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Should I Invest in the Stock Market?
Investing in the stock market is a major contributor to a higher quality of life or early retirement. With one major stock market index averaging 10% gains per year in the past century (more on this later), few alternatives can compare.
Considering savings accounts yield less than 1-2% interest a year, it’s no wonder stocks are such an attractive investment. However, blindly investing can be a cause of stress and financial ruin.
Luckily, the majority who contribute to a 401(k) retirement account already gain stock market exposure through a professionally-managed fund within.
Building Wealth with the Stock Market
Understanding how to invest in the stock market (or even if you should invest) is one of the keys to building wealth. Otherwise, poor financial literacy could potentially cripple your finances and ensure you stay poor your entire life.
I was in the same boat when I started working, ignorant of the potential benefits of investing. But everything changed when I started looking into my former job’s 401(k) retirement plan.
Since my 401(k)-plan offered tax deductions, it was the perfect vehicle to start my investment journey. After considering my income, taxes, expenses, average stock market returns, and my investment timeline, I realized I could potentially become a billionaire.
But since I needed funds for business endeavors long before retirement, I also had to invest in the stock market outside of my retirement plan. These early decisions, fueled by my ambition to achieve the Billion Dollar Plan, paved the way for me to quit my job and start my own businesses.
Compound Interest
Compounding interest, where your earnings generate even more earnings, is the reason why long-term investing is an indispensable strategy to building wealth.
In the last century, stocks have enjoyed an average return[ref link=https://tradingninvestment.com/stock-market-historical-returns/] of 10% annually, even after accounting for inflation. Therefore, consider the following investment scenarios (assuming a 10% interest rate).
Your starting investment of $1,000 into the stock market earns $100, for a total of $1,100. The next year, your $1,100 earns $110. Your earnings increase over seven years, nearly doubling your initial investment to $1,948.72. Your earnings also increase to $194.87 that year, nearly double your starting interest earnings.
But if you had invested an additional $1,000 every year for seven years, your principal of $7,000 would increase to $10,435.89. If you chose to invest the entire $7,000 as a lump sum at the start, you would have $13,641.02 instead.
From these examples, we can see that time is the most important aspect of compounding in the stock market. The more you invest early on, the more you generate in the long-term.
Over the course of a 40-year career, even small sums of money can grow exponentially. If you invest about $5,000 a year (only $14 a day) for 40 years, $200,000 ($5,000 a year) becomes $2.4 million by the time you retire.
Meanwhile, putting your money in a bank account would make your poorer! With the past century’s average annual inflation rate[ref link=https://inflationdata.com/inflation/inflation_rate/historicalinflation.aspx] at 2.84%, $1 million would only be worth about $316,000 after 40 years.
Comparing Stock Investments and a Career
Investing in the stock market is no riskier than investing in the job market. In fact, the company you work for might even be listed on the stock exchange!
Whether you buy that company’s stocks or pay for an education to enter the company’s workforce, you’re still investing money in hopes of earning a return on your investment.
Regardless, you want that company to succeed so you can keep earning a living. Depending on what you pay for (schooling or stock shares), you’ll earn an appropriate payout (salary or dividends).
Even when the company fails, it won’t differentiate between shareholder or employee. A bankrupt company can no longer pay you – investors lose their money and employees lose their jobs.
Differences Between Stock Investments vs. Career
There are different benefits between investing in stocks and working a career.
The primary benefit of working is that you can generate a steady paycheck. With stocks, you only earn money through dividends and increases in stock value. While dividends are guaranteed payments, negative price movements may negate your dividends and yield negative overall returns.
However, working a job also comes at the cost of time; if you don’t work, you don’t get paid. For stock investments, you only need to research a company in which you want to become a shareholder; your money does the rest of the work for you.
Additionally, strong company/stock performance usually benefits investors more than its employees. Workers usually don’t get raises or bonuses from a company’s strong stock performance. But if you know a company that does, give them a shoutout in the comments!
