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Guide to stock market investing
Investing in the stock market can bring substantial rewards, but the unwary can also incur substantial losses.
This page is a guide to how to invest in the stock market
What you will need before you get started
You will need to have saved up a sum of money to invest, which you don't need for emergencies or day-to-day living, which you can afford to keep invested for a substantial length of time and which you can afford to lose. This means money that is over an above your emergency fund of at least six months living expenses and in money that you are not using for your retirement fund.
Never ever invest with money that you will need in the near future and never ever borrow to invest. Investment has the potential for great rewards but also for big losses. You don't want to compound the risks by borrowing the money to invest.
When you are a beginner in stock market investing, you will inevitably make mistakes. Therefore start investing with small sums. As you get more confident and have masted the basics of stock market investing, then start putting in bigger amounts.
Once you have a sum with which you can invest, you then need to choose a broker - see this guide on how to choose a stockbroker for advice.
Finally, you then need to decide which sector to invest in, what style of investing to go for and then to select the stocks you want to invest in.
Choosing which sector to invest in
There are seven broad groups of companies that you can invest in, and each sector is affected differently by economic conditions. Part of the art of investment is in choosing the correct sector to concentrate in for the point of the business cycle the economy is in. Most good financial newspapers such as the Financial Times will list shares grouped according to the following sectors.
1. Mineral extraction
These companies are involved in the extraction and supply of primary products that are used in the rest of the economy eg oil, copper, iron ore and so on.
Most of the companies in this sector are large multinationals, though you will sometimes find small exploration companies and small specialist companies eg companies specialising in geological surveying.
The profits of these companies are liked closely to the price of commodities on the world markets. The commodities are all priced in dollars, so the exchange rate will affect the profits of companies in this sector outside the USA.
This is an international sector - the overall global market is more important than the domestic market. A big market for commodities is China, which uses these primary products to produce goods to resell on the world market, which is in turn reliant on the global economy. Thus, the best time to invest in mineral extraction companies is just before a global boom is ready to start, and the best time to sell is when the boom is in fukl swing and all prospective earnings are fully priced into the shares.
2. General Industrials
This sector includes building and construction companies, motor manufacturers, electrical and mechanical engineers and chemical companies.
These are cyclical companies and are heavily dependent on the economic and trade cycle. In particular, during recessions when capital investment dries up, these companies perform poorly. The company profits tend to move ahead of the trade cycle because capital expenditure is greatest at the start of a period of economic growth. Profit margins can be high because not many new companies start up in this sector and hence competition is reduced.
Some parts of this sector are entirely dependent on the domestic market eg construction, other parts eg motor and chemical manufacturing depend on the international market.
3. Consumer goods
These companies manufacturer durable and non-durable goods. Durables are things like furniture, white goods (eg washing machines) and black-goods (televisions, electronic music systems, plasma screens etc). Non-durables are goods such as food, drink and pharmaceuticals.
The economic cycle doesn't affect this sector as much as it does the general industrials. In particular manufacturers of necessities tend to remain stable regardless of the cycle.
Brand-names are increasingly important in this sector, as is the ability to sustain big advertising budgets to maintain the brand. Profit margins tend to be low due to extreme competition. This sector is becoming increasingly international.
The service sector includes companies like supermarkets, transport, hotel and media companies.
This is a labour intensive sector, whose expenditure can increase in times where it is difficult to attract staff. The domestic market is the most important for this sector. Some parts of the sector are immune from the economic cycle eg supermarkets. Other parts of this sector eg hotels and media are heavily affected by the economic cycle.
Utilities supply continuously demanded services to households and business such as electricity, water, and telecommunications.
Demand is stable as these are essential services. They are capital intensive because they need a big physical infrastructure. Because of the amount of capital required, there are very few entrants into this sector, and natural monopolies build up. As a consequence, this is a highly regulated sector to prevent abuse of the monopoly situation occuring.
Because they are usually supplying to the majority of their market already, these companies have low growth prospects, but instead pay a high dividend yield. These shares are thus best for those looking for a stable low risk investment that will provide an income.
This sector consists of the retail banks, investment banks, general and life assurance companies and other financial services companies.
The financial sector is capital intensive. If they can easily get access to capital they quickly get into trouble, as shown during the world financial melt-down of autumn 2008, when the money markets ceased to function and banks and others refused to lend capital to each other.
Banks are highly geared - they borrow from savers in order to be able to make loans. Small changes in the differences between savings and lending rates have big impacts on profits. In addition, in recessions they frequently have to write off bad debts, which can wipe out the profits of previous years.
The life assurers by contrast have stable profits and low gearing. The general insurance companies (i.e. they insure against fire, burglary etc) have volatile profits and no borrowings.
For the banks and insurance companies, staff costs are also a big element of expenditure.
The domestic market used to be the most important, but banks have tended to get involved in purchasing liabilities from other countries, which makes problems in one country spread to others.
7. Investment Trusts
Investment trusts are essentially investment funds, but unlike unit trusts, they are "closed" in that there are a fixed amount of shares available to invest in, and they are quoted on the stock exchanges. The share performancee is based on the underlying investments.
Choosing the style of investment
Once you have chosen which sector to concentrate on, you will then need to pick the shares to invest in.
There are two essential methods of picking shares - a growth strategy where you choose companies which you think will grow rapidly, and a value strategy where you pick shares that are undervalued by the market.. Both can be profitable. See the following guides for more on how these strategies work:
How to know when to sell stocks
There is no such thing as true "passive investing" where you buy stocks, lock the certificates in a drawer and forget all about them. You need to continually monitor your stocks for changes in performance and assess whether you should continue to hold or to sell. Here are some things to consider:
1. When you bought your share, you did so based on certaincriteria (the earnings per share, the dividend yield, the level of debt etc). Always continue to monitor the stock against that original criteria, and watch for moments when to starts to diverge. Usually when you buy a stock, the price-earnings ratio is fairly low, and then starts to rise, as the market spots potential in the company and starts to hoover up the stock. However, there gets the point where the P/E ratio is so high the company concerned would have to make fantastic profits to judtify it. The first hint that they won't make magical profits, and the share will fall back to earth, because it had become over-priced based on an assumption of extraordinary growth. Therefore when the P/E gets too high, consider off-loading some of your shares.
2. Changes in management. Management matters. Often when you have a very good team in place, and a new team takes over, there are changes in performance. Look for any big changes in direction. Even when they promise "continuity" things can't help changing just because the new CEO may have a subtly different set of priorities that can have big consequences for the company.
3. Is the share being hyped? The joke used to be that when a company or investment trend featured on the cover of Time magazine, it was time to sell. "the Time magazine rule" has proved right in calling the end of the dot.com boom, the strength of the dollar, the oil price, you name it. That's because the mainstream press are clueless about finance and only report a story way after the professionals have made their profit and moved on, and only the suckers are participating in the trend. There is an old story of Joe Kennedy selling his shares just before the Wall-Street crash after his shoe-shine boy gave him stock tips. He reasoned that if the trend had got so far that even shoe-shine boys were participating there was no-one left to buy shares, and the market would fall.
Finally be aware of long term trends. Some bear markets can last decades. We have been in a secular bear market since 2000, with the Dow Jones barely level with it's 2000 level. The general economy can affect how stocks perform, as does quantitative easing by the central banks which unleases a surge of short term money which often finds it's way into the markets..