Six Steps for a Beginning Stock Investor

Once a person has their debt under control, the next thing that they want to do with their money is figure out ways to maximize it, and most of the time the potential gains of the stock market look like a great place to put money.

But how? For the average person, the diversity of options for investing in stocks are overwhelming. Should I buy a mutual fund? Should I buy individual stocks? How do I even get started when I’ve figured out what I want to do? What are my investing goals? How do I even describe those goals?

I used to feel overwhelmed by such questions until I sat down and did the research, but I discovered that for the beginning investor, there’s really only a handful of simple steps that you need to follow to make smart investment choices. If you’re at the point where your debt is under control, your savings account is getting quite fat, and you’re looking for better options, here’s how you get started.

How To Get Started in Stocks

1. Figure out your goals.
When you first start thinking about this, it seems nebulous. It’s often hard to tangibly state what your goals are, especially if you’re young and single. However, you often find that they day you get married, it feels like a flood of goals hit you at once – buying a house, having a child, and so on.

Here’s what to do to get started. Take out a sheet of paper and list every financial goal you have in your life right now. What are you saving for? What would you like to be saving for? Things that might wind up on this list are retirement, your children’s education, a house down payment, complete debt freedom, a car, “walk away from your job” money, money to start a business, and so on. Some of those will be important to you, some won’t, and you may have some that aren’t even listed there.

Then, take that list and rank them by importance to you (or to you and your spouse). Don’t worry about what society says, but I will say that younger people tend to undervalue the importance of retirement. Other than that, it’s really about what’s important in your own life – not in what society thinks or what someone else sees as being important in life.

I tend to argue in favor of focusing on the top two to four goals. This way, an average person can actually reasonably accomplish those top goals in a reasonable timeframe. Figure out that time frame for those top goals. How much time is it before you reach that goal?

This doesn’t mean that your goals are set in stone. Everyone’s life changes over time and your goals may in fact change. The point is that your investment decisions are led by your goals, so before you even start investing, you should have a good grasp on what your goals are.

In my own life, I have several goals: retirement (targeted for age 60), my children’s college education (targeted for about seventeen years down the road), a new minivan (targeted for 1-2 years from now), and a new house in the countryside (targeted for about twelve years from now). Each of these have a different investment strategy, which we’ll get to in a minute.

2. Know your risk tolerance.
One major piece of the puzzle that people don’t address before they start investing is their risk tolerance. Often, they overestimate their risk tolerance, then find themselves in an investment situation that leaves them feeling very nervous about their financial position.

Spend some time thinking about this. Would you not worry if you woke up and found out that you had lost 5% of your investment if you knew in the long run it would build up in value? How about 20%? If you had $10,000 in stocks, and then over a very bearish month, $2,000 of that vanished, how would you honestly react? Would you take your money out?

The reason this is important is that it is extremely dangerous to be invested in something that exceeds your risk tolerance. If you find yourself waking up in the middle of the night nervous about where your money is, you’re likely to make an emotional move, like taking your money out when it’s about to rebound.

As a general rule of thumb, if you feel nervous about losing money at all, you probably shouldn’t be invested in stocks. Keep it in cash, in either your bank account or in certificates of deposit. Don’t feel weird – my best friend is in this camp.

On the other hand, most people have some degree of risk tolerance, though, and if you find that losing 10% or so won’t make you scared and ready to pull out, then you should dip your toes into stock investment. We’ll get to the specifics later.

3. For short term goals (less than two years or so), keep the money in cash.
That means store it in a savings account or perhaps buy a short term certificate of deposit at a bank – whichever option gets you the best interest rate and enables you to have cash in hand on the day you need it.

Why? Keeping it in cash means that it won’t be exposed to the up and down nature of the stock market. Quite often, over short term periods like two years, it’s quite possible that not only will you not turn a profit, but you might actually lose a piece of your invested money.