Another key difference in stock ownership is diversification. While there’s a limit to how many jobs you can reasonably hold at a time, you can simultaneously hold hundreds (or thousands) of different stocks in case one fails. You can lose your job (and therefore income), but a healthy mix of stocks can continue to earn money even if one of them fails.
Naturally, it’s better to get a guaranteed paycheck from work and invest in the stock market simultaneously. But if you had to choose between the two, it may be safer to hold a diversified batch of stocks (with sufficient capital) than rely solely on a career for income.
Stock Market Primer – The Basics
The stock market is a collection of all the stocks of public companies. Each share of stock represents partial ownership in a company, no matter how small.
Any investor who owns a share becomes a shareholder and has a stake in the company’s future. Shareholders also earn certain privileges, such as collecting payment (dividends) and voting rights for (or against) company policies.
What Is a Stock?
Shares of stock represent a piece of ownership in a company listed on the stock market. a part of that company.
Investing in a company entitles you to several benefits. If the company remains profitable and expands, its stock price will continue to appreciate. Some companies even pay their shareholders for holding onto the stock (dividends).
What is a Dividend?
A dividend is a recurring payment that investors receive for owning a stock. Just like business owners may pay themselves, owning a stock (and therefore, part of the company) may entitle you to payment.
In simple terms, a dividend is your ‘salary’ for owning a piece of the company. If your shares entitle you to a dividend payment, you’ll usually receive one quarterly (every three months).
To receive the dividend for each payment period, you must own the stock before a specified date (ex-dividend date). If you purchase a stock after this date, you won’t receive a dividend until you hold onto the stock until the next ex-dividend date.
Stock Price
A stock’s price changes based on supply and demand. When a company does well, investors try to outbid each other to purchase shares before the price increases by too much. The supply can’t keep up with demand, so the prices inevitably increase.
But when profits decline, so does its stock price. Nobody wants to own an unprofitable company. As more people try to dump their shares, the supply exceeds demand and the share prices plummet.
Although this is an oversimplification of how events affect stock price, it’s important to gauge whether a company is over or undervalued. Doing so will allow you to buy when the stock reaches a more favorable price.
Stock Market Capitalization (Market Cap)
Stock market capitalization, or market cap for short, denotes the overall value of a company.
While two stocks may be worth $100, some may be inclined to believe they are of similar size. But one company may only have a thousand stock shares, for a total market cap of $100 thousand. Meanwhile, another company may have a million shares worth $100 each, bringing its market cap to $100 million.
Therefore, the market cap gives you a more complete picture of a company’s worth than its share price alone. Large market cap companies with more capital at their disposal tend to have the resources to weather unfavorable conditions like market downturns and diversify their products and services.
Stock Value – Price to Earnings Ratio (P/E Ratio)
A stock’s value is often denoted by its price-to-earnings ratio, or P/E ratio. Although stocks may have equal prices, that doesn’t necessarily mean both companies will perform equally well.
For example, consider two companies with equal stock prices of $100. If Stock A earns $5 per share and stock B earns $10 per share, which would you rather own?
Naturally, you’d want to own the stock which earns more for its value. This is where the price to earnings ratio comes in, or P/E ratio. To calculate it, simply divide its share price by its earnings per share.
Since stock A is worth $100 and earns $5, its P/E ratio is 20. In other words, its price is 20 times more than its earnings. Meanwhile, stock B’s P/E ratio is 10, meaning it costs 10 times more than it earns.
Compared to stock A (P/E of 20), stock B (P/E of 10) seems to be less expensive. However, that doesn’t mean that stock B is better than A.
There are some reasons that justify why a stock may have a higher P/E ratio, such as:
- Investors are optimistic about the company’s growth.
- The company is in an expanding market.
Meanwhile, a low P/E ratio may indicate that:
- Investors are pessimistic about the company’s growth.
- The stock is in a stable market, where growth is slow and steady.
However, a high P/E ratio can just mean that a stock is overvalued while a low P/E ratio may simply denote an undervalued stock.
What are Options?
