Step by step guide to investing in stocks (Part 1)

So you’ve probably read on personal finance telling you to make money “work harder” for you…

Or you like the idea of generating passive income through stock investing…

Or you simply want to generate better returns for your retirement portfolio.

 You’re eager to begin but it seems like a daunting task, there is so much information out there and you don’t have any idea how or where to start?

Investing may seem overwhelming at first, the financial jargon and complexity of interpreting financial statements can be a huge obstacle for beginners. I was in your shoe when I started out my investing journey, in my early days I read a lot of books on investing and trading and learnt the different school of thoughts. I spent hundreds of hours reading articles, research papers and financial statements over the years and I hope to share this with you to shorten your learning curve.

So I will walk you through the basic concepts and terminologies of stock investing and equip you with the knowledge to kick-start your investing journey. Let’s begin with an old folk story…

A-tired-old-king-watches-a-peasant-talking-in-this-childrens-book-illustration-by-Julian-de-Narvaez.jpg

Long ago, when an inventor of chess introduced the game to a king, the king was so impressed by the new game that he wanted to reward the inventor and that he will fulfil the inventor’s request.

The inventor then replied, “My wish is simple. I only wish for one grain of rice for the first square of the chessboard, two grains for the second square, four grains for the third square, eight for the fourth square and doubled the grains of rice for each subsequent square till the 64th.”

Baffled and amused by his request, the king happily agreed.

After a week when the treasurer was still not done, the king asked what the problem was. The treasurer replied, “Well it took me a while to run the calculations but we don’t have enough rice in the kingdom or even on the planet to fulfil his request!”. The treasurer informed him that the reward would add up to a huge number—far greater than all the rice that could possibly be produced in many centuries!

The total number of grains equals 18,446,744,073,709,551,615 – much higher than what most intuitively expect!

This story explains the power of compounded interest. Now think about this, “Would you rather have a million dollars or the sum of a penny doubled every day for a month?”.

Have you heard of the eighth wonder of the world?

Albert Einstein once said, “Compound interest is the eighth wonder of the world. He who understands it, earns it… he who doesn’t… pays it.”

Compound interest is the addition of interest to the principal sum of a deposit, or in other words, interest on interest.

Here’s an example of compound interest/returns on $10,000 principal over a 10 year period:

Returns 2%  5%  10%
Period
1  $  10,200.00  $ 10,500.00  $  11,000.00
2  $  10,404.00  $ 11,025.00  $  12,100.00
3  $  10,612.08  $ 11,576.25  $  13,310.00
4  $  10,824.32  $ 12,155.06  $  14,641.00
5  $  11,040.81  $ 12,762.82  $  16,105.10
6  $  11,261.62  $ 13,400.96  $  17,715.61
7  $  11,486.86  $ 14,071.00  $  19,487.17
8  $  11,716.59  $ 14,774.55  $  21,435.89
9  $  11,950.93  $ 15,513.28  $  23,579.48
10  $  12,189.94  $ 16,288.95  $  25,937.42

2 fundamental factors that we can learn from this…

One, is that compounding takes time, we should invest with a long-term perspective and returns will snowball over time. Hence the earlier you start investing, the better off you will be.

Two, achieving higher than average returns will help you reach your financial goals faster. Compounding at 10% per year as compared to 2% results in double the ending balance.

Now that we have discussed the basics, let’s move on…

So what are stocks?

A stock represents a share in the ownership of a company, it gives the owner rights to vote in shareholder meetings.

The more shares or stocks you own, your voting power increases. Some investors will own shares large enough to take control of the company or influence the decisions of broad members. Collectively, shareholders have the power to remove management who are under-performing such as the recent case with International Healthway Corp (IHC).

As an owner of shares in the company, you are entitled to receive dividends if the management declares to distribute them.

If the company is profitable or performing well, the management may choose to distribute dividends as a reward for shareholder loyalty. Conversely, the management may choose to cut dividends or not distribute at all if performance is poor.

Dividends vs Capital Gains

As an investor, we can make money from stocks through…

Dividends are money paid by the company to its shareholders out of it profits or cash reserves. Companies issue dividends if there is no requirement to hold excess cash, this may be due to a sale of an asset or higher than expected operating cash flows.

Or…

Capital gains refers to the positive difference between your purchase price and current selling price of the stock. This can very easily lead to speculation without a proper investing mindset.

Investing vs Speculation, what is the difference?

“An investment operation is one which, upon thorough analysis, promises safety of principal and an adequate return. Operations not meeting these requirements are speculative.” — Ben Graham

The idea of making ‘fast money’ lures many to the stock markets and predicting short-term outcomes is high-risk. Speculation can lead to detrimental effects on one’s psychology and financial solvency hence should be avoided at all cost. An individual who buys or sells stocks with little or no research done to understand the underlying business is said to be speculating. Obviously, the topic itself can be debated at length but this is not our objective here, so let me summarise the factors that defines a true investor:

Sound investment framework – good investors use frameworks to identify investment opportunities, this ensures that investment ideas run through a selection process with guidelines based on sound principles. For example, an investor who adopts a value approach may identify investment opportunities based on simple valuation metrics such as Price to book value (P/B) or Price to Earnings (P/E) and etc.

Related topic: 3 Easy Steps to create Deep value Investing Framework
Related topic: 3 Quick & Simple Ways to Value a Stock
Patience & Long-term mindset – as shown earlier, the key to successful and safe investing is having a long-term perspective. Be patient and let compound returns do its magic!
Knowledge – Investors need to understand the underlying business behind stocks they own. Interpreting financial statements and understanding economic forces that drives it, is crucial in making educated and sound investment decisions.

The key is to view stocks as partial ownership of businesses and to view its management as partners if you begin with that in mind, investing becomes rational and enriching.

Type of stocks

Most companies are categorised in terms of market value and a proxy to that is the Market Capitalisation which refers to the current share price multiplied by the company’s shares outstanding. A company may fall under the following 4 categories:

Large Cap (Bluechip) – Refers to companies with market value of more than $10 billion. In smaller markets like Singapore, a company with $5 billion market value can be considered a Large cap.

Mid Cap – Refers to companies with a market value in the range of $2 – $5 billion ( $0.5 – $1 billion in Singapore).

Small Cap – Refers to companies with a market value in the range of $0.5 – $1 billion ($100 – $500 million in Singapore).

Micro Cap (Pennystocks) – Refers to companies with market value lower than $500 million (below $100 million in Singapore).

Fundamentals or Technicals, which is better?

I’ve probably heard this question a thousand times…

Having been in both camps, I started out with technicals but over the years I gravitate towards fundamentals. Why you may ask?

I guess as a beginner, I viewed the markets as binary. Either it goes up or down, so why bother learning about everything else right? So, I started out with a short-term trader mindset and technical analysis appealed to me. Being a short-term trader, I always got involved with market ‘noise’ and trading along the flow of markets. The ‘high’ frequency of trades and constant ‘monitoring’ of markets added with the stress of managing multiple short-term positions were mentally taxing and it took a toll on me, I realised that it was not sustainable.

Eventually, I moved on to taking longer-term positions which require more research done on fundamental analysis and understanding businesses. As a fundamental investor, I now focus on long-term performance, as a result, I am much calmer and able to manage my portfolio with less stress.

So what are the components of fundamental research? What factors do fundamental investors look out for?

Look out for my next post as I discuss more on fundamental analysis and explain the basic theories and simplify concepts so that you can begin implementing them in your stock research.

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