If you don't have any experience investing on your own, getting started can be rather intimidating. It can be difficult to determine how much of your money should be in stocks, what type of stocks you should look for, or what common "rookie mistakes" you should avoid. With that in mind, here are 10 things all investors should keep in mind while getting ready to buy their first stock.
1. How much of your portfolio should be in stocks?
There is no set-in-stone rule, but generally speaking, as you get older and closer to retirement, you should reduce your exposure to stocks in order to preserve your capital. As a rule of thumb, take your age and subtract it from 110 to find the percentage of your portfolio that should be invested in stocks, and adjust this up or down based on your particular appetite for risk.
2. Index funds vs. individual stocks
An index fund allows you to invest in many stocks by purchasing one investment. For example, an index fund gives you exposure to all 500 stocks in that index.
Index funds can be an excellent tool to diversify your portfolio and reduce your risk. After all, if your money is spread across hundreds of stocks and one crashes, the impact on your overall portfolio is minimal.
3. How many different stocks should you buy?
If you only want to buy individual stocks, I suggest buying at least 15 different stocks across several different industries in order to properly diversify your portfolio. However, this may not be practical when you're just starting out.
An alternative to buying lots of individual stocks is to invest the bulk of your money in index funds, and buy one or two stocks with the rest. This takes most of the guesswork out of investing, while still allowing you to get some experience with evaluating stocks.
4. Dividends or no dividends?
Many stocks choose to distribute their profits to shareholders in the form of dividends, while others choose to use their profits to reinvest in the growth of the company. In general (but not always), dividend stocks tend to be less volatile and more defensive than non-dividend stocks. It's important to note that just because a company pays a high dividend doesn't necessarily mean that it's a better investment.
Over the past 80 years, dividends were responsible for 44% of the total return of the S&P 500 index, and dividend reinvestment can be an extremely powerful tool for creating long-term wealth.
5. How much profit can you expect?
I'd advise new investors to take a long-term view of the markets. In any given year, the market could gain or lose a substantial portion of its value. However, over long periods of time the markets are surprisingly consistent. Over any recent 25-year period, the S&P 500 produced average annual total returns of at least 9.28%, so it's fair to expect this level of performance over the long run -- even though over any shorter stretch it can vary significantly.
6. Only buy what you know
One investment rule I never break is that if I can't clearly explain what a company does in a sentence or two, I won't invest in it. For example, I really don't understand most biotech companies (nor have I really tried to), so I'm not going to invest in their stocks. On the other hand, the business models of my largest stock holdings such as Realty Income, FedEx, and Google are rather straightforward. It's important to only invest in businesses that are easy for you to understand, especially while you're just starting out.
7. Watch out for red flags
There are several red flags to watch for when choosing stocks. Just to name a few, beginners should avoid the following types of stocks
- Companies that don't earn any profits
- Stocks whose share prices seem to always drop (look at the three- or five-year chart)
- Companies that are under investigation
- Companies with lots of debt
- Stocks with recent dividend cuts, or an unstable dividend history
8. Know how volatile your stocks are
Before you buy a stock, it helps to know how volatile you can expect it to be, which you can determine by looking at its beta (included in virtually any stock quote). A stock's beta essentially compares its volatility to that of the overall S&P 500 index. If the beta is less than one, the stock can be expected to react less to market swings, and if it's greater than one it is more reactive.
For example, if a stock's beta is 2.0 and the S&P 500 drops by 5%, its share price could be expected to drop 10%.
9. History tends to repeat itself
Although past performance doesn't guarantee future results, there are some historical patterns that tend to continue. Specifically, stocks with a history of profitability and consistent earnings growth tend to keep it up. And, stocks with a strong history of dividend increases are extremely likely to increase their dividends in the future. Do a little research and compare the historical behavior of stocks you're considering.
10. Rookie mistakes to avoid
Finally, there are some dangerous traps rookie investors should avoid. This is not an exhaustive list, but these are among the most costly:
- Buying penny stocks: Avoid "penny stocks," which I define as any stock trading for less than $5 or any stock that doesn't trade on the Nasdaq or NYSE. Of course, there are exceptions, but it's probably a good idea for beginners to steer clear of these.
- Buying stocks on "rumors": Never buy a stock because it's "about to" do anything. Always do thorough research and make a well-informed decision with the long term in mind.
- Using margin: There are some valid reasons to use margin (borrowed money), but beginners shouldn't touch it. Investing on margin can amplify your returns, but it can also increase your losses.
Never stop learning
As an experienced investor, one of the most valuable lessons I've learned is that I'll never know everything about investing. The smartest thing you can do is to continuously absorb information about how the markets work, how to evaluate stocks, and other investing topics. If you do that, your investing skills will grow over time, and so will your portfolio.
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Matthew Frankel owns shares of FedEx, Google (C shares), and Realty Income. The Motley Fool recommends FedEx, Google (A shares), and Google (C shares). The Motley Fool owns shares of Google (A and C shares). Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.