4. For medium term goals (two to ten years), diversify at your comfort level.
If your investment window is more than two years, the odds that you’ll come out ahead on the stock market start to get better, but it still comes with some risk. The stock market is never a guarantee, and past performance is never a guarantee of future returns.

Another factor to consider: how much is your life relying on this money? It makes sense to be more conservative with retirement money than with, say, money you’re saving for a new car. That’s because a downturn in your retirement can force you to work for years longer, while a downturn in your car savings just means you might have to continue to drive an older car for a year longer. The more vital that money is to your life plans, the more conservative you should be with it. If you’re not sure, be more conservative than less – keep plenty in the savings account and just dabble in the stocks.

5. For long term goals (ten years or more), stocks are a pretty good place to put your money.
Over the history of the stock market, almost every period longer than ten years has seen a profitable return in a broad stock investment. Even better, during many ten year stretches, the returns are quite impressive. Because of that (even though past performance isn’t a guarantee of future returns), it generally makes sense to put long term money heavily in the stock market.

6. The best place for first-time stock investors to put their money is in a low-cost index fund.
There are several reasons for this.

First, an index fund allows you to be invested in a lot of stocks at the same time. That way, you’re not affected by the ups and downs of a single company just as you are getting your toes wet in stocks.

Second, a low cost fund means that the investing house isn’t eating much of your money. Look for a fund with a cost less than 0.2%. That way, the gains go into your pocket, not in the pocket of your investing house.

Third, an index fund will introduce you to the ups and downs of stock investing. While they’re nowhere near as volatile as individual stocks, they are volatile. Many index funds can go up or down 3% on a single day. In other words, it’s a great way to find out where your risk tolerance really is without a deep risk of losing a lot of your money.

Personally, I only invest in index funds, for reasons I’ve specified in the past.

How can I get started with these? The best way is to get an account with a large investment house and transfer your money in online – the interface is often like online banking. I personally use Vanguard when I invest (though I’m currently focused on eliminating debts), as Vanguard offers a wide array of low-cost index funds.

Once you sign up with an account, the best first fund to buy is an index fund made up of a huge number of domestic stocks. If you sign up with Vanguard, take a serious look at the Vanguard Total Stock Market Index. It has a total expense ratio of 0.15% – in other words, when you invest, each year Vanguard charges only 0.15% for managing the fund, which is very cheap – and includes virtually every significantly large company on the New York Stock Exchange.

Once you’ve started, set up an automatic investment plan so that you put in a certain amount each week or each month. Not only does this make it incredibly easy to keep up with your savings, it essentially automatically follows the investment strategy known as dollar cost averaging (which reduces investment risk).

Just sit on that for a while. Watch it. See whether you’re comfortable with the ups and downs of it. Learn more over time, and then you’ll figure out on your own where to go next. Maybe you’ll find that the volatility is too much for you and you’ll move the money to savings. Maybe you’ll want to diversify and buy an international index fund. Maybe you’ll have no problem at all with the volatility and dip your toes into individual stocks. It’s up to you.

Remember, though, that today is always the best day to get started.

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  1. That is a very good summary. I would add that each person needs to define their asset allocation and stick with it. Included in that asset allocation should be some percentage for foreign equities. If someone had omitted them over the last several years, they would have left a lot of money on the table.

    Best Wishes,
    D4L

  2. Frugal Dad says:

    I second the Vanguard Total Stock Market index mutual fund for those that want stock exposure with minimal fees, and minimal downside risk (as opposed to narrowly focused small cap which invest in only a handful of speculative stocks).

  3. George says:

    It’s not many folks that would admit their next goal is to own a minivan :-)

  4. Trent Hamm Trent says:

    Well, I have two kids under the age of three and we’re seriously discussing a third. Our two current vehicles are a subcompact and a pickup truck – we simply won’t own a vehicle that can carry all of us. Considering there’s a decent chance we will have one child in a booster seat and two in carseats, that would mean we need something with some serious space, but also with some fuel efficiency – and that’d probably be a minivan.

