Now that we’ve discussed the what of investing (stocks and bonds and what the differences between the two are), it is now time to learn more about the how of investing and in particular how one can enter the stock market and start investing. Hopefully by now you’ve at least become slightly curious about how this investing really works, whether or not you feel like this will be your thing to do.
Generally speaking there are three different ways you can invest in a stock market:
- Handpicking shares (and bonds) of individual companies
- Getting a collection of shares and bonds through collective or mutual funds
- Passive investing through Index tracking or Exchange Traded Fund
We’ll look at each option in turn to find out more about each way of investing in detail. In this step we’ll start by looking at handpicking shares of individual companies. Remember that these steps are only an introduction to the complexity of investing, so don’t just take my word for it, but read up if you’d like to find out more. There are many good books, articles and websites around that will explain this all in greater detail.
To make things easier on me as well as on you when reading, I have decided to talk about “handpicking shares” where in reality I am talking about both shares and bonds (yes, you can call me lazy if you want..!)
Handpicking shares – an overview
Investing through handpicking some shares might sound like a very easy option, and in a way it is, as all you do is decide in which company to invest, you buy some shares and that’s you started (or done). Then after a while you might decide to sell those shares, or maybe even buy some more. You don’t need anybody to manage your portfolio, you just need a broker to buy those shares for you and maybe sell them again at a later stage. The only costs you’ll have (nothing is for free of course!) is paying that broker when they buy the shares for you and again when you sell your shares.
This type of investing is a form of active investing: you actively decide where to put your money, hoping to get better returns than the average, and based on the prediction that the companies you are investing in will do well over time, thereby making you money through dividends and / or capital gains.
But here’s the crux: which shares are you going to buy? Where do you start? You could think you’ll play it safe and buy shares of a big successful tech company for example. But have a look on the internet and see how even big succesful enterprises can see huge fluctuations in their share prices. What about mid-size or smaller companies? But have you got any idea how to judge whether they will be successful over the next say 5 years? Or even still exist by then? The prices of shares can be affected by a gazillion different factors, so how are you ever going to know enough about each company on the stock market to decide which shares to buy?
Let’s imagine however that you put all your money into just one company that somebody told you was going to be the best investment of the year. If the company is indeed successful and increases its yearly profit then you’re sorted: each year you get paid out more dividend and the value of your shares goes up, so if you decide to sell you will have made money on your investment. But what if the company doesn’t do so well: profits go down, then become losses and soon your divident payments are defaulted more and more often. When you finally decide to sell your shares, the prices have dropped tremendously as people don’t have faith in the company anymore. You sell at 40% of the price you paid when you bought your shares and have thus lost 60% (not even including inflation) on the original money you put in.
So how do you know which company to invest in and which one to avoid? This is exactly the problem that investors face, as unless you follow the financial news meticulously, read company reports and follow the market, you probably don’t know. But even if you do know a lot about the financial markets, a company doing well at the moment might be on the verge of bankruptcy in just a few years’ time.
Handpicking stocks means that if you choose your shares well, you probably do very well out of it, but if you don’t choose well, you’re likely to lose a lot of money.
In summary, the advantages of handpicking your shares include:
- you are in complete control of what to invest in: more aggressive, more defensive.
- there are no costs between the day you buy and the day you sell.
- you might beat the market and do extremely well.
- you don’t end up with shares you don’t want.
- you can buy shares that are still very cheap when they are not yet in the big 500 list because you foresee a great success of that company.
- you decide which types of companies to invest in, i.e. maybe you don’t want to invest in the tobacco or arms industries.
The disadvantages of handpicking include:
- you might lose a lot of money if you make the wrong decision, especially if you end up with the worst 10% of shares.
- you need to know a lot about the individual companies on the stock market
- you need to keep up to date with new companies, as well as existing companies to find out how they are doing to decide whether you want to trade or buy more shares of individual companies
- As a small investor, you will likely only be able to invest in a small number of companies, meaning your portfolio won’t be very diversified.
- you are on average and over time unlikely to beat the market unfortunately
- investing can become very stressful as you’ll likely be anxiously trying to keep up with prices and end up buying and selling continuously.
Step 50 – Investing through Handpicking Shares – in detail
To find out more about how handpicking shares works, let’s do the following mental exercise. Imagine you are given $1,000 to invest. You can invest in as many or few companies as you’d like, as long as you stick to the $1,000.
- Open a spreadsheet in excel or in another digital programme or just use a piece of paper.
- Write $1,000 as your starting balance.
- Decide which shares you want to buy. (You might want to decide which market to choose first, such as NASDAQ, Dow Jones etc., or just take the S&P 500 (Standard & Poor’s 500) for an overview of 500 big companies on the market).
- How are you going to decide on the companies? Do you want to read companies’ yearly reports, projected profits, history of their stock prices in the last 3 months or 3 year? It’s completely up to you how you’d like to make the decision on what to invest your money in. (Of course, if you ended up doing this with REAL as opposed to imagined money, you might need more time, pay for professional advice, read more articles etc. but the whole point here is for you to realize that when you handpick, YOU make all the decisions).
- Ignoring costs for a second (again real life doesn’t work like this, but let’s just pretend), put down in your document which shares you are buying, how many you are buying and the total price based on the current actual prices (just type in S&P500 and you’ll find actual prices of all the companies’ shares). For example:
- 10 shares company A, $37.19 each = $371.90
- 2 shares company B, $110.18 each = $220.36
- 20 shares company C, $17.15 each = $343.00
- 1 share company D, 60.53 each = $60.53
- Total: $995.79 and $4.21 left
- Now start keeping track of your stocks over the next few days / weeks. You might want to do this daily, or weekly, up to you, obviously the more often you check in with your stocks, the more fluctuation you see, the more interesting this exercise becomes.
- Once you’ve done this for a few days, let’s say you can now also determine to sell your stocks. (We’re again going to ignore selling costs for now). For each transaction, put down for how much they are sold, then reinvest that money into another company – or decide to keep it.
The aim of this activity is two-fold: to give you a better idea of how prices of stocks can fluctuate, but most importantly, how difficult or arbitrary it might seem to pick stocks if you have no idea where to start. Maybe you’re in luck and manage to choose the right shares and make a decent amount of (imaginary) money. But how long are you going to be lucky? Who knows, you might lose 50% of your money within the next 48 hours. Or if you’re not so good at picking your shares (and why would you be if you’ve never done this before), how long until you lose interest and wish you’d never started as you see the value of your portfolio going down and down..
Read more about my 100 steps mission to financial independence or simply decide to take control today and join us on our step-by-step quest on how to make your finances work for you, starting with step 1.