Learning how to invest
Learning how to invest can take you farther than you ever expected both in your personal and financial development. Investing is one of the most exciting and rewarding activities. It challenges your intellect and rewards you for working smart.
- What does that mean to learn how to invest?
- Why do some people talk about investing and others talk about trading, what’s the difference?
- How much money “trading capital” do I need?
- What is a stock, bond, mutual fund or ETF?
- What does it mean to buy long or sell short?
- How do I decide where to open an account?
- What is the difference between a margin account and a cash account?
- How do I know what type of investing or trading will work for me?
- What’s next?
Learning how to invest
This is a journey and you will never stop learning how to invest. It is one of the most rewarding and fulfilling activities you can do. If you get the investing bug you will never get rid of it. The basics of learning how to invest or trade starts with the act of buying a security with the intention of holding it for a certain amount of time and then selling it for a profit. Stocks, bonds, mutual funds, and ETFs are all considered securities. Depending on what you want to accomplish this holding period could be as short as one hour or as “long as forever”, as Warren Buffet would say. I had a friend tell me that learning how to invest is like Easter egg hunting, you are always excited and on the look for an egg but when you find one you never know what’s going to be inside.
Learning how to invest is not an easy or simple task. It takes work and study to be successful. Successful means consistently making money in the market. You will hear stories at any gathering how someone bought XYZ stock and made a killing, this can happen just like from time to time someone wins the lottery. As you begin your journey into learning how to invest you will need to first understand some basics.
Investing versus Trading
Investing and trading can be used interchangeably. The best distinction between an investor (investing) and trader (trading) is the attitude toward stock market movements. Trading is anticipating and profiting from the market fluctuations. Investing is the pursuit of acquiring and holding suitable securities at a suitable price.
Trading tends to be more to flexible and can potentially make money when the market goes up or down. Investing tends to only work when the market is going up. One of the more famous investors is Warren Buffett. He truly looks for an investment that he can hold forever. That does not mean he never sells, he has sold many investments over the years. He also, could be called a trader because he has used different types of options to speculate in the market. For our purposes on learning how to invest, the word trading will mainly be used in the following information.
The first thing you must do before learning how to invest is to set aside trading capital. How much money do you have set aside to trade? More importantly, what was it originally earmarked for? DO NOT TRADE MONEY YOU NEED TO LIVE ON!!!! If you don’t have any money set aside, take the time to generate it before you begin trading. This additional revenue is called “Trading Capital.”
Money you need to live on is the currency required to pay your bills and reduce your debt. I’m confident that once you’ve acquired the skills of trading, you can consistently make 15% + a year, but while you are learning how to invest you won’t start out with that kind of success. So if you have credit card debt, car loans, or any loans that carry an interest rate of 15% or greater, I strongly recommend you pay off those bills first. By doing that, you’re guaranteeing yourself a 15% plus rate of return. There are many helpful online resources, how-to books, and even radio shows, that offer sound, practical advice on debt reduction. One of the best finance coaches is Dave Ramsey. Go to www.daveramsey.com. Both his national radio show and website offer helpful, often “bite-the-bullet” advice from someone who’s personally experienced financial misfortune, then climbed his way out of the abyss through sound, fiscal management.
Trading money you need to live on is a sure recipe for disaster, especially for those that are just learning how to invest. Murphy’s Law is always alive and well! If anything can go wrong, it will! The lure of trading money set aside to only pay bills could be a “train-wreck” waiting to happen if you jump in before everything else is in place, especially for those just learning how to invest! This “available money” changes your psychology, suppresses clear-thinking, and could cause your financial ruin if you don’t put the brakes on. There must be a clear financial separation between money you need to live on and trading capital!
Trading capital is funds set aside for learning how to invest, and would not change your lifestyle if you lost it! Yes, I said, “Lost it”! In trading, you cannot make money without losing it. The key is to make more than you lose! Here is a great statement from Van Tharp’s Peak Performance Course: “It’s like wanting to be alive, always willing to breathe in, but not willing to breathe out”. You cannot have one without the other.