Options are in a class of financial instruments called derivatives, as they derive their prices from a stock’s price movements. They are intended for advanced investors to make complex and leveraged trades, with a greater potential for earnings and losses.
The primary options are calls and puts. Each call or put option is a time-sensitive contract which enforces a potential trade of 100 shares of stock at an agreed-upon strike price.
Call Options
Buying a call option contract grants the owner of the contract a right to buy a stock, provided that two conditions are met:
- The stock price moves in-the-money (goes higher than the agreed-upon strike price).
- The option must not have expired.
On the other end of the trade, selling a call option earns the seller a premium, or fee. However, they have an obligation to sell the stock at strike price if both conditions are met.
A call option buyer has unlimited earning potential while the call option seller can face unlimited losses.
The higher the price goes above the strike price, the more the buyer can earn. Meanwhile, the seller has agreed to sell the stock at the strike price, even if they must acquire a stock they don’t own to fulfill the contract. Since there is no price cap on stock prices, the seller can face unlimited losses (theoretically).
Put Options
Buying a put option allows the buyer to sell a stock at a fixed strike price, but only on the condition that:
- The stock price moves in-the-money (goes lower than the agreed-upon strike price).
- The option must not have expired.
Meanwhile, the seller of a put option collects a premium while agreeing to buy the stock at the strike price.
A put option buyer earns more money the greater the stock price drops, until the stock price reaches 0. Meanwhile, the put option seller must buy the stock at the strike price, even if it drops all the way to 0.
Investor Mindset
Stocks are readily accessible to the public, making it easy for anyone to start their investing journey. At diverse price ranges, potential investors of all economic backgrounds can afford to invest in something.
However, not everyone has what it takes to be a successful investor. An investor’s mentality can influence (but not necessarily determine) their future performance.
Successfully investing in the stock market requires discipline, patience, and consistent study. While you won’t be rich overnight just from reading this guide, but you can become extremely wealthy over time.
If you want to become a successful investor, you must get rid of your preconceived notions about the stock market.
You may learn things you didn’t know were possible. It may challenge the beliefs you’ve been taught throughout your entire life.
But most importantly, you should always fact check information you find online. After all, good investors always do their due diligence and verify information before making investment decisions.
‘Buy and Hold’ or ‘Buy and Sell’ Stocks
Generally, investors should buy and hold stocks long-term rather than trade for quick profits. Recall that investing in the S&P 500 (a stock index) has yielded a 10% annual return within the past century, even after accounting for inflation.
While these gains reflect a long-term trend, stocks are volatile in the short-term. Since even seasoned investors fail to ‘time the market,’ a beginner would fare no better.
Most investors lose money by buying high when the stock market is doing well (and expensive) but selling out of fear when prices crash. Therefore, you should only buy a stock if you believe in its long-term growth or sustainability, allowing you to ride out the rollercoaster without fear.
Furthermore, you can enjoy a lower tax-rate when you’ve held stocks for at least one year, making them eligible for a long-term capital gains tax rate. Otherwise, you’ll end up paying a short-term capital gains tax, which is equal to your income tax rate. Use this method to lower your taxes when investing in stocks.
Investment Risks: Investing vs. Gambling
It’s easy to dismiss the stock market as a ‘rich person’s casino,’ but mistaking investing for gambling is a costly mistake. If investing feels like gambling to you, then it’s a sign that you’re doing something wrong!
Investing should feel like you own a business, as stocks represent ownership of an actual company. Only own stocks in companies whose business model you understand, as buying a business you know nothing about makes little sense.
Would you buy a cheap business just because it’s ‘affordable’? Would you sell a profitable business because someone offered you more than you paid, despite it being a bad deal?
Approach investing with a business owner’s mindset, instead of trying to buy and sell for a quick profit!
Risk Tolerance
The only thing stopping you from investing is your risk tolerance. Most people will tell you that you should only invest what you can afford to lose. While true, a better rule is to invest what you don’t for short-term or moderate-term use.
