Stock trading can be a lucrative undertaking if you understand the risks before you start investing. The stock market usually outperforms many other markets, such as bonds or the commodity market, but also carries a higher degree of risk. On the other hand, index funds which track the performance of a specific group of stocks are also a viable alternative which can have reasonable returns combined with lower risk.
The following chart shows you the total return index for stocks, bonds, bills, and gold. As you can see, the return on stocks has been higher compared to all other asset classes, the lower-risk bonds and bills are second, and gold is third, tracking the inflation rate.
How much time and interest do you have for investing?
The first thing you should ask yourself is how much time and interest you have for investing. Are you really passionate about the markets, and can you devote long hours throughout the week for trading? Or would you rather buy your portfolio of stocks and forget about it?
There are thousands of stocks available for trading, and obviously you can’t track and analyse them all. Many stock traders specialise in a group of stocks, such as tech stocks, energy stocks, automobile stocks, or others, but still need to follow the market news regarding the individual companies in their basket. These include the changes in the management of the company, revenues, profits, earnings per share (EPS), future prospects, market risks, and much more. As you can see, you’ll still have to devote a few hours per week to regularly track all the changes in your basket of stocks, revaluate it by closing or reducing some positions, and open or increase other ones that have more profit potential.
Fortunately, the existence of index or mutual funds can help you to reduce both your risk and time in the markets, as fund managers will do the challenging work of picking the right stocks for the indices. Even indices can outperform many of the other markets on an annual level, and have a proven track-record. By investing in index funds, your balance will simply move in the direction of the underlying stocks they track.
What is your level of risk tolerance?
Another important task before getting started in stock trading is to evaluate your risk profile. Do you tolerate higher risks with the potential of higher returns, or are you a risk averse person who doesn’t feel comfortable with risk? This might be easier to answer with a concrete example: how would you feel if your trading account dropped 20% in a single day? Answers to these types of questions will help you tremendously in choosing the right type of investment. Generally, individual stocks carry the most risk, followed by mutual funds and index funds. You can also decide to diversify across other asset classes, such as bonds, gold, or cash. This way, you’re able to reduce your risk even more, but keep in mind that the potential profits also diminish.
It's very important to determine your risk tolerance before getting involved in stock trading. If you’re risk averse and invest in a risky portfolio, you’re more likely to make an emotional move that will negatively impact your trading performance.
How to choose your stocks
Stock prices go up and down regularly, depending on the current level of supply and demand for a stock. If demand for the stock exceeds supply, stock prices rise. And if supply for the stock exceeds demand, stock prices fall. However, the stock price itself gives little clues about the overall health and future prospects of a company, which in turn affects the future demand of the stock and its price. Therefore, you need to study the fundamentals of the company you’re interested in investing in. The following points will give you a basic overview of what you need to pay attention to.
- Outstanding stocks: as the name implies, this is the number of all outstanding shares of a company.
- Market capitalisation: this is calculated my multiplying the current stock price with all outstanding stocks.
- Shareholders: these are investors who own shares in a company. Shareholders usually hold rights to vote in the company, and receive dividends if the company decides to distribute part of its profits.
- Earnings per share (EPS): this figure shows you how much a company earns per share. It’s a ratio that divides the company’s net income (minus dividends) by the number of outstanding shares. Earnings per share are an important number that can move the price of a stock in a matter of seconds. It’s reported on a regular basis, usually with the company's quarterly earnings report. If the number is above the market’s forecast, the stock price usually goes up. And if it’s below the market’s expectations, the stock price usually falls.
- Dividends: profitable companies can decide to distribute a part of their profits to stockholders. This is called a dividend. If the company is in its early stages it can decide to reinvest its profits to grow, which is also beneficial to shareholders.
- Price to earnings ratio (P/E): another important indicator of a stock’s performance is its P/E ratio, which divides the stock’s price with the company’s EPS. The P/E ratio can also be used to identify overbought and oversold stocks.
A portfolio for beginners
If you’re a beginner in stock trading, you should consider investing in lower-risk index funds and learn as you go. There are index funds that track the broader market (S&P 500), large-cap stocks (Dow 30), and others. The main advantage of index funds is that they’re well diversified and have a low risk.
The following chart shows the Dow 30 index, which tracks the performance of the 30 largest public-owned US companies by market capitalisation. Since 2007, the annualised average return of the index was 6%, and with dividends reinvested the average return climbs to 8.75%.
A portfolio with individual stocks
Investing in individual stocks can see increased returns compared with index funds, but also take more work to stay up-to-date with each company stock you bought, its risks, future prospects, and market-moving news. If you want to invest in individual stocks, you should diversify across different sectors to lower your risk, but don’t go overboard with the number of companies as you need to follow them on a regular basis. Also take note that investing in 10 or more companies requires a larger initial capital.
Choosing a broker and getting started in investing
Once you feel confident enough to enter the market, it’s time to open an account with a broker.
Stock brokers can generally be grouped into two categories: full-service brokers and discount brokers. While full-service brokers, as their name implies, offer a full range of services to their clients, their initial deposit can be quite high – sometimes $50,000 or more. If you plan to invest a lower amount, choosing a reliable discount broker is your way to go. However, don’t expect your discount broker to give you the same support as a full-service broker. The task of making all investment decisions will fall on your shoulders.
Make sure the broker is regulated, secure, and offers reliable customer support. The best way to get a feeling for the broker is to reach out either online or with a call, and to ask all the questions you have about opening your account. Once you finish the paperwork and make an initial deposit, you’re ready to start trading.
Know when to buy and sell
Finding the optimum moment to enter and exit the market is crucial for success. Once you open your broker account and make a deposit, don’t rush to buy everything in one day. This will increase your exposure on the market and could lead to significant losses if things don't go as planned. Instead, invest a little bit at a time, and do the necessary analysis beforehand.
It’s also essential to look up the chart of a stock and check how the price has recently performed. Make sure that the stock is in a steady upwards trend, which means that the price makes successive higher peaks and throughs. If you’re interested in becoming a serious trader, chart study is essential, and is also known as “technical analysis.” In general, if you’re still a beginner when it comes to stock trading you should avoid volatile stocks that show large price swings.
Before opening a trade, you should also have a clear expectation of how much the stock will rise. Once it reaches that level, close your position. This can also be done automatically through your broker’s trading platform with a “take profit” order. In the event that your analysis turns out to be false and you end up with a losing trade, know in advance how much you’re ready to lose on that trade. Put a “stop-loss” order through your trading platform to avoid losing too much. Remember, you should know how much money you’re risking on every trade you make!
Costs of trading
Stock trading also involves trading costs, which you need to consider before you start trading. Every time you open or close your position, your broker will charge you a fee (commission) which varies from broker to broker. Although these fees are usually at a reasonable rate, they can easily add up if you trade constantly. Check the fees with your broker of choice and calculate them into your trading decisions.