Tag: Stocks

At What Price Should I Buy a Stock?

At What Price Should I Buy a Stock?

Deciding at what price to buy a stock or other security is almost as hard as deciding whether to buy the security at all.  There are many different approaches for deciding at what price to buy a stock.  One of the ones I’ve seen discussed 

Mutual Funds and ETFs

Mutual Funds and ETFs

Mutual fund and ETFs (exchange-traded funds) allow you to invest in securities without having to select individual positions. Instead, the fund manager makes the decisions as to when to buy and sell each security. As such, a fund is an easy way for new or 

Picking Stocks

Picking Stocks

Many investors create their own portfolios by picking stocks in individual companies. As discussed in my post on the basics of stocks, picking stocks in individual companies is one of several strategies for creating an investment portfolio. Alternatives to picking stocks in individual companies include buying mutual funds and exchange-traded funds. I’ll talk about those strategies in another post.

When I first started investing in the early 1980s, mutual funds were quite common but index funds and exchange-traded funds, while they existed, were not well known. I started my investment story by picking stocks in individual companies. One of the best books I’ve ever read on investing is One Up on Wall Street by Peter Lynch, originally published in 1989.

Confirmation of Independence: I have no affiliation with the author or publisher of the book I am reviewing. I do not receive any compensation for recommending it or if you purchase it.     I truly think it is a great source of investing information.

Lynch was the manager of a very successful mutual fund, the Fidelity Magellan fund, from 1977 to 1990. During that time, the fund had a 29.3% annual average return or more than twice the average return on the S&P 500 over the same time period. If you are considering picking stocks in individual companies, I recommend his book even though it is quite dated. It references companies and trends with which you may not be familiar, but the fundamental concepts are still relevant and it is a quick, easy read.

In this post, I’ll essentially provide an overview of some of the key points I learned from One Up on Wall Street and illustrate them with some personal examples when I can.

Picking Stocks in Companies You Know

One of the first concepts that Lynch introduces is that you are your own local expert. You are familiar with the business in which you work and shop. You are a consumer and you can observe trends in the area in which you live. By watching the world around you, you can identify possible investment opportunities, possibly even before the “market” or “experts” discover them. In many cases, if you identify a trend very early and invest in a company that will benefit from it, you can earn a much-higher-than-market-average return on your investment. In fact, Lynch points to this opportunity as giving individual investors a better chance of beating the market than professional investors who have to invest larger amounts so tend to purchase more mature companies.

Our Kids’ Choices

To illustrate what I mean by “invest in what you know,” I will use an experience we had with our children as an example. When they were in their early teens (probably around 2004 or 2005), we gave them each a very small amount of money to invest. Our son, who was very interested in trains and large equipment, chose the following companies:

  • Microsoft
  • John Deere
  • Canadian Pacific Railway
  • Canadian National Railway
  • ASV – a company that makes skid-steer loaders.

Our daughter, who was much more aware of what was happening in the retail space, chose the following companies:

  • Apple
  • Nordstrom
  • JC Penney
  • Target
  • One other company that I don’t recall.

How it Turned Out

I don’t remember exactly when we started this exercise, so have looked at the two- and five-year average annual returns starting on January 1, 2006. By using two-year returns, I have excluded the impact of the market decline in 2008 and early 2009. The five-year returns go through December 31, 2010, so include the market decline and part of the recovery.

The S&P 500 averaged a 4.5% increase per year during the two-year period and was essentially flat for the five-year period. By comparison, my daughter’s stocks increased at an annual average rate of 9% over the two-year period and 8% over the five-year period. My son did even better, with annual average returns of 15% over the two-year period and 9% over the five-year period.

What is even more impressive about my son’s returns is that his returns were dragged down significantly by a single company – ASV. When my son bought it, the company had its own patented suspension system for its tracks. As I recall, not too much later, it had a change in management. The new management decided to license the patent to Caterpillar. Unfortunately for ASV, Caterpillar’s much larger market share caused a large reduction in ASV’s sales that couldn’t be made up by the licensing fees. Over a several year period, ASV’s stock price went down by about one-third. This experience illustrates another lesson when looking a company’s fundamentals for investment decisions – carefully follow the decisions of any new management teams.