Since the stock market has a history of going up in the long-term, you need to be able to weather the short-term spikes and crashes. Waiting out a market crash is the best way to get your money back, and then some.
The only exception was the Japanese stock market crash of 1989[ref link= https://asia.nikkei.com/Spotlight/Datawatch/30-years-since-Japan-s-stock-market-peaked-climb-back-continues] which has yet to recover. Even so, those who invested with a diversified dollar cost averaging strategy (to be discussed later) would still find themselves doing okay in the market today.
The only losers in that stock market were those who dumped their life savings into stocks at the peak of the bubble, promptly sold during the crash, and never invested again. Manic buying and panic selling are the easiest ways to lose money!
When investing in stocks, be ready to invest consistently over the long-term. If you only have enough funds to cover emergency expenses or for day-to-day spending, AVOID investing in the stock market! You won’t be able to take out your emergency funds without severely diminishing its value!
Trading vs Investing
One key difference between trading and investing is your investment timeline. Always invest in the best opportunities, and don’t sell unless a better one comes along. This is how Warren Buffett, one of the greatest investors of all time, approaches investing.
When you invest in stocks, make sure you want to hold them ‘forever’. Identify which companies you would be comfortable owning for the long-term, rather than making short-term trades for quick profit.
Your investments may fluctuate, but great companies will grow (along with their stock prices) over time. If the past century isn’t any indicator of that, then I don’t know what is.
Most of all, pick companies whose business model you understand! As a consumer, you probably have a better idea of which brands or services are popular. This is one advantage that you can leverage over institutional investors. Then verify whether you believe their stock is a good investment opportunity.
Research and Critical Thinking
Research and critical thinking skills will set up your stock picks for success. You don’t have to be right all the time, just most of the time. Even the greatest investors may pick the wrong stocks from time to time.
But if you simply invest based on stock picks other people say are good, you’ll become the type of “investor” who pays for stock market alerts. Instead of focusing on WHY someone might buy a stock, you’ll end up focusing on WHAT they’re buying.
Most of the time, their alerts are designed simply to take money from you. It makes as much sense as going to a casino and picking the same slot machine that a jackpot winner used.
That isn’t to say that you shouldn’t mirror great investors, but you should understand why they’re buying a stock, as opposed to what they’re buying.
If you’re asking someone to pick stocks for you, you might as well give up stock picking and choose a low-fee ETF or index fund. You’ll likely have better performance managed by a professional, without having to trust someone on the internet you don’t even know.
The Myth of Stock Market ‘Risk’
There’s a myth that investing in the stock market is risky, but that’s only if you do everything this guide says NOT to do. In fact, this is a personal story about my parents, an embodiment of everything you shouldn’t do in the stock market
As hopeful traders during the dot-com bubble[ref link=https://en.wikipedia.org/wiki/Dot-com_bubble], the stock market crash of 2000, they suffered the consequences because of their ignorance of investing.
At the height of euphoria of the dot-com bubble, they engaged in risky day-trading. They recounted stories of making thousands of dollars by indiscriminately buying and reselling stocks daily. It didn’t matter WHAT stocks you bought and sold; all you had to do was buy SOMETHING.
As ‘investors’ pumped the stock valuations higher without any sort of rationale, the bubble would eventually have to burst. When it did happen, stock prices plunged and whoever was left holding the bag potentially lost over half their fortune.
Investing in stocks isn’t inherently high-risk; it’s gambling money in the stock market that is. My parents didn’t know what they were doing; they were taking advice from other mom-and-pop investors. When the market does well, everyone’s an expert.
These conditions seem to reflect today’s reality, with 15% of investors in a study[ref link=https://www.aboutschwab.com/generation-investor-study-2021] stating they started investing in 2020. This has pushed the stock market to all-time highs, which may not reflect the true companies underlying each stock.
As Warren Buffett says, “Be fearful when others are greedy and be greedy when others are fearful.” Although there’s no reason to stop investing altogether, make sure you’re not buying simply because everyone else is pushing up the stock market to new levels.
