What You Need to Know Before Investing in the Stock Market
Dan Nastou, CFA
First off, I’m a big believer in the idea that anyone can become a successful investor.
And while a lot of us have some preconceived notions about the stock market, the truth is, investing in stocks remains one of the best ways for individuals like you and me to passively grow our wealth. In fact, it’s probably the best way for most of us.
That’s because when you buy a stock, you become a partial owner of that business.
Think about the richest people in the world, they’re usually business owners, right? Well, when you own the stock of a company, you’ll be along for the ride as their silent partner.
As the business earns money and grows, you’ll receive your share of those gains without so much as lifting a finger. And if you own the right mix of businesses, and let your investments compound for long enough, you can generate tremendous wealth over time.
But investing isn’t all fun and games (unfortunately). So before you dive headfirst into the stock market, here are some key things you should know.
1. Set realistic expectations
I hear this question a lot, “How much should I expect earn on my investments?”
Well, like most things, the devil is in the details. Your investment return can/will depend on a lot of different factors, like which investments you choose to own and how you manage them.
But broadly speaking, the stock market as a whole has averaged annual returns of about 7%-10%* over the long run.
At that rate, your money would double every 7 to 10 years. Invest for a few decades and you can amass a pretty serious fortune. Of course what’s happened in the past is no guarantee of what will happen in the future, but it’s a fairly reasonable starting place for your long-term plans.
Now I’m sure some of your are saying, but I want to get rich quicker than that! Earning 7% to 10% a year is for boomers! Well, maybe it is. But realistically, it’s probably the best you’re going to do without taking on an excessive amount of risk. And that’s a discussion for a different time. So for now just be happy with earning a solid return.
2. Be prepared for the ups and downs along the way
While it’s true that over long periods of time the market has averaged an annual return of about 7% to 10%, that’s just, well, an average. In some years you would have earned more, in some years less. And in some years you can even see a decline. So if you want to unlock the magical compounding power of the market, then you should be prepared to invest for years/decades.
You also need to be prepared for the occasional large dips. Because unfortunately, they’re inevitable. And those big drawdowns can be really painful.
In fact, psychological research has identified something called loss aversion, which means we typically feel more pain from a financial loss than the joy we feel from a gain of equal size. In other words, we feel the dips more than the rips. I’m willing to bet you’ve experienced this first hand before, whether with your investments or in life. The losses just plain hurt.
So what kind of “downs” should you expect?
Historically, the stock market tends to drop by 10% or more about every two years. Incidentally, a 10% drop is typically referred to as a “correction”.
Larger drawdowns happen less frequently, but more often than most people realize. The market fell by over 30% in February/March of 2020 with the onset of COVID 19, and it fell by just under 20% in late 2018. On both of these occasions, the market recovered within months, although that’s not always the case with larger corrections. For example, in 1929 the market crashed and it didn’t recover until the 1950s, which is about as bad as we’ve ever seen in modern times.
The point here is not to scare you away from investing, but to illustrate that there will be some downs along the way. Inevitably you’ll experience a large correction if you’re in the market long enough. When you do, you’ll need to be patient and be prepared to take a long-term view.
And if you simply can’t bear the thought of seeing your investments fall by ten, twenty, thirty per cent, or maybe even more, then you really shouldn’t have that money invested in the market in the first place. Remember, investing is for long-term goals.
3. For most people, indexing is the optimal strategy
We all want to think we can pick the next hot stock and earn a fortune over night. It’s exciting, it’s financially alluring, and it’s so easy to do!
Except, in reality, it’s probably just not going to happen. In fact, even professional money managers have a tough time beating the market, and they dedicate their working lives to it.
So for the vast majority of us, a better strategy is to stick with low-cost diversified index funds that mimic the broad market.
Even legendary stock picker Warren Buffett recommends this strategy for the average investor. If the best stock picker of all time thinks we should index, that says a lot.
Fortunately, there are a number of easy and affordable ways to index.
During the 1970s, Vanguard pioneered retail index funds. And they remain a powerhouse in the industry, with roughly $7 trillion of assets under management as of January 2021. They offer some excellent retail products, which you can check out on their website, and you can also invest in their funds through your brokerage account or IRA. (In case you’re wondering, no, we don’t get a fee for referring you, we just think they’re a great option.)
If you’re just starting out, you can probably get away with a very simple portfolio comprised of a few diversified funds or even a single global fund. It doesn’t need to be terribly complicated. Creating a diversified portfolio through index funds is easier than ever. The real key is to get started early and make regular contributions to your investments over time.
4. If you really want to pick some stocks…
Okay, admittedly, stock picking can be fun. And if doing it makes you more engaged with your finances, then it can be a win-win (as long as you don’t get too carried away).
This is far from a comprehensive list, but a few things to consider;
1) Protect your downside. If you’re going to pick stocks, then you’ll want to limit your losses if and when you make a bad pick. Probably the best way to do this is by limiting the total percentage of your portfolio you commit to individual stocks to a fairly small amount, say 5-10% max, and then just index the rest.
2) Do your research first. Don’t buy a stock just based on a hot tip or a headline. Dig in and make sure you really understand the business and have a good reason for buying into it. Here’s a tip, if you can’t present a logical investment thesis to a group of your friends, then you probably shouldn’t be making the investment.
3) Understand the financials. Choosing an investment isn’t just about predicting what will be hot/trendy. You should also understand the financials of the business, which means reading through their 10K (annual report), 10Q (quarterly report) and other publications. Learning how to read the financials is key for determining if what you’re buying is worth the price. Even a great business can be a poor investment if you overpay.
4) Develop a system. There are a number of ways to make money through actively selecting investments. Personally, I think the best approach is to try to find excellent businesses at reasonable prices and then hold those for as long as you can. But that’s not the only way to invest. The key is to figure out what works for you, and to be honest with yourself. Is your system actually working or would you be better off indexing and spending your time doing something else?
Playing the long game
Ultimately, anyone can be a successful investor these days. Creating a low-cost, diversified portfolio is easier than ever. And if you make regular contributions to your investment funds and give it enough time, your wealth will grow.
But for most of us, the real challenge will be maintaining a long-term view amidst the daily, weekly, monthly gyrations of the market. It’s hard not to feel glee/anxiety when your investments rise/fall. It’s human nature. But buying and selling based on our emotional responses is akin to portfolio poison. It’s the last thing you want to do.
So the key is to find ways to keep these emotional reactions in check. Maybe it means not looking at your portfolio every day/week. Maybe it means working with an advisor, or creating your own set of trading rules that you absolutely must follow. You need to figure out what works for you and then stay on track. Because the sooner you start, and the longer you stay invested, the better off you’ll be. In other works, start early and stay in.
If you’re looking for more details on how to actually start investing, then check out our Investing Cheat Sheet.
Or if you want a more comprehensive overview of your finances, feel free to take our money quiz. It offers friendly, tailored feedback and suggestions for next steps (without the judgement).
A few more suggestions;