creates good buying opportunity for them.
So, he bought a lot of their shares at very cheap price. Next, he just patientially waited for market to rebound.
If you look back at the history, stock market has always rebounded and went on to make new higher even after great depression.
Your Very First Investment
Now, you are ready to make your very first investment.
Then, it’s time to open a brokerage account.
When you are opening a new brokerage account, do your research and find a brokerage firm that suits your needs.
Here are a few things to consider:
- Good 24/7 customer support
- User-friendly & advanced trading platform
- Low fees & commission
- Reliable research resources
Once you have stock your trading account ready, you can buy and sell stocks through your broker’s trading platform.
Before you make any investment decision, you should already have a well-thought plan as well as a sound strategy.
Your strategy tells you what stocks to buy or sell at what price.
Your plan tells you what to do in all possible scenarios, so that you won’t let your emotions take over and make the wrong decision.
For example, if the market goes against you, you should have already planned for it. Based on your plan, you should know when you can add more position to average down your cost and when you should just cut your loss.
Any type of investment is inherently risky.
It’s true that investing in stock market can give you high returns, but it also comes with its own risk.
But, here’s the good news.
Risk can be managed.
Smart investors don’t shy away from risk. They manage their own risk.
Here’s how you can do the same.
You don’t put all your eggs in one basket.
Diversifying your investments in uncorrelated sectors can reduce your risk.
The theory behind it is that if one goes down, the others would likely go up.
For example, having a good mix of defensive stocks and cyclical stocks is one way to limit your risk.
- Set A Stop-Loss
Another way to limit your risk is to have a stop-loss.
For each investment, you can have a pre-determined stop-loss.
It can be a percentage stop-loss.
For example, a maximum 20% loss in share price.
You can also have a maximum loss limit in dollar amount.
For example, a maximum $500 dollar loss in your stock investment.
When your loss reaches a pre-set limit, you will cut your loss.
- Position Sizing
What is position sizing?
It tells you how much money you can use to buy one particular stock.
For example, you have $100,000 to invest in the stock market.
You allocate $10,000 to buy Amazon shares. That’s 10% of your total capital.
If you think that a particular stock has a lot of upside potential but is very risky, you can allocate a small percentage of your total capital to buy this stock.
This way, you can limit your downside if things don’t go your way. At the same time, you can still enjoy some of the potential upside if it actually materializes.
These risk management strategies will ONLY work if you adhere to it.
If you don’t stick to it, it is no different from not having a risk management strategy in place at all.