  5. Esther says:

    I’m in the middle of The Dick Davis Dividend, which suggests model portfolios along with a generous helping of Davis’ (a stock market commentator of 40 years’ experience) insights on the stock market. It’s a fairly new book so I don’t think you’ve reviewed it, trent, but I’d recommend it so far to people who want to know about the realities of stock investing and is planning to invest ‘spare’ cash towards various goals. You could probably glean much of the information he imparts elsewhere – online, even – but not in such a no-nonsense, condensed form.

  6. Lisa Spinelli says:

    These are great tips. More of for a hobby than anything, I’m working on setting up a small stock portfolio on Ing Sharebuilder. I’ve never really been involved in stocks before, and hope to go through the process on my newly started blog. At the risk of sounding solicitous, if you’d like to follow along, just click on my name here. I am obtaining funding for this by giving up coffee and other means which will not tap into my regular income. The goal: $1000 invested in solid value stocks by end year 2008.

    This is not the only topic on my blog. This will probably take up two to three entries a week. Maybe I will see you there! Lisa

  7. Ryan says:

    Maybe not the best time to buy into a stock fund, though. I just joined Vanguard a month ago, bought into the Total Market Index fund and immediately watched my $3,000 drop to $2,850. I knew it was going to be bad timing, but figured I was in it for the long run, so eh.

  8. Karl says:

    “Maybe not the best time to buy into a stock fund, though.”

    This might be a great time to invest in an index fund. Sure it’s taken a hit the past week or two, and who knows, maybe it will continue to drop, but if you are invested for the long term, ideally you’d like the prices to be low while you are buying, and then shoot up just before you sell.

    Just think of it like a “stock sale” where you should buy now before prices go back up again!

  9. Trent Hamm Trent says:

    Don’t worry about what the stock market is doing this minute if you’re going to invest in stocks. Market timing never really works.

  10. Nina says:

    I’ve been playing a stock market game over at Stocktrak.com for about four weeks now. My profolio, which is diversified with stocks and t-bills (for now), is doing HORRIBLY. Even though it’s fake money I’m dealing with, I can’t help but feel so frustrated when I’d lose like $60,000 in a course of 4 weeks! Now imagine if that were real money!

  11. Nina says:

    Yikes! I meant to spell out portfolio, not profolio. :)

  12. KC says:

    I started investing in the stock market in 2000 (talk about bad timing). I invested in VFINX (Vanguard S&P 500 index). I paid something like $112/share and put in about $4000. A year later it was worth $86/share. GULP!! The only thing I regret now…is that I did not buy more at $86 a share. Cause last year it peaked at $142/share (its low this month is $122/share – I’ve still made money, but could have made more if I wasn’t scared).

    So what did I learn from that? I am buying like a kid in a candy store right now. I’ve branched out into other index funds and a few carefully selected stocks, but I’m not letting this opportunity pass me by again. But that being said I am much more financially stable now, so I can take the downturns and still sleep at night. And I have had 7 years to read like crazy and follow the markets. I’m not recommending anyone wake up tomorrow and bet the farm on the market, I’m just saying this is an excellent learning oppotunity. And if you are thinking of investing Roth IRA money now might not be a bad time to deposit and buy that index fund – you’ve got plenty of time to recover if it falls further, right?

  13. Harm says:

    As Karl pointed out, though it’s counterintuitive,
    the stock buyer would actually like to see lower
    prices when you’re buying…..the lower the market
    indexes go, a. The better deal stocks (in general)
    ARE, and b. The less they CAN fall, LoL.
    Of course, one wants to see higher prices
    eventually :)

  14. A lot of people often think that the stock market is a get rich quick plan to fix their financial troubles. I’m glad you clarified on how the stock market is a great tool on investing, but is a risky venture. The stock market isn’t to be shunned because of the risk, but as you pointed out should managed by the variance of time.

