I find it interesting how foreign things like stocks and investing are to so many people. So I decided to write Investing 101 as a primer for anyone interested in learning a bit more. I will add more to this primer over time, as readers ask specific questions that they want answered.
There are a few things that we need to get out of the way, before we can go onto specifics about investing. First, investing is not about getting rich quick. Investing is about putting money into an asset, and allowing it to grow over time. Removing any money from a portfolio after less than three years is not really investing. Second, even a properly maintained portfolio goes up and down in value during certain periods of time. The higher the desired growth rate, the more volatile the portfolio is going to need to be.
I have a rule for both investing and trading. Essentially it is “do not count your chickens before they are hatched.” More specifically, do not consider any growth in portfolio value profit, until you have used that profit. I am not suggesting that you should go out and spend all your profits right away, but rather that you can never really say how much you have made.
You can only say how much you have spent. I could have an account that goes up by $1,000,000 over the course of a few years. But that portfolio could end up crashing. I could buy the next big thing (like bitcoin), but hold it too long and end up sitting on something worthless. Sure, there are assets that have a longer track record, and diversification helps to reduce the risk of loss, but it is the use that you have been able to derive from something that determines what it was worth.
I’m going to address the concept of a margin account before getting into anything else, because understanding margin accounts will be useful in later discussions. A margin account is essentially a line of credit that a broker provides. The credit is secured by your positions. Usually the margin account is roughly 2:1. If you purchase $1,000 worth of stock, you’ll only have to pay $500. The other $500 will be on margin. Of course, you will be charged interest for this loan.
More importantly, while a margin account can double your profits, it also doubles your risk. Suppose a stock that you purchased goes up by 5%. Now, you only paid $500 for that stock, but you have $1,000 worth of it. So after the 5% increase, you’ll have $1050 and you’ll have made a profit of $50. But that’s a 10% profit on the $500 you actually paid. But if that stock drops by 5% and you now only have $950, your loss is 10%! So you have to be careful when using margin. The real power of margin is that it helps protect you from the T+3 rule, which I’ll get to in a bit.
Stocks are instruments which carry ownership in a company. The units for buying, selling, and otherwise transferring stock is a “share” in the company. So if you purchase, say, 100 shares of stock in say IBM, you are becoming a part owner of IBM. This purchase gives you rights to the profits and equity in the company. In general, being an owner also gives you the rights to vote on certain matters, such as selecting members of the board of directors, mergers, etc. That isn’t always the case however. Some corporations have multiple classes of stock.
Most people buy and sell common stock. Some companies however also provide “preferred stock.” This class of stock usually gives the investors first dibs on profits, and on recovering losses in the case of a business failure. In general, preferred stock offers a fixed dividend rate, which can be substantially higher than the dividend rate of common stock. In fact, common stock might not offer any dividends in some cases. But in return, preferred stock usually doesn’t convey voting rights. So there’s a trade off. You can get a higher rate of return, but you have no say in what the company does.
You make money buying and selling stock, because it is generally the case that the company itself grows. As it grows, people are willing to pay more to buy a stake in the company. Therefore your stock price will go up. If you buy 1,000 shares at a company for $10 a share, and it rises to $15 a share over the next 5 years, you’ll be able to sell it for $15,000 or a profit of $5,000. Of course, since any business can fail, there is always risk involved in trading stock. Companies also usually charge fees to trade stock, so that can cut into your profit.
ETFs and Mutual Funds
An ETF or “exchange traded fund” is purchased and sold on an exchange in the exact same way as a stock. However, unlike a stock, you are not purchasing equity in any company.
There are options to automatically get a high degree of diversification. You can purchase an ETF (exchange traded fund) or mutual fund, which track key indexes like the S&P 500. That’s not a bad idea. However, it gives you no experience on picking and choosing stocks!
T+2 and Freeriding
Margin isn’t actually the only loan that your broker can or does give you. It used to take three days, before the SEC changed its rules, but it still takes take two days for a sale to clear. Therefore, buying and selling the same stock repeatedly, within a two day period, means that you’re selling a stock that actually isn’t yours yet, with money that isn’t yours yet. That’s called “freeriding.” If you accidentally violate these rules, you’ll end up being locked out of using any uncleared funds to purchase new stock.
But you can get around the freeriding problem by opening a margin account. Since the margin account is a true line of credit that you’re receiving from the broker, you don’t have to worry about whether or not funds have cleared or not.
Investing vs Trading
As I mentioned earlier, investing is not trading. Investing in stocks and trading stocks are two very different methods of generating income. Investing in stocks is relatively easy, requires very little money to start, and carries relatively low risk. Trading is difficult, requires a lot of money to start, and carries a very high risk. If you are buying stock and are holding onto it for the long run, hoping for it to grow, you are investing. If you are buying and selling stock, based on how you think the stock’s price is going to trend in the near future, you are trading, not investing. For a beginner with little money, I suggest sticking to investing.