Without ASV, our son’s returns were much more impressive – 19% over the two-year period and 13% over the five-year period.

Don’t Invest in What You Don’t Understand

A related concept, but somewhat different one, is to avoid picking stocks in companies and sectors you don’t understand. Lynch has all sorts of great examples of why people buy stock in companies whose business they don’t understand – hot tips from a “rich uncle,” aggressive buy recommendations from a broker and so on and so forth.

Not understanding a company’s business can be everything from it having a very technical focus to not being familiar with its marketplace (i.e., to whom and how it sells its products) to being so diverse that it is hard to figure out what drives profits.   Essentially, his advice is that, if you can’t explain to someone what the company does in a few sentences, you shouldn’t buy its stock.

One Example of My Choices

I fell into that trap. We had a little extra money many years ago and decided to take some risk by making a very small investment in a private placement. When a company sells its stocks to a small group of investors and not the general public, it is called a private placement.

The two choices we were offered were a company that was marketing telemedicine to the Veterans Administration and a barbeque restaurant that was just opening its first locations. Our assessment was that the restaurant space was grossly overcrowded and that telemedicine would catch on quickly with the aging population and increases in technology. Not understanding that the telemedicine company didn’t actually have any customers or the challenges of getting a contract with the Veterans Administration, we made a very small investment in it.

Were we wrong! Many years later, we wrote off the entire value of the investment in the telemedicine company as it had become worthless. The restaurant was Famous Dave’s.

Ten Baggers

One of Lynch’s goals is picking stocks that are ten-baggers. These are companies whose stocks appreciate to at least 10 times what you paid for them in relatively short periods of time. By identifying trends in your local area, you are more likely to be able to earn the high returns associated with companies that start small and grow rapidly. As an example, consider the increases in Apple’s stock price.

Annual price change for Apple stock

The picture above shows the annual appreciation of Apple stock from 1981 through 2018. If you had owned the stock during any of the years circled in green, you would have more than tripled your money in two years. Not quite 10 times, but 3 to 5 times in 2 years is still a return anyone would envy. If you look at the returns in more recent circled in orange, you’ll see much more modest appreciation. The returns were still very attractive, but much lower than the earlier period.

Lynch points out the benefit of having just one ten-bagger in a portfolio with otherwise mundane performers. For example, if you invest the same amount in 9 stocks each having a total return of 5% per year, your total return in 5 years will be 27.6%. If you add a ten bagger to the mix, your total return increases to 115% or 16.5% per year.

Although our daughter didn’t have any ten baggers, her portfolio benefited from a similar effect. From 2006-2010, her three retail stocks had an annual average return of -1.6%. Apple, on the other hand, was almost a 4.5-bagger (its price at the end of 2010 was 4.4 times its price at the end of 2005). The addition of that one company to her portfolio increased her return from -1.6% to +8.2%!

Do Your Research

Once you’ve identified a company with an appealing product or service, it isn’t time to buy yet! Lynch suggests looking at the company’s financial statements and several financial metrics.  The importance of this step is illustrated by the price volatility observed in GameStop and other companies’ stocks in January 2020.  I’ll talk about a few of them here.

Percent of Sales

The first thing to check is whether the new “thing” is big enough to have an impact on the profitability of the company. To illustrate, let’s look at two companies that make widgets. Company A makes primarily widgets, so 90% of its sales is from widgets. Company B makes a lot of things. Only 5% of Company B’s sales is from widgets. A new thingamabob has been designed that will double the sales of widgets with no impact on the profit margin (percent of sales cost that turns into profit). Company A’s profit will increase by 90%, whereas Company B’s profit will increase by only 5%. Because stock prices are driven in large part by estimates of future profitability, you would expect that Company A’s stock price would increase much more if it added thingamabobs to its widgets than Company B’s stock price.

Future Earnings

For many reasons identified by Lynch, stock prices don’t always move in line with earnings. Nonetheless, the more that earnings increase, the more that the stock price is likely to go up. Lynch suggests that you make sure you understand how a company plans to grow its earnings.

