How to invest in stocks

 

How to invest in stocks is a well-known concern for millennials as well as for the other young investors. Though there are other safe investment instruments available in the market, investing in stocks offer better return historically. A merely $8000 investment each year for 30 years can make an investor millionaire.  However, investing in stocks are not risk free. Investors should learn first the strategies for how to invest in stocks or how to buy stocks before even think to buy stocks.

People have different beliefs and so are their stock investing styles. Every legendary investor has followed some sets of rules to become successful investor. Like all successful investors, general investors should follow some rules how to invest in stocks or how to buy stocks. Some critical rules that may help people to take better investment decision and manage his portfolio more efficiently are:

Select the right stocks

Investing in stock is not an easy game. You need right preparation for investing in stocks. Selection of stock is the first step of stock investing. Without well-defined selection of stock, no investor gets great return from the stock market. Good investment can give you big return and bad investment decision is investors should have fixed criteria how to invest in stocks and how much money will go for which stocks.

Sometimes investors think that past performance of the stock is the indicative of future growth of the stock. This is not true. Stock moves because of its fundamental performance and sometimes for technical reasons. Stock never made a big move without very strong reasons. Best stock is one which has strong fundamental as well as technical reasons for buy stocks. Some formal fundamental criteria for stock selections are:

  1. EPS
  2. Sales Growth
  3. Revenue Growth
  4. Innovation

Technical Criteria:

  1. Simple Moving Average (21 day, 50 day, 100 day or 200 day)
  2. Relative Strength
  3. Fibonacci Retracement
  4. Stock Accumulation and Distribution

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10 how to invest in Stock

 

In the above chart, blue symbol apple had impressive 35% growth in the last 15 years and even last year apple had 40% return on investment(Source: morning star). But 2015 apple return is negative -4.64%.. Another example is most well known big cap equity index SPY indicated by magenta color, had 16.65 percent return on capital last 3 year(Source: morning star).But in 2015,SP 500 return is only negative (-.72%.)

Learn the Stock Trading Basics or How to Buy Stocks:

After investor decides which stock or ETF or Index he wants to buy for his portfolio, he needs to learn some stock trading basics for better return on his portfolio and for safe investment.  In other words, investors need to know some basic steps how to buy stocks for his/her portfolio.

Trading Commission:

Trading commission or fee could be a big concern for an investor. If an investor wants to hold his position long time, trading fee may not be big concern. Still low trading fee can help you boost your return especially if your portfolio is small.

For example, you want to start investing with $1000 and choose 7 stocks to hold for the portfolio. You paid $ 70 commission fee for buying the stock. Now you have ($1000-$70) =$930 capital to invest.

Assume you are good at picking stocks and you made 10% return on the stocks.  Average Market return on stocks is 7%. Your return is ($930*10%)= $93.

After one year, you sold all the 7 stocks and paid another $70 commission fee. Your total cost is (70 +70) = $140.

Your total return with invested capital is (930 +93) = 1023 and total commission fee $140.Net profit on capital is ( $1023-$140-$1000)= -$117.

In other words, you lost 11.7% of your capital in first year though you beat the market with 10 % return on capital only for the commission.

Call and Ask Spread:

The price a buyer willing to pay for a stock for a specific time period is called call or buyer price. On the other hand, the price a seller wants to get for the ownership of his security or stock in a certain period of time called ask price or seller price.

Difference between call and ask price or buyer price and seller price is called call and ask spread. Sometimes call ask spread play a big role in stock price. This is very true for low liquidity and low price stock.

 

For example, you want to buy a stock @ $10 and stock is trading at a lower volume. Stock asking price is $10.20 and bidding price is $9.90. Bid ask spread is ($10.20-$9.90)= $.30 .

If you buy the stock at $10.20, you lost 30 cents for each share. 30 cents seem to be small amounts.  But for this stock this is 3% percent of stock price. In other words, if you bought10000 shares@ $10.20, you will lose $3000 only for liquidity.

 

In the same way, you will also loss $3000 if you want sell the stock later. So total loss is (3000+3000) = $6000 only for bid ask spread.

This is equivalent to 6 % of total capital. If you make average market return from the stock, your net will be zero or negative because of only stock spread. A good criterion to consider for how to invest in stocks.

 

Liquidity:

Every investor should think about Liquidity. Without Liquidity, stock is susceptible to manipulation and high bid ask spread. Investors should look for the stock with minimum volume 100000 share per day and higher the volume is better.

