Stock Market Investing - Getting Started

One of the most common question that people ask is "which stock do you recommend?" or "which stock will go up?". I think the thought process behind that question is that once we know which stock is headed upwards, we are ready to put big money in it and we expect to make a lot of money from the trade. Well, it is possible for someone to make a lot of money in one trade so that he doesn't have to work anymore. But for most of us, we will have to find a way to consistently make successful trades. Only consistent successful trades over longer haul produces wealth; wealth that is sufficient enough to cover for our retirement or childern's education or any other bigger purpose.

Before you put any money in the market, you need to realize the POTENTIAL of the money you have in hand right now. Because the money you have in hand is the capital for producing more money in the stock market. If you happen to loose that capital, then the game is over. You have lost the hen that was going to lay golden eggs for you. That is why your mindset before investing or trading (yeah, there is difference between trading and investing) should be to question yourself "Which stock/security is worthy of my dollars?". Read this article on the significant six questions that you need to ask yourself before investing in any trade.

Investment Vehicles

There are many vehicles that you can use to navigate up through the stock market. They range from professionally managed funds like Mutual funds to highly leveraged securities like options. Let us see which one(s) are better for our need.

Mutual Funds: A Mutual Fund is a company that combines investor’s money and generally purchases stocks, bonds other securities. A professional manager will make purchase decisions of securities on behalf of the investors. Investors in turn pay small fees to these managers. These funds are suitable for people who rather have a professional make the investment decisions for them. Here is quick primer on how to invest in a Mutual Fund?

Exchange Traded Fund (ETF): A new class of vehicle has emerged to popularity these days called ETFs. ETFs, like Mutual funds, are funds that pool in investor's money to invest in the market. But ETFs have some significant advantages over Mutual funds, like having low expense ratio, etc. You can find many other advantages of ETFs over Mutual Funds.

Stocks: If you are able to decide which stock can benefit you, then you can directly go for stocks. But purchasing stocks can be much more volatile than buying Mutual funds and ETFs. If the stock picking and the timing goes well, then stocks can be very rewarding as well. There are many reasons why a stock goes up or down, but here is an important reason that causes stock prices to go up.

Options: Options are a highly leveraged and time sensitive instruments. An option at the basic level is a right to buy or sell a security at a predetermined price for a stipulated time period. With just two basic moves (called CALL option and PUT option), many strategies can be formed using these. This is very similar to a Chess game where you have defenses and offenses using any or all of those 16 pawns and their moves. I recommend that you spend some time learning these instruments before you put your hand on them.

Bonds: Bonds are debt instruments, where you lend your money to a government body or to a corporation as a debt. A bond holder has a higher entitlement to the money lent out than a stock holder of the same company. However, bond returns are much stabler and usually are lesser than the stock returns. Bonds can be used to hedge the risks of stocks and stock funds.

Similarly there are many other kinds of vehicles that can exist in stock market, like: Real Estate, Gold, Structured Debts, etc. No matter which vehicle(s) you choose, do not put all the eggs in the same basket. Understand the concept of Position Sizing and limit your losses to the minimum.

No matter which instrument(s) you choose for your portfolio basket, educate yourself with the principles and techniques of Portfolio Management. Many of these principles and techniques, when practiced, should not only stabilize your portfolio but also make you a better investor at the end of the day. Besides these, there are some trading tips that can help you make better trading decisions and grow as a smarter trader.

Economic and Market Analysis

If you have been investing in stock market already, then you would notice that much of the variation in any individual stock price is attributable to the variation in entire market, like S&P 500. For example, you would see a big dip in most individual stock prices on Aug 16th because that was the day when S&P 500 took a big hit too. That is why it is important to analyze the entire market to sense the pulse and the momentum of the market. Understanding the Bull Market behavior and Bear Market behavior will give you a great insight into the working of the markets. Here is an interesting article on how stock prices jump when bull market injects the stock with energy boost!

Having known that the general market itself contributes in a major way to the variation of an individual stock price, you would ponder what creates the variations in the market. The general market dances to the tunes coming from state of the economy. And feeling the tunes of the economy is important. These tunes can come in the form of: Inflation rate, Unemployment, Political policies, Business laws like Sarbanes Oxley, political instability in the world, etc. An average individual investor can use government websites like (bea.gov, bls.gov, etc) to understand the current state of the economy.

Individual Stock Analysis

No matter which vehicle you choose to invest in, whether a fund or a stock, you (or the fund manager) will have to analyze individual stocks to make a better trade. At the heart of the stock analysis lies two approaches, Fundamental analysis and technical analysis.

Fundamental analysis involves analyzing a business by it's financial statements, it's financial fitness, it's profitability, it's management, it's competitors, it's markets and it's outlook. This process is rigorous and time consuming. An individual investor will have to spend a lot of time collecting this information, unless he is subscribed to a service who can provide fundamental analysis reports. The result of fundamental analysis ususally includes: stock evaluation, current performance analysis, future outlook and target stock price, etc.

Technical analysis assumes that all of the factors, fundamental or otherwise, is already reflected in the stock price. Technical analysis considers trends in stock prices, momentum in price and volume, and predicts the future prices by extrapolating historical patterns in price and volume. Stock volume is an important signal before the stock prices go up, as described in this article on "Volume precedes Price".

Trade selection for options

Stock Options are a whole different ballgame. While dealing with stocks you always looked for stocks/funds going upwards, but using Options you can profit even when stock goes downwards or sideways. This adds another level of choices for an investor. Depending on what you think is the stock direction (up, down or sideways), there are whole range of choices you can setup for trading Options. Imagine this like a game of chess where every movement of an opponent will open up a wide range of choices for you to make. For example, if I predict a stock price to go up then I can choose to do any of these: buy a CALL option or setup a collar trade or Bull Call spread or Bull put spread & many others. If you are not following this paragraph, then do not worry we will go through this in detail later.

Summary

As you can see, there is so much to understand and learn for an individual investor before he can invest systematically in the stock market. But mastering one lesson at a time, this challenge will gradually appear as fun and interesting. And once you start enjoying investing, this can become a hobby (or business) of your lifetime for it has no retirement rules!

-Nidhi