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15 Investing Concepts to Know Before You Buy Stocks

By Catherine Brock - Oct 21, 2022 at 7:00AM
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15 Investing Concepts to Know Before You Buy Stocks

What you don't know can hurt you

Investing in the stock market is one of the most accessible ways to build wealth over time. The trouble is, you can also lose wealth -- and fast.

Give yourself a running start at investing success by learning some basic concepts now. You'll be more likely to avoid the biggest, most common investing mistakes. Plus you'll feel more comfortable creating an appropriate investing strategy and managing your own risk.

Here are 15 easy-to-understand investing concepts that'll help you invest smarter. The end result should be a shorter, less stressful path to future wealth.

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1. Compound earnings

Compound earnings refers to making money on your initial investment and on your earnings from that investment.

Say you buy a stock for $100 and the value increases 10% to $110. You now have $10 in unrealized gains plus the $100 that was your starting investment. If the stock rises another 10%, the increase won't be $10 again -- it'll be $11. This is because your earnings and your initial investment are appreciating.

In real life, of course, stocks don't go up continuously without a few downturns. But if you wait long enough, your earnings on earnings can generate far more wealth than your initial investment.

ALSO READ: Beyond Passive Income: Compounding Is What Really Creates Wealth

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2. Investing purpose

Before you begin trading stocks, spend some time defining why you want to invest. You might be looking to build retirement wealth, turn some quick profits, or something in between. Defining your goal will help you make consistent, purposeful trading decisions. After all, the stocks you buy for retirement wealth are not the same stocks you'd buy for fast gains.

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3. Buy and hold

Buy and hold is an investment style that requires you to purchase stocks you plan to hold indefinitely. This is very different from buying stocks you think will appreciate in the next week, month, or year. With a buy-and-hold strategy, your main goal is to generate long-term wealth through compounding.

That takes time, but it can be less risky than frequent trading. This is because the stock market generally shows more consistent growth over long periods of time versus shorter ones. The longer you stay invested in a diversified portfolio, the more likely you are to see gains.

ALSO READ: Got $1,000? 5 Buffett Stocks to Buy and Hold Forever

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4. Risk and return

Risk and return go together. While there are strategies you can take to manage risk, you cannot eliminate it from your investments. And usually, assets with high return potential also have high risk.

The main implication here is that there is no such thing as a can't-lose investment. If an asset can rise in value, it can also fall.

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5. Systematic risk

There are different types of risk to understand as an investor. Systematic risk is the type that affects the entire stock market rather than a single industry or stock.

Economic and political factors influence broader stock market trends. You see this in the financial headlines -- high inflation reports prompt many stocks to decline, while better-than-expected jobs reports can cause many stocks, across different industries, to rise.

You can't avoid systematic risk. You can only manage it somewhat through asset allocation.

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6. Asset allocation

Asset allocation is the composition of your investments across different asset classes, such as stocks, bonds, real estate, and cash.

Each asset class responds in its own way to economic, financial, and political factors. When the economy is weak, for example, stocks may lose value while bonds become more attractive to investors. Combining these different, sometimes offsetting behavior patterns into one portfolio can reduce overall volatility.

ALSO READ: 5 Things to Know About Asset Allocation

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7. Rebalancing

Rebalancing is the process of restoring a targeted asset allocation. Say you've decided that a conservative allocation of 60% stocks and 40% bonds is where you feel comfortable. This composition provides some growth opportunity through your stocks but anchors that growth with the stability of bonds.

In a rising stock market, your 60% stock holdings will appreciate to 61%, 62%, and so on. As your relative stock exposure rises, your asset allocation gradually gets more aggressive. Rebalancing addresses this problem.

To rebalance, you'd sell a portion of your stock holdings and use the proceeds to buy bonds.

ALSO READ: It Doesn't Matter How You Rebalance, Just That You Do

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8. Unsystematic risk

Unsystematic risk affects only one industry or company. Regulatory changes that affect all automakers or a class action lawsuit that impacts a single pharmaceutical company are two examples.

There are several types of unsystematic risk. A single company could falter due to an aggressive debt structure, operational or strategic missteps, or legal issues.