Look for the sector

If are a novice investors and do not exactly know what stocks to buy or how to buy stocks, A good starting point is buy stocks in a sector that you understand or you have some knowledge about that sector. This is strongly suggested if you have no idea how stock market fundamental works or how people do the technical analysis for buying stocks. This strategy will give you some edges at the beginning of your investment without prior stock investing experience.

For example, a web developer has good idea about search engine and web development. If he buys a stock related to search engine or internet technology, he should always have idea what other search engines are doing and company’s edge in the search market, he invested. He can take decisions whether he should buy more stock or sell stock without knowing fundamental or technical analysis.

A thumb of rule is buy stocks from a sector or industry groups that are the leaders in the market.   Selected stocks must pass the predetermined fundamental and technical analysis criteria. There is no exception in this rule. Some of the well-known sectors in Stock markets are:

  1. Tech Stocks
  2. Financial Stocks
  3. Biotech Stocks
  4. Solar stocks
  5. Consumer Discretionary stocks
  6. Oil stocks
  7. Healthcare stocks
  8. REIT Stocks
  9. Agriculture Stocks
  10. Consumer Staples
  11. Utilities Stocks
  12. Telecommunications Services Stocks

Look for stock investing Catalyst

This is very important factor that every investor should you consider before buy stocks and must know how to invest in stocks. After initial lock up period or after first pull back after IPO, stock do not make a home run or possibility making new high is very low until stock gets a catalyst for movement. Catalyst for the stock is an event that rapidly changes the exchange price or market price of the stock and lubricates the movement of the stock in either direction. Some of the catalyst for the stocks are beat EPS or Revenue with big margin, entered in the in the new big market, analyst big recommendation.

The catalyst can be good or bad for the stock. If catalyst is good, stock made upward movement. If catalyst is good and highly significant for the stock, stock may make a new high and start a new home run. Highly significant catalyst can be an approval from FDA, a new innovation in the tech company.

For example, iPod, iPhone are highly significant catalyst for apple stock that make it the largest company in the world. If anyone invested only $1000 in   apple stock in 1999 that investment market value in today’s market is more than 300k- that’s 30000% return over the investment. For big return from investment, investor should look for this catalyst when investing in stocks.

 

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Apple stock and Blackberry stock movement-How to invest in stocks

 

Chart clearly shows from the beginning of 2008 apple stock started a big move and blackberry stock price is falling sharply. After that apple stock is moving forward and BlackBerry stock is falling down.

On the other hand, if catalyst is bad, stock price will move down. Stock price usually moves down more by bad catalyst than the good one. Example of bad catalyst is miss the earning consensus, downgrade by analyst, lost market share of a product to a competitor in a big market etc. Again if catalyst is bad and highly significant, the impact can be disastrous to the stock.

Highly significant bad catalysts are improper accounting report, manipulated earning report, lost market to the key product. For example, blackberry was the key provider of mobile smartphone market. Company lost its share to apple’s iPhone and share price came down from $150 in 2008 to $7 in 2015 – that means if anyone invested $1000 at blackberry in 2008, the market value of that investment is less than $50. In other words, investor has lost more than 95% of his money.

 

 

Wait for a minimum time

Buying IPO is exciting for popular stocks. People buy IPO because IPO stock moves a lot and sometime investors double their return within a few months of investments in IPO. Twitter IPO was priced $26 and IPO opened at $45- a gain of 73% over IPO price. Stock also got momentum and moved up to $75 – that another 67% gain from the IPO. That’s total 190% gain from IPO within two months from IPO price. This seemed to be massive gain from a stock within two months.

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Twitter,GoPro,FB price Movement after IPO

 

Chart shows what happened to Twitter stock after big run is short period. This is also true for the stock GoPro, which moved all the $100 from mid 20s.After pull back, stock never recoverd.

On the other hand, FB did not move up at a large scale after IPO and stock performance was poor first year of its IPO. After that, stock started to move to the higher price and moved up to $133 from its initial IPO $38.

This strategy is only good if you are an active trader or day trader. However, this strategy is not good for long term investor as we have seen what happens to twitter stock latter.

Another point is that most of the stocks do not make that kind of big run within short period. Every stock that comes to the stock market make a pull back after certain period of time. At the beginning stock price go through lock up period and underwriters support the stock to make sure stock has the liquidity.