Stock Market Assets
Although named the ‘stock market’, there are many other assets besides stocks. Here are some of the major equities you should familiarize yourself with before you start investing.
Individual Stocks
Individual stocks represent a share of a single company. These are the most plentiful equities on the market. However, aside from options, individual stocks one of the riskiest assets for retail investors.
The exception is if you employ some stock portfolio management strategies (discussed later) to invest in individual stocks. Otherwise, it may be better to invest in one of the professional managed funds below.
Index Funds
Index funds invest in stocks to mimic the performance of a financial market index. The stock index most discussed here is the S&P 500, which represents the 500 largest companies in the stock market. The Dow Jones Industrial Average (DJIA) represents the 30 largest market cap companies in the stock market.
Although there are several other indices, these two are the most well-known and believed to best represent the state of the overall stock market.
Electronically Traded Funds (ETF)
Electronically traded funds (ETFS) are a batch of stocks managed by professionals to match the performance of a market index or capture the performance of a particular market or asset. While an index fund is an example of an ETF, not all ETFs are index funds.
The rest are mutual funds, which work by pooling money together from many investors and diversifying stock or equity ownership to reduce risk. In return, the fund manager receives a small fee for selecting the stocks.
Meanwhile, index funds are mutual funds that track various stock market indexes. By purchasing an S&P 500 index fund, you can match the performance of the top 500 market cap companies in the stock market.
ETFs make diversifying into stocks much more manageable than manually buying all the different stocks within. It also minimizes the need to research all individual companies, and instead focus on a particular market sector.
Real Estate Investment Trusts (REIT)
Real estate investment trusts allow people of all financial backgrounds to invest in real estate. These companies own and manage real estate properties to generate income on behalf of shareholders. They offer much higher dividend rates than the average stock as well.
Managing Your Stock Portfolio
Stock Picking
One of the most common requests from beginner investors is picking the right stock to buy. Usually, the question is some variation of “What stocks should I buy?” or “Which stocks are the ‘best’?”
However, no one can tell you the highest performing stocks, unless they do so from hindsight. Investing with this mentality will almost certainly set you up for failure.
The truth is that many people have ulterior motives for telling you which are the ‘best stocks’ to buy.
- Newsletters want you to pay for a subscription to stock alerts.
- ‘Gurus’ want you to buy their course.
- Analysts can influence trading patterns and manipulate stock prices.
- Fund managers want to build credibility and get you to invest in their fund.
As a rule of thumb: people who make money do. Those who can’t make money ‘teach’ you what to buy.
You should approach every stock recommendation and investment information with this level of skepticism. Never believe anything (including this guide) without cross-referencing the facts and doing your own research.
Stocks to Bonds Ratio
When deciding on an investment ratio of stocks to bonds, it is best to tailor the needs to the individual investor. While stocks are a more ‘aggressive’ investment and bonds are more ‘conservative’ it is perfectly fine to have a healthy mix of both.
Generally, a younger investor will want to invest a higher ratio of their portfolio into stocks. A longer timeline allows the investor to weather market downturns and see an overall upward performance of their portfolio.
However, an older investor who may need to tap into their funds may opt to have a higher ratio of safer bonds. Since stocks are more volatile, an investor nearing retirement may lose a lot of money in the event of a significant market downturn.
That’s not to say that a young investor shouldn’t invest in bonds, or that an older investor shouldn’t invest in stocks. But generally, a younger investor will start heavily investing in stocks. As they age, they may increase their ownership of bonds to preserve more of their capital.
Diversifying Stock Investments
Since a single stock may fail at any time, investing in multiple companies with good track records is essential for success. While concern about a single company going bankrupt is understandable, the possibility of losing all your money to a well-researched, diversified investment portfolio is unlikely.
Think about it for a moment. Have you ever seen a chain of bankruptcies throughout different market sectors, with companies all over failing?