Day trading is a special form of trading, and it requires a fairly large amount of money to start. It also carries more risk than pretty much any other stock transaction. A day trade is defined in terms of a round trip. A day trade occurs when you buy and sell the same stock in a single day. If you perform more than 4 of these trades in a five business day period, you will be classified as a pattern day trader. But you cannot actively be a pattern day trader unless you have at least $25,000 in a margin account.
Now, while day trading is incredibly high risk, I’m going to tell you something that you probably won’t hear from most professional investors, traders, or advisers. Day trading is not a zero sum game. The usual claim is that day trading requires someone to lose in order for someone else to win. If one person is making money, someone else is losing it. The problem is, this reasoning happens to rely on a flawed assumption: day traders are buying and selling from each other. But current research suggests that this isn’t the case. You can read more on the source of income for day traders, here.
Risk and Diversification
Diversification helps reduce the amount of risk you take on when investing. However, not all risk can be diversified away. There are two main types of risk: systemic risk and unsystemic risk. Systemic risk is the risk due to fluctuations in the market and economic system as a whole. See Market Cycles Definition | Investopedia. Unsystemic risk is risk due to individual businesses. For instance, Chipotle stock has been hard hit because of a recent E. coli outbreak. That can be diversified away.
But it takes about 20 stocks, properly diversified, to eliminate unsystemic risk: risk not due to overall fluctuations in the market. That means, with a normal broker, like TDAmeritrade, you’re spending $9.95 x 20 or $199, just to purchase the stocks. Now, if you’re investing more than $10,000 at a time, that’s 2%, which isn’t great, but can be managed. And if you are investing more than $10,000, it might be better to go with a company like TDAmeritrade or Interactive Brokers, as they have a lot more options. Especially since you don’t need more than 20 stocks to properly diversify and any more than that and you risk over-diversification (The Dangers Of Over-Diversifying Your Portfolio).
One way to diversify a portfolio is through the permanent portfolio method. This method uses 25% cash, 25% gold, 25% long term bonds, and 25% diversified stocks.
Robinhood is a relatively new platform for investing. Its services are limited, and it can only be accessed through the Robinhood App, but there are no fees for basic transactions. This is helpful for those who are only purchasing a small amount of stock at a time.
If you want a little more control and a slightly better selection, you can use Motif. With Motif Investing you can purchase a collection of 30 stocks, called a motif, for a single fee of $9.95. You can also sell or restructure that same Motif for the same price. That’s really quite useful. It means you can pick and choose a fair number of stocks, properly diversify, and not have to take a huge hit. In fact, it even reduces the problem of over-diversification, which is primarily that it costs more to handle 30 stocks, usually, than 20. It doesn’t however eliminate the added complexity of researching an addition stocks however.
TDAmeritrade is useful for investors with more experience and more money. While they are much more expensive than either Robinhood or Motif, they offer greater choice and tools. Not only can you buy and sell stocks and mutual funds, but you can also purchase bonds, futures, options, and trade on the foreign exchange market. They also have great research tools and tools for day traders.
IB is probably my favourite broker for larger accounts. While a person needs to put a minimum of $10,000 into the account to start, IB has access to pretty much everything that TDAmeritrade has and more. They have access to stocks, bonds, forex, options, and so on, and allow you to trade in multiple currencies and on multiple exchanges in a number of different countries. If you are looking to diversify into foreign assets, IB is probably the way to go. Additionally, IB has some nice features like a secured credit card which can directly utilize your margin. This feature of course puts your assets at some risk, so it should be used carefully, but it also provides a very low interest rate because any debt you accrue is secured by your assets.
Improving your own “human capital” will aid you greatly in any endeavor, including investing in various markets. Some people disagree, but I think a solid background on finance and economics is very useful when investing. As such, I would suggest a basic finance course, which would allow you to understand a corporation’s balance sheet and profit and loss statement, along with a macroeconomics course, which will give you an idea of how to analyze information coming out about economic policy and conditions.
Coursera’s “The Language and Tools of Financial Analysis” course is a fairly decent option for learning about corporate finance and their “Principles of Macroeconomics” course provides a good introduction to that topic.
There are a number of companies which offer practice accounts. Papermoney, through TDAmeritrade’s thinkorswim is one of them. Using these practice accounts, you can play around with a virtual account, using real time market data. You can practice investing, or even day trading, without having to worry about losing any money.
Disclaimer: I am not a professional investment adviser. I offer no warranty on this information. Any risk taken is your own.