Dumb’s Guide to Investing Money in Stock Market

June 10, 2016

“My money isn’t safe in the markets.”

That’s the conclusion a lot of people drew from the financial devastation of 2008. Stocks were sold as people watched their 401K turn into a 201K and worried about it becoming just a 101K. Some people may have gone to cash or lowered their monthly contributions to their savings accounts. Anything to lower their exposure to the markets. Things seems to be turning the other way around. Let’s see what we mean by

“Investing Money in Stock Market”

Investing money in stocks is a very common form of investments which is frequently done by millions of investors around the globe. You need not be a financial adviser or a hedge fund manager for that matter. People from all sorts of professions be it Doctors, Engineers, Accountants etc. invest their ‘extra’ money in the financial securities like FDs, Stocks, Debt securities etc. Among these, Stocks are highly bought and sold on the exchanges around the globe. Therefore, it becomes very important to understand the rules and have the appropriate knowledge about the step which you are about to take. To make the most out of your money, you need to invest it in the right place and at the right time, hence you should educate yourself about the driving factors for a stock and make the most out of your investments.

Understanding the company

Warren Buffett famously says he doesn’t invest in what he doesn’t understand. If the greatest investor of the past 60 years is brave enough to acknowledge that he doesn’t understand all companies, we should all probably take heed. A quick scan of older news stories and the company’s past quarterly statements help answer this question. Does the company have a history of steady earnings growth? Are earnings volatile?

Doing a background check of the company is important. If you are looking for a long term investment in stocks and shares you must understand the functioning of the company. This first basic question is a simple one, but that doesn’t mean it’s easy. To answer the question, there are plenty of places to look, including the company’s Web site. Be it the way it makes profits, or any upcoming new projects by the firm, or any new M&A activity planned by the company. This will give you a fair idea on how the company is going to perform in future. Company’s profitability is very important, more the company is profitable, better will be the dividends distributed among the shareholders. It is also advisable to keep an eye on company’s competitors which might hurt the company’s market share. Imagine how safe it was and is upto some extent investing in Coca-cola’s stocks which had virtually no competitor in the beverage industry except for Pepsico since the past decades.

Don’t Miss Out On – Dumb’s Guide to Understand the Balance Sheet

Understanding the risks associated

There are always risks associated with stocks and it needs to be properly evaluated before coming to any conclusion. You must weigh down your options. Identify the risk profile and the risk appetite you have. Know the maximum amount of money you can lose. The key to mitigate risk is to invest in various options not just one or one specific industry. If you own shares of 5 oil companies you might face hard time during the time when all the oil companies are down which is presently happening. Usually, higher risks are associated with higher rate of returns.

Understanding the company’s stock valuation

You need to look at the company’s recent performance and the check whether the stock is not overvalued. It’s wonderful to find a company whose earnings are growing exponentially, but the other side of the equation is the value the market pays for that growth and the prospect of future growth. Usually, investors set high expectations which shoots up the company’s stock. When this bubble bursts, the stock takes a big hit. There are several ways to determine the company’s valuation one of which is P/E ratio. It stands for price-earnings ratio which is the ratio of current market price of the company’s share to the earnings per share of the company. Lower this ratio, it means the stock is undervalued. In a nutshell, P/E ratio tells you how much the investors are willing to pay per dollar earning of the company.

Understanding profitability. Is the Company Profitable?

This is also a simple question, which can be made more complicated by all sorts of variations on a company’s earnings. Investors can read the quarterly and annual earnings reports to check out how much net income the company reported, in dollars and in per-share earnings. Later down in this column we’ll address ways to mine for red flags in earnings.

Understanding the market sentiments? Social thinking

Yes this is important too! In Emerging markets, stocks are also driven by the investor sentiments. You need to identify the ‘trendy’ companies by seeing what they are offering and need to relate to what is the present social, economic and political atmosphere and try to relate it to the company. These days, we do see a lot of “Digital India” campaign. We can therefore believe that the electronics industry might do well in near future due to high demand.

Remember Porter’s Law! Who Are the Company’s Competitors?

Companies don’t operate in a vacuum. For every Coke, there’s a Pepsi — and a host of other competitors as well. Is it a small but growing niche player in a competitive industry? Is it an industry dominated by one company, or is it a fragmented industry where even the biggest player controls less than 10% of the market — such as in the supermarket business? Also, investors should increasingly pay attention to foreign competition, where lower-cost competition can put pressure on profit margins. Companies are constantly trying to take business from one another. Investors should know where their companies stack up: Does this company have the biggest market share in its industry?

Understand the management of the Company?

Unlike professional money managers, individual investors don’t have the ability to drop by a company’s headquarters and chat up the management before making an investment decision. However, that doesn’t mean there aren’t plenty of ways to find out about the leadership. Any company worth its salt will have a Web site that lists the senior managers, how long they have been with the company, their background and the company’s history. If the company’s executive suite has a rotating door, that may not reflect positively on the company’s stability. Beyond the company line on the executive suite, investors should research articles about the executives. Often, trade publications from any given industry are useful in digging into a company.

Understand the act of re-balancing

Rebalancing is bringing your portfolio back to your original asset allocation mix. By rebalancing, you’ll ensure that your portfolio does not overemphasize one or more asset categories, and you’ll return your portfolio to a comfortable level of risk. A good strategy for reducing risk is to spread out your investments across the stocks of lots of companies, but that has complications, too.

One common strategy that people suggest to reduce risk when investing in stocks is to invest in a lot of different companies at once. If you buy stock in 20 different companies in twenty different markets, you’re going to reduce your risk of losing all of your money – after all, 20 companies simultaneously failing is a pretty unlikely event. But you’re also reducing your ability to earn big returns – after all, 20 companies simultaneously skyrocketing is an unlikely event, too.

The real drawback here is that if you invest in 20 stocks, you’re going to have to execute 20 “buy” orders with your brokerage, as was discussed above. If each one costs you $10, that’s $200 in fees. If you then need to sell all of those stocks, you’re going to have to execute twenty “sell” orders. That’s going to add up to another $200 in fees. If you have $10,000 to invest, that’s $400 in fees that vanishes right off the bat – you’re only going to actually get to invest $9,800 of it (after paying the $200 in buy fees) and then they’ll scrape off $200 in returns when you sell it, too. So be wise in taking decisions.

Create and maintain an emergency fund.

Most smart investors put enough money in a savings product to cover an emergency, like sudden unemployment. Some make sure they have up to six months of their income in savings so that they know it will absolutely be there for them when they need it. Consider an appropriate mix of investments. By including asset categories with investment returns that move up and down under different market conditions within a portfolio, an investor can help protect against significant losses. Historically, the returns of the three major asset categories – stocks, bonds, and cash – have not moved up and down at the same time. Market conditions that cause one asset category to do well often cause another asset category to have average or poor returns. By investing in more than one asset category, you’ll reduce the risk that you’ll lose money and your portfolio’s overall investment returns will have a smoother ride. If one asset category’s investment return falls, you’ll be in a position to counteract your losses in that asset category with better investment returns in another asset category.Also remember most stocks pay you dividends, which provides a stream of income for you without having to sell the shares.