There are really two different ways to invest in stocks, also known as equities: 1) invest via mutual funds (or ETFs), and 2) invest in individual stocks directly. There are plenty of financial advisers who will tell you that investing through mutual funds is the only way to go, and given the way that a lot of people invest in individual stocks, they are right. Because many people go in and out of stocks, churning their account, creating a lot of taxes and fees, and often missing out on a lot of big moves because they sell a stock too early, most people would be better off investing only through mutual funds.
Still, if done right, individual stock investing can make sense and be very profitable, especially for money that you have to invest after putting away money in your 401k and kids college plans that is invested primarily or entirely in mutual funds. People can (and do) beat the market averages by investing in individual stocks over long periods of time. This isn’t done by timing the market or jumping from stock to stock in an effort to be in the next hot stock at just the right time. It is done by investing in a very uncommon way that actually takes far less time and effort than the market speculating most people do. Here’s how to start investing in individual stocks with $10,000:
Find businesses, not stocks. The first thing to do is to get the mindset of a business investor, not a stock trader. A stock trader is concerned about the movements in the price of individual stocks and tries to time purchases to make profits. People who say things like “buy low and sell high” are stock traders. Instead, make investments in businesses that you think will do well over the next several years. Think the same way you would if a friend presented you with the opportunity to invest in his business. You would check things out from the standpoint of being locked into the investment for the next several years, knowing that it would be difficult to sell. Once you invested, you would also see the money as “gone” unless the business succeeds and does well. You wouldn’t expect to see any of your money back if the business failed. If the business did succeed, you would expect to receive profits from the business for many years rather than selling your stake to someone else immediately. You want to find businesses that will grow and become more profitable over the next ten or twenty years, eventually paying out a share of the profits to you each year in the form of dividends.
Things to look for when choosing a stock are the earnings growth rate (something in the teens is good), a history of steady increases in share price, a good management team who has shown that they know how to manage the business well, a high return on equity figure (at least 10%), little or no debt, and the ability to continue to grow the business. Earnings growth is what causes the share price to increase over long periods of time and is what eventually leads to dividends and then dividend growth.
Concentrate your investments enough, but not too much. If you are going to buy 50 or 100 shares of twenty different companies, you might as well just put your money into a mutual fund. The advantage individual stock investors have over the pros is that they can concentrate their money so that when the stock does well they’ll make huge, life-changing profits. Hold 100 shares of a company at $20 and its stock price goes to $80 and you’ll make $8000. This is nice, but not life changing. Hold 1000 shares and you’ll make $80,000 – enough to maybe pay off your home or put a child through a couple of years of college.
Still, you don’t want to have so much of your money in a single stock that it would be financially devastating should you be wrong. Individual companies do go bankrupt, and when they do, even though the company may emerge out of bankruptcy a few months later, the stock investors are usually wiped out. Don’t put more into a single investment than you can stand to lose, and cut back on positions that get too large and start to dominate your portfolio. You can (and should) eventually start to put some of your profits into mutual funds to gain diversification and preserve the gains you have made. If you do well, the dollar amount you have invested in individual stocks will remain about the same but it will become a smaller and smaller portion of your portfolio as you shift money into mutual funds.
Gather a watch list. You’ll want to find 3-5 stocks that will become your watch list. These are the stocks that will become your initial holdings and will be your only holdings until your portfolio has grow substantially. When you have money to invest, you’ll buy whichever of these stocks is at the best price at the time and which best balances your portfolio based on the amounts you hold of each stock.
These should be stocks that you expect to do well over the next several years and your watch list will change little from year-to-year. This is why it doesn’t take a lot of time to invest once you have developed your watch list. You only move companies from the watch list if the business fundamentally changes and you only add companies to the list once your portfolio has grow to the point that you need additional diversification. Having a small number of companies allows you to get to know the businesses very well.
Wade in slowly. You’ll want to buy in stages, rather than investing all at once. Don’t expect to buy at the bottom. Sometimes you’ll buy in, only to see the stock decline in value. Don’t despair – that just means that you’ll be able to buy more shares at a bargain price. Remember that it is the business you’re buying, not the stock, so share price movements shouldn’t matter much to you for a while.
With $10,000, I would take $6,000 and invest about $2,000 each in three of the companies on my watch list. I would then wait a couple of weeks to a month and hope that one or more of them would decrease in price. As they did, I would take the $4,000 remaining and buy more shares until I was fully invested.
Keep adding to your positions. From that point, I would keep saving up money from my salary and investing whenever I had $2,000-$3,000 to invest, buying whatever was the best bargain from the companies on my watch list or adding to smaller positions to keep things in balance. I would wait until I had a reasonable amount to invest to avoid paying too high a percentage in brokerage fees.
It is regular investing that helps you succeed. By buying over a long period of time, you get a better price for the stock since you’ll be buying more on dips. This also helps psychologically since you’ll see decreases in share price as buying opportunities rather than losses on your portfolio. I’ve had stocks that were paper losses in my portfolio for a year or more who later turned around and become some of my biggest successes. Remember that you are buying the business, not the stock. Share price won’t matter for many years down the road.
Monitor the company, not the stock price. Of course you’ll glance at your brokerage statement from time-to-time and see which positions have grown and which have fallen, but that shouldn’t be your primary focus. In fact, if you wanted to just ignore the share price most of the time, that would be just fine. When the stock drops in price, there is nothing you can do – the damage has already been done. When it shoots up, watching the price closely may allow you to convince yourself to do something foolish like selling out and wait for a decline to buy back in, perhaps only to see the stock continue to climb.
Instead, you should focus on the fundamentals. Read through the annual report when it comes out and get an idea of how the company is doing and what their plans for growth and expansion are. If they see earnings decrease, see if there is something systemic or just a result of market forces beyond their control. It is only if something has fundamentally changed in their business or their opportunities that you would sell out of a company.
You should also monitor for things like decreases in earning growth rate, changes in return on equity, and taking on a lot of debt. Changes wouldn’t necessarily result in your selling, but they may point to fundamental changes in the business or market that would mean it was time to sell. Sometimes you’ll also just choose a company that just doesn’t work out, and by monitoring fundamentals you’ll decide that you made a mistake. Sometimes the share price will have already fallen, other times it will not.
Trim back if a position does too well. You certainly want to leave your holdings with room to grow. You don’t want to sell out each time that a stock goes up a little or you’ll end up with a lot of losing positions and miss out on a lot of growth. Companies that do well tend to keep doing well since it normally means that management has hit upon a good business strategy and you have effective managers and employees working for you. Sometimes you’ll also get a Microsoft or a Home Depot that will make you a millionaire if you bought in early and held your stake.
Still, you don’t want a position to become so large that it will become financially devastating for you should something happen, because it can. You should always ask yourself if you could withstand the loss of the entire position. If the answer is no, sell some shares and invest the proceeds elsewhere, holding some of the profits back to pay for taxes on the gain. Also, if you’ll be needing the money for something in the next few years and you have a stock that has done really well, it is generally a good idea to cash out and put the money in bank CDs or elsewhere so that it will be there ready when you need it regardless of what happens to the stock.
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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.