Ready to take your first steps into the world of stock investing? Are you sure? Just like a beginning polo player needs to know how to ride already, a beginning investor needs to have the financial house in order before putting money at risk in the market. Still got credit card debt? Would losing your job mean you couldn't pay the mortgage next month? You're not a beginning investor just yet. Put yourself through the first three steps (at least) of our 13 Steps to Investing Foolishly. Meet you back here when you're ready.
(Is that the sound of many mice clicking?)
Okay, now that you've got your financial basics ship-shape, let's look at some of the concepts you need to understand as you take your first steps toward stock ownership. And don't forget another tool for Fools, our Beginning Investing online seminar, which you can take at your own pace.
Index investing -- Ann Coleman (TMF AnnC)
Index investing may be the single most valuable concept for the individual investor ever articulated. John Bogle, founder of the Vanguard Group, came up with the idea in the early '70s in an attempt to align mutual fund management with fund investors' best interests. (That in itself was a revolutionary idea at a time when many funds routinely charged a 9% sales load!) He explains it all most recently in Common Sense on Mutual Funds: New Imperatives for the Intelligent Investor.
Contrary to expectations, and in spite of the best efforts of an army of well-paid professional stock pickers, managed mutual funds were dismally underperforming the market at the time (and have continued to do so). Bogle reasoned that since the S&P 500 index is one widely respected measure of the market, one could automatically match the market's performance simply by investing in all the stocks that make up the S&P 500 index and keeping expenses extremely low. What a concept!
Twenty-five years later his revolutionary idea has given birth to hundreds of index funds matching not only the S&P 500 but dozens of other broad-market and specialized indexes including the Dow Jones Industrial Average, the Wilshire 5000 total market index, the Dow Jones Health Care Sector index, the Nasdaq Biotechnology sector index, the Morgan Stanley Capital International Sweden Index -- you get the picture. If there's a stock index out there, and there seems to be one for just about every segment of the market, it probably has an investment vehicle tracking it. Many of them (the only ones you should consider investing in) have no sales load at all, and annual expense are often the lowest in the fund industry, typically less than one half of one percent (0.5%).
While foreign and sector index investing requires some specialized knowledge, the broad market indexes like the S&P 500, the Dow, or a total market index offer beginning investors the opportunity to participate in the long-term growth of the economy in true set-and-forget mode. What could be simpler?
You can find index investments at most mutual fund companies (watch out for their fees, though) or simply buy exchange traded funds (ETFs) through any broker. For more on index investing, check out our 60-Second Guide on the subject.
The price/earnings ratio (P/E) -- Ann Coleman (TMF AnnC)
The price to earnings ratio ("P/E") is the unit pricing method for stocks. Ever start to buy a big can of tuna thinking you would get the best deal only to find that the price per ounce (the "P/O") was about twice as high as the P/O of the little six-ounce can? (You haven't? Better start shopping more carefully!) Unit pricing has made grocery stores safe for those of us who can't do long division in our heads, and the P/E lets us compare stock prices in the same way. To compute it, you divide the price per share by the company's earnings per share (EPS). The P/E is the price of a dollar of earnings (profits). For example, if you buy shares of a stock that has a P/E of 30, you pay $30 for each $1 of profit.
What you are really buying when you buy a share of stock is the right to a portion of a company's future profits. But since a "share" of a company is not defined (it could represent one-half ownership of a company, or one-five-billionth ownership, or anything in between), the price per share is meaningless. The P/E converts price per share into the cost of a dollar's worth of annual profits. That's a much more meaningful number.
For example, let's imagine two similar companies, one selling for $100 per share and one for $50 per share. Would the $50 company be a better buy? (If you said you don't know, you're with us so far. If you thought "yes," re-read the previous paragraph, please.) But let's suppose that the $100 company is earning $5 per share and the $50 company is earning $2 per share. That would give the $100 company a P/E of 20 and the $50 company a P/E of 25. Now which is the better deal?
If you said you still didn't know, you're right. The $100 company is cheaper in terms of current earnings, but what really counts is how much the company will earn while you own it. That's much harder to measure, but understanding P/E is the first step in estimating a company's true value.
Dollar cost averaging: great strategy, silly name -- Robert Brokamp (TMF Bro)
Dollar cost averaging (DCA) kicks assets, plain and simple. It's a no-brainer strategy that reduces risk and can turn a portfolio molehill into a mountain.
But what a ridiculous name. I prefer to call it "investing on autopilot." You could also call it "Steady Eddie." Heck, call it "navigating Jell-O" if you want. Just do it.
What is it?
Dollar cost averaging is the systematic -- and usually automatic -- investing of a specific amount of money at specific intervals. If you participate in your company's retirement plan, you already dollar-cost average. You invest a certain amount of money (e.g., 10% of your paycheck) on a regular basis (each time you get paid). No fuss, no muss, and no attempt to pick the market's peaks and valleys (a dubious practice).
Why do it?
Let us count the ways:
- You buy more shares when prices are low, and fewer when prices are high. You do the same with boxes of cereal and whoopee cushions -- why not investments?
- If you participate in an automatic investment program, such as through a dividend reinvestment plan (or Drip) -- which you can also learn about in Jeff Fischer's Investing Without a Silver Spoon -- you don't have to write a check. The money can be transferred from your bank account to your investment account without any risk of getting a papercut on your tongue while sealing the envelope.
- DCA is easy to budget for.
- You put yourself on a disciplined savings program. Stick to it, and you'll build up quite a stake over the years.
- You can boost your net worth even though you might only have a small amount to invest at any one time.
So get out there and "surf the fat lady's belly," or whatever you want to call it. Just do it.
Next: Intermediate Investors »
Robert Brokamp's (TMF Bro) favorite band is Giant Ladies Who Might Be Barenaked. Or something like it. Just check out his profile.
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