To be absolutely clear, I am ONLY talking about using Trading Capital for learning how to invest as a novice. Professionals should already have this issue under control. If that means taking your lunch to work, not buying your daily Starbucks, or putting off any large purchases until you have enough money set aside. Depending on your circumstances, this may not be an easy or quick task, but the sacrifices need to be done. Between the potential trading gains, and your contributions, you should be able to get it to $50,000. Why $50,000? This gives you more options from trading platforms, commissions, and the amount of positions you can trade. Even if you’re paying $8.95 for each trade, that adds up to $17.90 round trip! If you completed 100 trades on a $5,000 account, that’s $1790, or 36% of your account! If you completed the same 100 trades on $50,000 it would only cost you 3.6%. Don’t ever under-estimate commissions and slippage!
Trading capital of $50,000 is an idea amount, not everybody will be able to start there. As you are learning how to invest, you need to answer a couple of question before you know how much to start with. One how often do you want to trade? The more often you trade the more capital you need. Brokerages require that you have a minimum of $25,000 in your account if you day trade. The second question is how many positions do you want to trade? I would recommend that you at least have enough money set aside to trade a minimum of 5 positions or about $5,000. This has to do with one of the most important parts of developing a trading system, position sizing. We cover more detail on position sizing in the Trading Plan section of this site.
After you have created your trading capital what next? What do you trade? There are many different vehicles that you can trade but as you are learning how to invest we will start with the basics stocks and bonds.
What is a Stock?
Stock is ownership in a company. This represents the amount of capital that has been invested in the company. As the company grows its equity then the value (not necessarily the price) of your stock will go up. Think of equity in a stock as the same as equity in your house. We will call this company House Inc. If you buy a house for $200,000 and you put 20% down or $40,000 and borrow $160,000. The $40,000 represents your equity or capital. Since you are the only one that owns the house you are the only stock holder. So your stock is worth $40,000.
Let’s take this a little farther; you are the CEO of House Inc. The income you receive is the revenue of House Inc. There are two ways you can increase the value of House Inc. Find ways to increase the value of the house through improvements or pay down debt. As CEO you will have to manage your cash flow in order to have enough money to make improvements to the house that increase the value and pay your bills. If the price of your house goes up (by improvements you make or the overall market) or you pay down the debt, then the equity will go up and your stocks value will be would worth more.
A very important point to understand as you are learning how to invest, just because the value of your stock goes up does not mean that the price will go up at the same time. The market is a very emotional place and can miss price investments based on how it feels not necessarily on the value of the company. The best way to explain this phenomenon is to quote Ben Graham in his bookThe Intelligent Investor.
Here is a snippet out of the book, The Intelligent Investor, by Benjamin Graham.
Imagine that in some private business you own a small share that cost you $1000. One of your partners, named Mr. Market, is very obliging indeed. Every day he tells you what he thinks your interest is worth and furthermore offers either to buy you or to sell you an additional interest on that basis. Sometimes his idea of value appears plausible and justified by business developments and prospects as you know them. Often, on the other hand, Mr. Market lets his enthusiasm or his fears run away with him, and the value he proposes seems to you a little short of silly. If you are a prudent investor or a sensible businessman, will you let Mr. Market’s daily communication determine your view of the value of a $1000 interest in the enterprise? Only in case you agree with him, or in case you want to trade with him. You may be happy to sell out to him when he quotes you a ridiculously high price, and equally happy to buy from him when his price is low. But the rest of the time you will be wiser to form your own ideas of the value of your holdings, based on full reports from the company about its operations and financial position.
This is an interesting way to say that the market does not always price your stock based on the fundamental value of the company.
What is a Bond?
This is a primer on bonds, as you are learning how to invest you will come to find out that bonds are actually more complicated than stocks. Bond is an IOU that you receive from a company. In return for the money you have basically loaned them they will pay you a predetermined interest payment and the bond/loan will be paid off at a predetermined time called the maturity date. There are four main components to a bond, par value which equals 100 per bond, coupon rate, maturity, and the rating. These three factors can vary. When you buy a bond they do not always price at par. They could be at a premium or discount to par. If you buy at a premium then the stated coupon will be higher than the interest you receive. If you buy at a discount then the interest you receive will be higher than the coupon. Maturity date is the date when the company is expected to pay you back your principal, but the bond can have a call feature where your bond can be called from you before the maturity date. There are many different ratings on a bond from AAA which is the highest rating to BBB which is still considered investment grade. There are also lower ratings than these and they are considered junk bonds or high yield bonds. Here are a couple of examples for clarification.