You can address unsystematic risk through diversification.

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9. Diversification

Diversification is the practice of holding a variety of assets in your portfolio. To reduce your reliance on a single company's success, for example, you'd hold 20 or more individual stocks. Ideally, those 20 stocks would be spread across all economic sectors. That, in turn, lowers your reliance on a single sector's performance.

You can also diversify across geographies and company size.

ALSO READ: 3 Things Beginning Investors Can Get Painfully Wrong About Diversification

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10. Dollar-cost averaging

Dollar-cost averaging, or DCA, is the practice of investing a small sum regularly versus a large sum all at once. Say your investing budget is $2,400 annually. You could invest this amount once a year or you could invest $200 monthly. The latter strategy is DCA.

DCA reduces your timing risk, which is the chance of paying too much for a stock due to the timing of your trade. A regular, monthly investment gives you access to 12 buy prices rather than just one. In time, these should average out to a cost that generally reflects the stock's value.

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11. Inflation

Dollars lose purchasing power over time. This results in inflation, or the gradual rise of prices.

Inflation offsets your investment returns. If your assets appreciate 10% this year but inflation is 8%, your net gain is 2%.

This is an important concept to understand when you are projecting long-term investment performance. If you don't account for inflation into your retirement savings plan, you may reach your wealth goals in dollars -- but those dollars will buy a lot less than you expected.

Note that the long-term average annual growth rate of the stock market, net of inflation, is just under 7%.

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12. Rule of 72

The rule of 72 is a quick formula that estimates how long it takes to double your money at a given growth rate. Simply divide 72 by your expected growth rate. The answer is your doubling time in years. So, funds invested at 7% should double in about 10 years and four months.

You can also use the formula to estimate the growth rate needed to double your money in a certain number of years. Doubling your investment in five years, for example, would require an annual return of 14.4% -- or 72 divided by 5.

ALSO READ: How the Rule of 72 Can Help You Get Rich

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13. Cash is king

One risk of investing is that your stocks will lose value just when you need to liquidate. Liquidating when stock prices are down produces less cash than you'd like. Depending on the situation, it often works out better long term to wait for the stock price to recover before you sell.

Having cash on hand outside your investment portfolio gives you that option. If an emergency pops up, you can pull funds from your cash account -- rather than liquidating from your investment account at the worst possible time.

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14. Passive investing

Passive investors buy index funds and hold them long term. Index funds mimic their underlying indexes, such as the S&P 500, the Wilshire 5000, or the U.S. Aggregate Bond Market.

The goal of passive investing is to track with the market, rather than beat it. The stock market historically has grown at about 7% annually after inflation over long periods of time. Targeting this market-level growth can be less risky (and easier) than attempting to beat the market through frequent trading.

ALSO READ: The Bear Market Is Becoming a Passive Investor's Dream

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15. Contrarian investing

Contrarian investors go against the grain. When most other investors are buying a certain stock or industry, contrarians are selling. And when other investors sell, contrarians buy. In doing so, you capitalize on low share prices as buying opportunities and take profits when share prices are high.

Contrarian investing requires a long investing timeline, because changes in investor preferences can take years to develop. You can see this by reviewing the history of tech stocks as an example. They were very hot in the late 1990s. Then the dot-com bubble burst and they fell out of favor. Ten years after that, tech companies regained their popularity. That strong run lasted another 10 years or so.

5 Stocks Under $49
Presented by Motley Fool Stock Advisor
We hear it over and over from investors, "I wish I had bought Amazon or Netflix when they were first recommended by The Motley Fool. I’d be sitting on a gold mine!" It's true, but we think these 5 other stocks are screaming buys. And you can buy them now for less than $49 a share! Click here to learn how you can grab a copy of "5 Growth Stocks Under $49" for FREE for a limited time only.

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Invest intentionally

Investing doesn't require a lot of technical knowledge, but it does require intention and discipline. Ideally, you have an investing goal that influences your strategy and asset allocation. From there, you make decisions about diversification and investing cadence to manage your timing risk and growth over time.

Follow those practices, and you're on your way to creating real wealth for your future.

The Motley Fool has a disclosure policy.

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