Ways to Increase Earnings

He identifies the following five ways for increasing earnings:

  • Reduce costs
  • Raise prices
  • Expand into new markets
  • Sell more product to existing markets
  • Revitalize, close or otherwise dispose of losing operations

If you plan to hold the company’s stock for a fairly short time, any of these ways of increasing earnings could provide nice returns. I tend to buy and hold my stocks for a long time (over 25 years in several cases), so I prefer companies whose growth strategies include expanding into new markets or selling more product to existing markets. The other three approaches tend to produce one-time increases to earnings that can’t be replicated over and over again.

Expanding into New Markets

One of the most common ways existing companies expand into new markets is through acquiring other companies. There are many companies that have grown very successfully through acquisition.

Berkshire Hathaway

One such company is Berkshire Hathaway, whose chairman is Warren Buffett. Over the past 40 years, Berkshire Hathaway has purchased such companies as Burlington Northern, Dairy Queen, and Fruit of the Loom, among others. The graph below shows the value of $1 invested in Berkshire Hathaway (stock symbol: BRK-A) since 1980 as compared to a $1 investment in the S&P 500.[1]

Comparison of S&P 500 and BRK appreciation

Clearly, Berkshire Hathaway has been highly successful in its acquisition strategy.

General Electric

Other companies have been less successful with their expansion and acquisition strategies. One such example is General Electric (GE). When I was young, I thought of GE as primarily manufacturing appliances and light bulbs. The graph below shows how the value of $1 invested in GE increased between 1962 and 2000 as compared to the same investment in the S&P 500.

Comparison of GE and S&P 500 appreciation from 1962 to 1999

Clearly, over that time frame, GE was very successful. In fact, my in-laws bought a few shares of GE for each of my kids when they were young (in the 1990s) because it was considered such a great, stable company.

Over the past 20 years, it has expanded its operations into loans, insurance and medical products and related services.   In hindsight, it appears that GE wasn’t sufficiently familiar with all of the business it entered or acquired.  It also used a lot of debt to finance its acquisitions and expansions.  As a result, its stock price suffered. The graph below shows how much a $1 investment in GE’s stock has changed over the past 20 years as compared to the S&P 500.[2]

Comparison of S&P 500 and GE price appreciation since 2000

Comparison

From 2000 to late 2019, Berkshire Hathaway’s stock price went up by a factor of almost 5 while GE’s stock price decreased by more than 50%. Interestingly, GE’s new CEO (hired in 2018) announced a transformation plan that includes selling several of its businesses, allowing it to focus primarily on “safely delivering people where they need to go; powering homes, schools, hospitals, and businesses; and offering more precise diagnostics and care when patients need it most.”[3]

You’ll want to make sure you understand which new markets a company plans to enter, think about whether management has sufficient experience or expertise to expand successfully and understand how much debt the company is using to finance these expansions.

P/E Ratio

The ratio of the price of a company’s stock to its annual earnings is known as the P/E ratio. A P/E ratio is one way to measure whether a company’s stock price is expensive. A rule of thumb mentioned by Lynch is that a stock is reasonably priced when its P/E is about the same as its future earnings growth rate. He acknowledges the important point that the future earnings growth rate isn’t ever known and that lots of experts spend a lot of time incorrectly estimating the earnings growth rate.

Nonetheless, you can at least look to see if a company’s P/E ratio is the right order of magnitude. For example, if you are looking at a company that slowly expands its sales in its current market, its earnings growth rate might be 5% to 7%. If that company’s P/E were 25, you’d know it was expensive. If the P/E ratio were 2, it might be an attractive buy. So, it isn’t necessarily important to know whether the company’s earnings growth rate is going to 5% or 7%, but rather whether it is likely to be 5% or 25%.

Schwab has an entire post on using the P/E ratio as part of stock analyses.

Debt/Equity Ratio

Companies can get cash from three sources to finance their operations – equity (selling shares of stock), borrowing and profits. Long-term debt is the amount of money that a company has borrowed, other than to meet short-term cash needs (such as through a line of credit). Long-term debt frequently is in the form of bank loans or bonds issued by the company.

The ratio of the amount of long-term debt to equity (the difference between assets and liabilities which is an estimate of the value of the company to the stockholders) is known as the debt-to-equity ratio. There are both advantages and disadvantages to a high debt-to-equity ratio. Let’s look at an example.