New Issue AA Rated Bond XYZ is pricing at par 100 with a coupon of 3.5% and matures in ten years on March 18th, callable in three years on March 18th. That means each bond cost $1000.00 you will earn $35.00 a year (typically paid out every 6 months) and they will pay you back your $1000.00 in ten years on March 18th, but the company has the option to call your bond in three years on March 18th and pay you back your $1000. This is the basic new issue bond with a callable feature. Not all bonds are callable.
Here are a few factors that can vary. Bond XYZ is now trading on the secondary market for 103 or a premium. Now you will pay $1030 for this bond you will still earn $35.00 per year but when the bond is matures or is called they will only pay you $1000. So they effectively lowered your by about $3.00 per year (assuming this happened in the first year after being issue), so now you are earning $32.00 or 3.2% rather than 3.5%.
To continue your journey on learning how to invest, let’s go back to House Inc. The money you borrowed could be considered a bond. The difference between the loan on your house and a bond is how the principal is paid. On a typical mortgage (not any of the fancy interest only or adjustable rate mortgages) you pay principal and interest with every payment and the loan is paid down until it is paid off at the end of the term. A bond only pays interest to the bondholder until the bond matures or is called away, when it pays back principal.
These are the two basic types of securities most people learning how to invest will need to understand. Outside of buying the individual security, there are a couple of ways to invest in these securities, Mutual Funds and ETFs.
What is a Mutual Fund?
Let’s start with Mutual Funds. For those just learning how to invest, this will be one of the easier ways to buy a portfolio of stocks, bonds or a combination. A mutual fund is a portfolio of stocks, bonds or even a combination. As a mutual fund investor you are buying a piece of the fund. Think of a mutual fund as a supreme pizza. The pizza has all of the toppings already backed into it and it is cut up into pieces. When you take piece of the pizza you are getting the same toppings on the pizza as everybody else that takes a piece.
The fund charges you a fee for management of the fund. Mutual funds only price once a day on the close, so you can put an order in to buy any time during the day and it will on execute at the closing price of that day. There are pros and cons about only being able to buy the fund on the close. One of the pros is that you will not be subject to a fast market and have a less of a chance of making an error in entering your order. The con is you cannot take advantage of intraday market moves.
There are two basic types of funds, actively managed or passively managed. Active managed funds have a portfolio manager that makes the decisions of which stock or bond to buy and how much. Passively managed funds track an index and do not have any active management other than to rebalance back to the index they are tracking such as the S&P 500.
Fees are a big pitfall when you are learning how to invest. There are fees associated with buying mutual funds. You have no-load funds and retail funds. No-load funds do not charge you a fee to buy the fund. Retail funds charge you some type of fee to buy the fund and these are usually offered through a full service brokerage firm. All funds have internal management fees that you never see. These fees get taken out and your returns reflect the return minus the fee. Not all no-load funds have cheaper internal management fees, so be careful when you are buying funds to check the internal fees. There are three main types of retail fund sales fees. Class A share mutual funds charge an upfront fee, typically between 4.75% and 5.75%, these funds will typically carry a lower internal management fee than the following fund Classes. Class B share mutual funds charge you a decreasing backend fee if you sell the fund within six years. Class C share mutual funds charge you an annual fee for the life of the fund in addition to the internal management fee. Most of these carry a 12b-1 fee which is charged to pay for the person that is recommending the fund to you.
What is an Exchange Traded Fund (ETF)?
As you are learning how to invest, one of the next options you have are ETFs. This stands for Exchange Traded Fund (ETF). It works a lot like a mutual fund in that it is a group of stocks or bonds and they are either passively or actively managed.
Two main differences between a Mutual Fund and an ETF is intraday trading and fees. The internal management fees for and ETF are usually considerably lower than its mutual fund counterpart. The sales fee is a commission that works the same as when you buy a stock. This fee will depend on what type of brokerage account you are trading through. An ETF can be traded as long as the market it open, which is 9:30am to 4:30pm Eastern. The ETF is a basket of stocks or bonds built to track the movement of the underlying components which is called its Net Asset Value (NAV). They have the ability to issue creation units for large block traders and this is a feature that is different than mutual funds.