    I suggest BRK.B as a stock to invest in rather then the Vanguard Index, Berkshire Hathaway is a well diversified company that many have not heard about. The long term gains are steady, and the stock is very conservative. You most likely use the products of the businesses that Berkshire owns.

  15. weeklymg says:

    I disagree on one minor point: I think one should take more risks with retirement funds if retirement is more than 10 years away.

    Also, a good alternative to VFINX is SPY.

  16. Chris says:

    Trent, very good, solid advice for new investors and experienced investors alike. Keep up the great work!

  17. gfree98 says:

    If the goal is long term for retirement, I’d seriously consider investing at least a portion through a 401k plan at work if it’s available.
    1)it’s easy and automatic once set up
    2)I consider the employer matching (usually 3-6%)as 100% return on that investment (very hard to beat)
    3)pre tax dollars are invested ($100 earned is $100 invested, instead of $100 earned is $70 available for investment after taxes)
    drawbacks –
    1)normally limited choices of investments
    2)penalties if you need to withdraw the money

  18. ngthagg says:

    All the advice seemed pretty reasonable except for #4. While I can see investing in the stock market over that period of time, what would worry me in that situation is how to get my money out safely. Let’s say I’m investing for some big purchase that will be coming up in about five years. I know that on the average I will make good interest, but if I’m going to need the entire amount of money at or near a specific date then I could end up with very poor performance if that date happens to be at a bad time.

    I’m comfortable handling this in long term situations. I won’t be retiring for 30 years at least, and so five to ten years before my target date, as funds hit peaks, I’ll move the money over into more stable, income generating funds. But in a shorter period of time, this just isn’t an option, especially not when the majority of the income will be coming from principal, not interest.

    How do you recommend handling the end period of this kind of investment?

  19. Harris says:

    To find a lot of information about finding a low cost mutual fund, go to http://www.chancefavors.com

  20. Kent says:

    Trent, solid advice. I think you’d enjoy browsing the pages of http://www.soundmindinvesting.com I’ve been reading and following their advice for over 10 years and I’ve done extremely well implementing the principles you’ve outlined here.

  21. Nico says:

    This is a great article and I definitely would like to take these first steps of diversifying my monthly savings from just my ING account. A low cost index fund sounds like exactly what I’m looking for… is there anything I need to watch out for if I wanted to open this type of account (I don’t even know what the account-type’s name is) at a place like Fidelity? I ask because I think I have some sort of account already through my employer’s automatic stock benefits.

    Thanks,
    -Nico

  22. Jon says:

    Forget index funds. Read some of the articles over at Market Watch or Hulbert and find a good investment newsletter. You can pay about $100 a year for a good one, and beat the crap out of index fund returns. The Vanguard total index fund made 5.49% last year, about the same as your run of the mill internet bank. The top performing newsletter raked in about 80% returns.

    The entire personal finance community seems to believe the only single option is to buy an index fund and put a blindfold on!

  23. bryson says:

    jon, index funds carry a lot less risk–so there’s a lower standard deviation for high and low outcomes. the expected payoff (statistically) in the long run is typically as good or better. but what i really wanted to comment on is how, after readings trent’s common-sense explanation, can someone think their portfolio (or mock portfolio) is doing horribly after only a few weeks? you should measure the success of your fund in the long term. the team that scores the first touchdown doesn’t always win.

  24. Yes, another Random Walk disciple! Let the “experts” pick their hot stocks, as for me and my house, we will systematically invest in low-cost index funds! Great advice Trent.

  25. cephyn says:

    One question I’ve had some trouble getting some decent advice on is fees – what’s an acceptable amount? For example, I don’t have a large chunk of money to invest – I wanted to build up a portfolio using Sharebuilder. With regular contributions, they charge $4 a trade. But how much should I be investing at a time to make that economical? If I’m only putting in $100 at a time, thats a 4% loss right off the bat. Am I better off putting that money into a savings account and then investing say, $1000 yearly? It sort of defeats $ cost averaging at that point, but do I come out ahead?