Consequently, stock price may not reflect the real price of the stock. That’s why every long term investor should wait minimum a period of time to see how stock react in the market before investing in stocks. This period should not be less than 3 months because stock has lock up period till 90 days. After 90 days passed, investor should wait for the stock to make pull back and make a good bottom. After investors are sure that stock made its expected pull back, investors should think about this stock to add in the portfolio if other criteria of good stock maintained.

Fundamental vs technical analysis

People always like to argue which approach is best for investing in stocks. Fundamental vs technical analysis are not substitute to each other rather they are complementary for each other. Investment legend William O’Neil book” how to make money in stocks” mentioned that a good stock needs both sound fundamental and technical reasons to make a big move. This is absolutely true for investing in stocks with some exception . One should pick up stock based on sound fundamental, but buy the stock based on technical analysis. Because technical analysis is really a good indicator for the supply and demand of the stock and market trend. Both Approach has advantage and disadvantage. The best approach is which   investment style is working for you.

Choose the Right Broker

Investing in stocks depends on broker.Brokers play important role in successful investment. Before choosing brokers one should look at brokerage firm’s reputation, fee per trade, leverage, customer service provided by the brokerage firm. Some of the very well reputed brokerage firms are Fidelity, Charles Schwab, E*Trade, TradeKing, TradeStation, tradeMonster, Scottrade, Merrill Edge, TD Ameritrade, Scottrade.

Know your trading strategy

After start stock investing, investor must have right investment or trading strategy. There is no fixed criteria for trading strategy. Best set of rules for how to invest in stocks are trial and error method. This method is test yourself with different trading strategy by investing in stocks, find out  sets of trading strategy that is best fit for you. Some people prefer technical analysis over fundamental analysis, some people like only fundamental trading style.

Trend is your Friend

Always look for the trend. Trend is the indicator of the performance of the market. Even stock with strong fundamental cannot stay in the uptrend in the bear market. Again week stocks make a big move in the bull market. Some investors are encouraged to buy in the bear market because they think stock is cheap now and best for value investing

This may be true from fundamental stand point. But no one knows when bear market will end. If stock price went down 20 percent, fundamental may indicate good bargain for the stock. But if market continuously goes down, stock price may move down 90 percent. Look at citi group stock 2009.

 

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Citi Group (C) price collapsed from 2006 to 2009

Chart shows, Citi group © reached the peak price at $562 in December,2006. After Price 20 % down, this seemed to be good bargain for some investors. As we saw, price moved down again and reached $281, which is great bargain price for investors who look for cheap price of the stock. Price again moved down to $56, which is 10 percent of peak price. That should be great opportunity who look for cheap price and great bargain. Ultimately stock got support at $9.7, which is 1.7% of stock peak price.

Citi group price movement is a good lesson for the investors who are looking for buy cheap stocks when market is falling down continuously without following Strategies of how to invest in stocks.

Some investors believe that if price fall down, stock will ultimately come back to the previous price. However, after 10 years of stock fall down, Citi group © regained only 10% of its previous high price.

Even though investors are accurate in their stock analysis and stock is really cheap, Time horizon will be problem by itself.   Fundamental analysis tells you this stock is cheap and a good bargain for future investment.

However, fundamental analysis cannot tell you when the stock price will rise.  Some famous hedge fund went out of business because of this arbitrage strategy According to Investor’s business Daily(IBD), 3 out of 4 stocks follow the market direction. Rather best investment approach is to look at the overall market trend first and then to look at the stock for investment.

Do not buy very low price stock

This seems to be heresy. But this is wise truth. Do not buy the stocks that are trading below $10 and investing in that kind of  stocks  are very risky. The same rule is true for penny stocks.The reason is if stock is really good, it must not be priced below the $ 10. As stock did not prove itself yet, that’s why price is below $10.

Buying penny stocks are always prohibited. I never saw any one make money on penny stock except the brokers who got big commission by sailing penny stock. I think wolf of Wall Street is a good movie to watch how penny stock works and who made money from the penny stock. This is true that someone may make money from trading penny stock, but the percentage should be very low.

 

Do not over invest employer’s Company

This seems odd because employees know pretty well about the company and investment is pretty safe. Even though this is true, Investor put himself on double risk than investing in other companys’ stocks. The risk is if company failed employee would lost lot of money from investment and   possibly his job. That’s double blow for investors.

Bottom line

How to invest in stocks is not a sprint, rather a marathon for every investor. This is even tougher for successful investor. However, if you understand how to invest in stocks and follow the right process and stick to you stock investing rules rewards could be lifelong passive earning. Warren Buffett famous how to turn $45 to 5 million in stock investing is an example of that.

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