Company A has $100 of profit before interest (and ignoring taxes) and $60 of interest payments, for net income of $40 ($100 – $60). Company B is the same as Company A but it has no long-term debt, so its net income is $100. If profit before interest went down by 40%, Company B’s net income would also decrease by 40% to $60. Company A’s net income, though would go from $40 to $0 or a 100% decrease. The primary disadvantage of debt is that it magnifies the impact of bad news. The 40% decrease in profit before interest turned into a 100% decrease in net income for Company A with all its debt. This magnification is called leverage or debt leverage.

On the plus side, increases in profits are also magnified. If Company A’s profit before interest increased by 50% to $150, its net income would increase by $50 to $90. The percentage increase in net income in this case is +125% as compared to the +50% increase in Company B’s net income.

Other Metrics

Lynch discusses several other things to check on a company’s financial statements before making an investment.   I talk about one of them, the dividend payout ratio, in my post on investing for dividends. I’ll let you read One Up on Wall Street to learn more about the other metrics and to get Lynch’s views and examples on the ones I’ve discussed here.

Create Your Story

For every company in which you invest, Lynch recommends that you create a story. There are two parts to the story.

Two-Minute Story

First, you should be able to describe the company’s business in what I would call an “elevator speech.” That is, it is important to be able to explain to someone else what the company does and why you think it will grow all in two minutes. If your explanation takes longer, it is likely an indication that the company’s business is too complex to benefit from a trend you observe or you don’t fully understand its business.

Additional Details

Second, you’ll want to have a story for yourself that includes a bit more detail about what you think will cause earnings (and hopefully therefore the stock price) to increase. Is it one of the one-time actions, such as cutting expenses or increases prices, or a longer-term plan to increase sales?

If the former, you’ll want to monitor the progress of those actions. Are they being implemented? Have they been effective? Has their full impact been reflected in earnings and/or the stock price? If the company’s plans don’t come to fruition or they were successful and reflected in earnings, you’ll want to evaluate whether you want to continue to own the company’s stock or whether it is time to sell it.

If the latter, you’ll want to understand what steps the company plans to take to increase sales. You can then monitor the company’s progress towards those plans. If it doesn’t appear to be on track, it might be time to considering selling the stock and investing in another company.

Final Thoughts

As I re-read Lynch’s book in preparation for writing this post, I was reminded how many useful tidbits he provides in it. Interspersed among the anecdotes are lots of lists, checklists and guidance on everything from identifying a company in which to possibly invest to determining the company’s growth pattern to reading financials to designing your portfolio. If you plan to start picking stocks in individual companies, I highly recommend One Up on Wall Street by Peter Lynch as a good first book on the topic. If you are looking for a shorter source for similar information, I suggest this post from Schwab.

 

 

[1] Taken from Yahoo Finance, November 8, 2019.

[2] Taken from Yahoo Finance on November 8, 2019

[3] General Electric 2008 Annual Report, https://www.ge.com/investor-relations/sites/default/files/GE_AR18.pdf, p3.

Investing for Dividends

Investing for Dividends

Investing for dividends is one of many strategies investors use to identify stocks for their portfolios. Among the strategies I identified in my post on what you need to know about stocks, this is not one that I have ever used.  So I reached out to 

Reading Financial Statements

Reading Financial Statements

Reading financial statement guides many investors in their decisions to buy and sell stocks.   Investors who focus on financial fundamentals look at recent financial statements in the context of other trends to estimate how much a company’s future profit might grow.  High-dividend yield investors need 

What You Need to Know About Stocks

What You Need to Know About Stocks

Stocks are a common choice for many investors.  There are two types of stocks – preferred and common.  Because most investors buy common stocks, they will be the subject of this post.  I’ll talk about what you need to know about stocks before you buy them, including:

  • Stocks and how they work.
  • The price you will pay.
  • The risks of owning stocks.
  • Approaches people use for selecting stocks.
  • How stock are taxed.
  • When you might consider buying stocks.
  • How to buy a stock.

What are Stocks?