  26. Michael says:

    Cephyn,

    You could set up a spreadsheet in Excel to help you answer that question. You already have the transaction cost information: $4 per trade. Now, find out the standard deviations and expected returns of your funds (Morningstar/Yahoo/Reuters/Google) and run simulations over x years comparing various grades between lump sum and dollar cost averaging. You might try annually, biannually, quarterly, monthly, bimonthly, weekly, and daily. To get better results you should have Excel run a lot of simulations for each and average them. Plot the final results from each of these on a line or bar chart. If you do all of this right you should see a curve. Toward one end you have lost money because you invested too frequently and were ate alive in commissions. Toward the other end you lost money because you didn’t average in enough, and also because you missed out on gains while saving up your lump sum, since markets rise on average. If you don’t see a curve you need to add more frequent or less frequent options. The peak is roughly the frequency at which you ought to invest.

    (This is a lot of work if you don’t know Excel well. Keep in mind what your time is worth.)

  27. jlawrence01 says:

    Several points:

    1)I started investing in 1983 and there have been a lot of up times and a couple of bad times during that period. If you spend your entire time looking at your accounts, you’ll sell at the drops and buy at the peaks which is counterproductive.

    2) Sharebuilder is NOT a good way to get into the market as a beginning investor. First, you will not be able to build a diversified portfolio with small amounts of money. Your expenses will be relatively high. Finally, when you go to sell, keeping track of the basis will be a headache. Ditto for DRIPS.

    3) There are many good no-load mutual funds with low minimums and with good performance. Personally, I prefer actively managed funds as I have generally had higher returns.

    4) The critical thing that few mention is making regularly scheduled investments on a regular basis. Aggressive savings starting at an early age and continuing through your productive years offset investing errors and the impact of down markets.

  28. Eli says:

    One strategy I truly believe in and which has worked out well for me so far are stocks with high and rising dividends (preferably paid monthly) The advantage I see in these is that if you have a long time horizon, (and you reinvest the divvies) then these holdings essentially dollar cost average themselves. If the share price goes down your dividends just buy you a bigger stake that month. The fact that I am able to invest in these via a self directed 401k plan is a big bonus.

    It’s not a very sexy or exciting strategy but it works for me. It feels less like gambling when your stocks pay out cash every month or every quarter. And the reinvested dividends means that the size of your holdings continues to grow so it’s not as big of a gamble as betting on share price alone. I try to buy companies like this when they are “on sale” and then basically plan on holding them forever as long as they are maintaining or increasing their dividends.

    I don’t understand why more younger people aren’t value investors. This strategy could really pay off over 30 or 40 years.

  29. cephyn says:

    Thank you for the reply Michael, that’s a great idea that I certainly will explore.

    jlaw, your reply really confuses me…

    “Sharebuilder is NOT a good way to get into the market as a beginning investor. First, you will not be able to build a diversified portfolio with small amounts of money.”
    Even if the money is put towards low-fee ETFs that track diversified indices?

    “Your expenses will be relatively high.”
    Exactly what I was worried about and asked about how to maximize efficiency…

    “Finally, when you go to sell, keeping track of the basis will be a headache. Ditto for DRIPS.”
    As a beginning investor, I have no idea what these sentences mean. :(

    But then you also say…
    “The critical thing that few mention is making regularly scheduled investments on a regular basis. Aggressive savings starting at an early age and continuing through your productive years offset investing errors and the impact of down markets.”

    um, isn’t that *exactly* what sharebuilder does?

  30. fabien says:

    I don’t have a portfolio nor do i have any stocks yet…. i’m a first timer and would like to get in to the stock and bond trade for retirement and childrens college funds…so far this site seems fairly simple… if any one has any suggestions contact me….ill_d0_u_dirty@yahoo.com

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