While the purely speculative companies of the dot-com bubble or businesses that shuttered due to the coronavirus pandemic may come to mind, the truth is that many good companies have remained. Had you remained invested after those market crashes, you would no doubt have healthy earnings in your stock portfolio.
In addition, these events only crippled a portion of the market. If all the companies you diversified in failed at once, it would mean a more catastrophic event had occurred (or you made some bad investment decisions). At that time, you would probably have better things to worry about than losing your money in the market.
That’s not to say investing has zero risks. As with anything in life, there’s an inherent risk to everything. However, we can minimize those risks through diversification.
Dividend Reinvestment Portfolio (DRIP)
Though it may be tempting to view dividends as passive income, you can also reinvest the earnings for even more gains
Over the past 40 years, the average dividend rate[ref link=https://www.multpl.com/s-p-500-dividend-yield] of the S&P 500 was 2.6% (higher than the average in the past century). Although a deceptively small number, it makes a huge difference when compounding interest comes into play.
By opting to not reinvest dividends, your average stock market return would’ve been 7.4% annually instead of 10%. Over the course of a 40-year investment period, a 7.4% return rate would yield only about HALF of what you could’ve earned, had you reinvested the dividends!
Buy Electronically Traded Funds (ETFs)
Earlier we talked about buying electronically traded funds (ETFS), which are index or mutual funds listed on the stock exchange.
Diversifying your stock portfolio can involve the complex task of researching and selecting multiple stocks. However, investing in an ETF takes the work out of manually diversifying into companies.
Some ETFs track a specific sector (technology, energy), while others track an index (S&P 500, DJIA). There are even ETFs that track the broader stock market. Sometimes, an ETF may contain hundreds of different equities as well.
Although ETFs take the work out of researching hundreds of different companies, you will still need to do a bit of homework. One thing to pay close attention to is a management fee set by the ETF, which can eat up your earnings.
Despite the fees, it’s still a good idea to invest in a low-fee ETF that won’t eat up into your earnings. Additionally, studies have shown that recently, an S&P500 ETF would have outperformed even professional hedge funds![ref link= https://www.aei.org/carpe-diem/the-sp-500-index-out-performed-hedge-funds-over-the-last-10-years-and-it-wasnt-even-close/]
Dollar-Cost Averaging
Timing the stock market is hopelessly impossible for the average investor. You will NEVER know when the market reaches its peak or falls to record lows.
Your emotions may cause you to buy at highs and sell at lows. To avoid this, you can rely on a strategy called dollar-cost averaging.
By allocating a set amount of money into the stock market each week or month, you take the emotions out of investing. When stock prices are high, your weekly investment gets you fewer shares. When they’re low, you get more stocks for the same amount of money. Ironically, this is the opposite of what people would normally do – they often purchase more when the stock market is doing well and less when it’s faring poorly.
Recall that the stock market has a general trend upwards from the past century, so waiting out any market drops will yield favorable returns. Dollar-cost averaging ensures you don’t buy excessively at market highs and chicken out when market lows create a discount on stocks.
Conclusion
If you’re still here, congratulations on completing this stock market guide! Although you’re not expected to remember everything from this guide, you can always bookmark it and brush up on it!
The sad thing is that most people fear investing even when there’s no risk. In the past, I offered a risk-free loan of $1,000 to a few of my coworkers for investing in the stock market for 1 year. If they earned money, they would be able to keep the profits, minus repayment of the loan with one year’s inflation. If they didn’t have enough, they only had to pay what was left.
To my surprise, they turned down my offer (which I thought was quite tempting). Although a lack of funds was the primary reason they wouldn’t invest, there was more to it. They were afraid of what they didn’t understand.
So with that in mind, I decided to put this guide together to help educate anyone willing to learn. Breakaway Limit’s believes that learning to invest (in yourself, in others, and in finances) will help build wealth, to fulfill its mission of equalizing opportunities, maximizing possibilities.
If this guide helped you understand stocks better, then we’re off to a good start to fulfill our mission. But if you have suggestions or any ways to improve this guide, don’t hesitate to contact us or leave a comment below!
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