Stocks are ownership interests in companies.  They are sometimes called equities or shares.  When you buy a stock, you receive a certificate that indicates the number of shares you own.  If you buy your investments through a brokerage firm, it will hold your certificates for you.  If you buy them directly, you will usually receive the certificate (and will want to maintain it in an extremely safe place as it is your only proof that you own the stock).  Some companies track their stock’s owners electronically, so you may not always get a physical certificate.

How Do Stocks Work?

Companies sell stock as a way to raise money.  The company receives the amount paid for the shares of stock when they are issued, minus a fee paid to the investment banker that assists with the sale.  The process of issuing stock is called a public offering.  The first time a company offers its shares to the public, it is called an initial public offering (IPO).

Stockholder-Company Interactions

After the stock has been sold by the company, the stockholder has the following interactions with the company:

  • It receives any dividends paid by the company.
  • It gets to vote on matters brought before shareholders at least annually.  These issues include election of directors, advisory input on executive compensation, selection of auditors and other matters.
  • It has the option to sell the stock back to the company if the company decides to repurchase some of its stock.

In addition to these benefits of owning stock, you also can sell it at the then-current market price at any time.

Why Companies Care About Their Stock Prices

Interestingly, after the stock has been sold by the company, future sales of the stock do not impact the finances of the company other than its impact on executive compensation.  That is, if you buy stock in a company other than when it is issued, you pay for the stock and the proceeds go to the seller (who isn’t the company)!

You might wonder, then, why a company might care about its stock price.  That’s where executive compensation comes in!  Many directors and senior executives at publicly traded companies have a portion of their compensation either paid in stock or determined based on the price of the company’s stock.  When the leadership owns a lot of stock or is paid based on the stock price, it has a strong incentive to act in a way that will increase the price of the stock.  As such, with appropriate incentive compensation for directors and executives, their interests are more closely aligned with yours (i.e., you both want the price of the company’s stock to go up).

What Price Will I Pay?

The price you will pay for a stock is the amount that the person selling the stock is willing to take in payment.  Finance theory asserts that the price of a stock should be the present value of the cash flows you will receive as the owner of a stock.

In my post on bonds, I explain present values.  They apply fairly easily to the price of a bond, as the cash flows to the owner of a bond are fairly clear – the coupons or interest payments and the return of the principal on a known date.

By comparison, the cash flows to the owner of a stock are much more uncertain.  There are two types of cash flows to the owner of a stock – dividends and the money you receive when you sell the stock.

Dividends

Dividends are amounts paid by the company to stockholders.  Many companies pay dividends every quarter or every year.  In most cases, the amount of these dividends stay fairly constant or increase a little bit every year.  The company, though, is under no obligation to pay dividends and can decide at any time to stop paying them.  As such, while many people assume that dividends will continue to be paid, there is more uncertainty in whether they will be paid than there is with bond interest.

Proceeds from the Sale of the Stock

The owner of the stock will receive an amount equal to the number of shares sold times the price per share at the time of sale.  This cash flow has two components of uncertainty to it.

  1. You don’t know when you will sell it. You therefore don’t know for how long you need to discount this cash flow to calculate the present value.
  2. It is impossible to predict the price of a stock in the future.

I find figuring out when to sell a stock one of the hardest aspects of investing.  I can get excited about investing in a company, but waffle on when to sell.  Brandon Smith, founder of Launchpad Finance, provides seven indicators that it is time to sell a stock in this post.  These indicators are important if you decide to let your winning stocks run rather than trim your positions in them.

What are the Risks?

The biggest risk of buying a stock is that its value could decrease.   At the extreme, a company could go bankrupt.  In a bankruptcy, creditors (e.g., employees and vendors) are paid first.  If there is money left after creditors have been paid, then the remaining funds are used to re-pay a portion of any bond principal.  By definition, there isn’t enough money to pay all of the creditors and bondholders when there is a bankruptcy.  As such, the bondholders will not get all of their principal re-paid and there will be no money left after payment has been made to bondholders and creditors.  When there is no money left in the company, the stock becomes worthless.

Any of the following factors (and others) can cause the price of the stock to go down.

Economic Conditions Change

Changes in economic conditions can cause the interest rate used for discounting in the present value calculation to increase. When the interest rate increases, present values (estimates of the price) will go down.

