An important aspect when investing in stocks is mindset – the way you think about your investments. Many people who are new to the investing world are used to looking at the interest rates paid by their bank accounts and think that the 10% return they see on their mutual fund is equivalent. It is absolutely not.
The correct mindset to have when investing in individual stocks is that you are buying ownership in a company. The correct mindset to have when buying into a mutual fund is that you are buying ownership in several companies at once.
Think of buying ownership into the pizza parlor down the street. Let’s say the owner is a friend of yours and is looking to expand. You see that he does a good business and think that you could make some money if you gave him some of the money he needs to expand in exchange for a cut of the profits from the expansion.
Now you know from looking at his past sales that it should be a good investment. Sales have been growing at 20% per year, so you think your ownership stake might grow in value by 10% per year or more, using a conservative estimate. This is not a hard-and-fast number – there is no written agreement that you will receive 10% per year. It is just the average return you expect based on looking at the past. You also have money to invest that you could afford to lose if things didn’t go as you planned.
You have no control over the economy, locally or nationally. A big recession could hit and cause fewer people to dine out. There could therefore be quarters where the pizza parlor loses money, so your ownership stake could decline in value. Someone else could also open a better place across the street and your pizza parlor could lose a lot of business.
The point is that, based on what you knew, you felt there was a good chance of earning at least a 10% return. You knew that some years the return would be greater, and sometimes it would be less. You were also willing to allow the time, however, for your investment to pay off. You didn’t expect the expansion to instantly add a huge amount of business. You didn’t need the money for a considerable amount of time, so you could allow time for the business to grow.
When you’re buying individual stocks, you’re doing the same thing although you don’t typically know the managers personally. The price of the stock is just what people are willing to pay at any given time, and this will go up and down based on how the business is doing at a given time, how the economy is doing in general, artificial factors cause by people doing various trading schemes, and other factors such as tax rates. Over long periods of time, if the business keeps growing and making more money, the value should go up. Stocks have typically returned substantially more than inflation over time, and therefore you can also expect to make more than inflation. The return in any given year, however, is up in the air.
If you buy a mutual fund, you’re reducing the fluctuations due to any particular business since one will be doing well when another isn’t. This is like buying ownership stakes in 100 restaurants rather than just the one pizza parlor. There are still fluctuations due to the overall economy and factors such as tax rates. The level of fluctuations will be less, but there will still be fluctuations.
So when buying individual stocks or mutual funds, you should buy as if you were making an investment in a local business. This means checking the books and buying a company that you feel will do well and not getting all excited about the fluctuations in the price of the stock. After you buy, you should expect good days and bad days in both the fortunes fo the company and the price of the stock. Sometimes the stock will decline in price even though the company is doing great.
That’s just what happens. You should not be selling just because the price drops a bit or just because you have a small profit. Making money in stocks takes time. If you’ve chosen well, however, given time, you should get a good return.
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Disclaimer: This blog is not meant to give financial planning or tax advice. It gives general information on investment strategy, picking stocks, and generally managing money to build wealth. It is not a solicitation to buy or sell stocks or any security. Financial planning advice should be sought from a certified financial planner, which the author is not. Tax advice should be sought from a CPA. All investments involve risk and the reader as urged to consider risks carefully and seek the advice of experts if needed before investing.
Picture Credits: Pierre Amerlynck , Downloaded from stock.xchng