Buying Long, Selling Short
As you are learning how to invest here are some of the more trading fundamentals that you need to know. When you are trading stocks and ETFs you have to ability to go long (buy a position) or go short (sell short a position). You probably are familiar with buying a position long. This is where you actually purchase the security for the current trading price with the anticipation that it will go up and you will make money if you sell it for a higher price. Selling short on the other hand is when you borrow a security from your broker and sell it with the hope that it will go down and you can buy it back cheaper and make money. Let me explain this a little further.
XYZ Stock is currently trading for $18.79, you think that the price will go down rather than go up and you want to take advantage of the price action. So you enter a Sell Short order with your brokerage. The brokerage then goes out and borrows those shares from another client that has a margin account and delivers them to you in order to sell. So you sell short 1000 shares for at total trade of $18,790.00. Your account will get a credit of $18,790.00 minus any commission. The price goes down to $15.67 and you decide to buy to cover your position. So now you go out into the market and buy 1000 shares at $15.67 or a total trade of $15,670.00 plus any commissions. The shares are then delivered back to your brokerage and you get to keep $3,120 minus both commission, which is the difference between what was deposited in your account $18,790.00 and what you had to spend to buy to cover $15,670.00.
As you are moving through your journey of learning how to invest, we need to discuss what to do next. After saving enough money the next step is to open a trading account. This can be done a lot of different ways. The decision is all based on what services you want to have available. There are the major brokerages, such as Raymond James, Edward Jones, Morgan Stanley or Merrill Lynch just to name a few. These typically will have people available to help you ever step of the way. They are more hands on but also tend to cost more. The other choices are online brokerages, such as Charles Schwab, Scott Trade, TD Ameritrade and E-trade. These will typically cost less but will not have as many hands on services. Both choices will typically have online access. For the type of trading on this website you should have enough tools at any of the above brokerages to execute your trading system.
Cash or margin account?
As you are learning how to invest, you need to decide if you want to trade in a cash account versus a margin account. A cash account is very simple. You can buy securities in your account with the available cash that you have on hand. This can keep you from losing more money than you have in your account. In a cash account you will not be able to sell short. On the other hand, a margin account allows you to borrow against the securities that you have in the account. It works by using the brokerage’s money. They loan you the money and use the securities in the account as collateral. Don’t think that you they are doing this out of the goodness of their heart. They usually charge above average interest for you to use this money. The downside of margin is the ability for you to lose more than you have in your account. The brokerage mitigates this by setting a margin requirement and if your equity goes below that you will have to sell the position to raise cash or deposit cash in the account.Click here to learn more about margin trading.
As you are learning how to invest, you need to have thought about how you want to invest or trade. In my opinion, the next steps in learning how to invest are the most important. This will define your success moving forward. It is critical that you understand this step before moving forward. There are several avenues to help you get a better understand of what to do next. First, take time to work through Trading Psychology. This will help you identify your strengths and weaknesses as it pertains to trading. Also, I would recommend you read the following books. There are many different types of trader/investors, so it is important that as you are learning to invest you get a better understanding of what type of strategies are used.
Rule #1: The Simple Strategy for Successful Investing in Only 15 Minutes a Week! by Phil Town, 2007
This book has a different take on trading/investing. Phil describes a strategy where you rely more on the fundamental analysis to make a decision on the potential investment, then uses technical indicators to make a decision of when to buy. I threw this into the mix for those who like to do research and look for value.
Little Book That Beats The Market by Joel Greenblatt, 2006
This is a very quick read. Written by Joel Greenblatt who is a hedge fund manager and professor. He shows how successful investing can be made easy for investors of any age. He teaches how to outperform the market by using his “magic formula”.
Trade your Way to Financial Freedom by Van Tharp, 2006
Dr. Van Tharp shows you how to use your personality, style and goals to help you carefully design and test your trading systems. He believes that putting all this together is what ultimately determines your true success.
High Probability Trading: Take the Steps to Become a Successful Trader by Marcel Link, 2003
This books details market-proven strategies for becoming a profitable trader from the beginning. He discusses 10 consistent attributes of a successful trader, strategies for controlling emotion, technical analysis, and market-tested signals.
These are just a few books that will give you an idea of different types of trading/investing strategies. Read as many investment books as possible as you are learning how to invest. This will give new ideas about what type of strategies are available.