Company Changes

Something changes at the company that causes other investors to believe that the company’s profits will be less than previously expected. One simple way that some investors estimate the price of a company’s stock is to multiply the company’s earnings by a factor, called the price-to-earnings ratio or P/E ratio.  Although P/E ratios aren’t constant over time, the price of a stock goes down when its earnings either decrease or are forecast to be lower than expected in the future. For more about P/E ratios and how a company calculates and reports on its earnings, check out this post

Increased Risk

Changes either in the economy or at the company can cause investors to think that the future profits of the company are more uncertain, i.e., riskier. When a cash flow is perceived to be riskier, a higher interest rate is used in the present value calculation.  This concept is illustrated in my post on bonds in the graph that shows how interest rates on bonds increase as the credit rating of the company goes down.  Recall that lower credit ratings correspond to higher risk.  The same concept applies to stock prices.  The prices of riskier stocks are less than the prices of less risky stocks if all other things are equal.

Trends in the Market

In January 2021, the price of several companies’ stock sky-rocketed initially triggered by retail investors buying stocks in which institutional investors had taken big bets that the price would go up.  Those stock prices may go down just as quickly as they went up.  It is important to understand why a stock price is increasing before you buy.

How Do People Decide What to Buy?

There are a number of approaches investors use to decide in which companies to buy stocks and when to buy and sell them.   I will discuss several of them in future posts.

Reasonable Price Investing

Reasonable price investors look at the financial fundamentals and stock prices of companies to decide whether and when to buy and sell them.

Technical Analysis

Technical analysts, sometimes called momentum investors, look at patterns in the movement of the prices of companies’ stocks.  To do so, they read stock charts.  Day traders tend to be technical analysts whose time horizon for owning a stock can be hours or days.

High-Yield Investing

Some investors focus on companies who issue dividends.

Mutual Funds and Exchange-Traded Funds (ETFs)

Rather than invest in individual companies, some investors purchase either mutual or exchange-traded funds.  Under this approach, the investor relies on the fund managers to select the companies and determine when to buy and sell each position.

Investing Clubs

A great way to get started with investing or expand your research is to join an investing club.  They provide the opportunity to pool your money with other investors to buy positions in individual companies that the group has resourced.  In addition, you get to know other people with interests similar to yours.

Turnaround Plays

Turnaround plays (companies that have struggled but are about to become successful) can produce some of the highest returns in the market.  However, identifying companies that will actually be successful under their new strategies is difficult.  As such, investing in turnaround plays can also be quite risky. The Piotroski score is one tool that can be helpful in identifying companies that are more likely to produce above-market-average returns.

How are Stocks Taxed?

There are two ways in which stocks can impact your income taxes:

  • When you receive a dividend.
  • When you sell your ownership interest in the stock.

The total amount of the dividend is subject to tax.  The difference between the proceeds of selling the stock and the amount you paid for the stock is called a realized capital gain or loss.  It is gain if the sale proceeds is more than the purchase amount and a loss if the sale proceeds are less than the purchase amount.

In the US, realized capital gains and losses on stocks you have owned for more than a year are added to dividends.  For most people, the sum of these two amounts is taxed at 15%.  For stocks owned for less than a year, the realized capital gains are taxed at your ordinary tax rate (i.e., the rate you pay on your wages).

In Canada, dividends and half of your realized capital gains are added to your wages.  The total of those amounts is subject to your ordinary income tax rate.

When Should I Buy Stocks?

Understand Stocks

The most important consideration in determining when to buy stocks is that you understand how stocks work.  One of the messages I wished I had given our children is to invest only in things you understand.  If you don’t understand stocks, you don’t want to invest in them.

Understand the Companies or Funds

You also want to make sure you understand the particular company or fund you are purchasing.  One of the biggest investing mistakes I made was when I was quite young and didn’t understand the business of the company whose stock I owned.

My parents gave me some shares of a company called Wang Laboratories.  In the 1970s and early 1980s, Wang was one of the leaders in the market for dedicated word processors.  Picture a desktop computer with a monitor that’s only software was Microsoft Word, only much harder to use.  That was Wang’s biggest product.  At one time, the stock price was $42.  Not understanding that PCs were entering the market and would be able to do so much more than a dedicated word processor, I was oblivious.

As the stock started going down, I sold a few shares in the high $30s.  When the stock dropped to $18, I told myself I would sell the rest when it got back to $21.  It never did.  A year or so later, the stock was completely worthless. Fortunately, I was young enough that I had a lot of time to recover and learn from this mistake.

Understand and Be Able to Take the Risk

You should also not buy stocks if you can’t afford to lose some or all of your principal.  Even though only a few companies go bankrupt, such as Wang, the price of individual stocks can be quite volatile.  As discussed in my post on diversification, you can reduce the chances that your portfolio will have a decline in value by either owning a large number of stocks or owning them for a long time.  Nonetheless, you might find that the value of your portfolio is less than the amount you invested especially over short periods of time when you invest in stocks.  If you want to invest in stocks, you need to be willing to tolerate those ups and downs in value both mentally and financially.

Market Timing

There is an old investing adage, “Buy low, sell high.”  In principle, it is a great strategy.  In practice, though, it is hard to identify the peaks and valleys in either the market as a whole or an individual stock.

People who invest over very short time frames – hours or days – often use technical analysis to try to identify very short-term highs and lows to create gains.  I anticipate that most of my followers, though, will be investing for the long term and not day trading.  While you will want to select stocks that are expected to produce a return commensurate with their riskiness, it is very difficult to time the market.

That is, my suggestion for new investors with long-term investment horizons (e.g., for retirement or your young children’s college expenses) is to buy stocks or mutual funds you understand and think are likely to appreciate whenever you have the time and money available to do so.  If you happen to buy a fundamentally sound stock or index fund just before its price drops, it will be difficult to hang on but it is likely to increase in the price by the time you need to sell it.

As Chris @MoneyStir learned when he reviewed the post I wrote about whether he should pre-pay his mortgage, a fall in the stock market right after he started using his extra cash to buy stocks on a monthly basis was actually good for him!  While he lost money at first on his first few month’s investments, the ones he made over the next several months were at a lower stock price and produced a higher-than-average return over his investment horizon.  The process of buying stocks periodically, such as every month, is called dollar-cost averaging.

How and Where Do I Buy Stocks?

You can buy stocks, mutual funds and ETFs at any brokerage firm.  This article by Invested Wallet provides details on how to open an account at a brokerage firm.

Once you have an account, you need to know the name of the company or its symbol (usually 2-5 letters that can be found using Google or Yahoo Finance, for example), how many shares you want to buy and whether you want to set the price at which you purchase the stocks, use dollar-cost averaging to purchase them over a period of time or buy them at the market price.

Limit Orders

If you determine you want to buy a stock at a particular price, it is called a limit order.  The advantage of a limit order is you know exactly how much you will pay.  The disadvantages of a limit order are:

  • You might pay more than you have to if the stock price is lower at the time you place your order.
  • You might not buy the stock if no one is interested in selling the stock at a price that is a low as your desired purchase price.

Market Orders

If you place a market order, you will buy the stock at whatever price sellers are willing to take for their stock at the moment you place your order.  In some cases, you may end up paying more than you want for a stock if the price jumps up right at the time you place your order.  The advantages of a market order are (1) you know you will own the stock and (2) you know you are getting the best price available at the time you buy the stock.

Transaction Fees

Many of the major brokerage firms have recently announced that they will no longer charge you each time you purchase or sell a stock.  Some firms charge you small transaction fees, such as $4.95, each time you place a buy or sell order.  Other firms have higher charges.  You’ll want to consider the fees when you select a brokerage firm.

Investing in Bonds

Investing in Bonds

Bonds are a common investment for people targeting a low-risk investment portfolioA group of financial instruments. More. One of the pieces of advice I gave my kids (see others in this post) is to never buy anything you don’t understand. In this post, I’ll tell you 

Investment Diversification Reduces Risk

Investment Diversification Reduces Risk

Investment diversificationThe reduction in volatility created by combining two or more processes (such as the prices of financial instruments) that do not have 100% correlation. More is an important tool that many investors used to reduce riskThe possibility that something bad will happen. More. Last