Congratulations, so you’ve decided to become a fat cat! The first step in learning how to invest is to buy a cigar. Then proceed to light it up with a dollar bill. This isn’t a requirement, but highly recommended. Because the first step in anything is looking the part and getting into the right mentality. Also helpful is getting a top hat and a monocle. Because there’s no point half-assing this, so you might as well go all the way! What’s not optional? Opening up a brokerage account.
What is a Stock Market
A stock market is exactly what you think it is. It’s a market where people buy and sell stocks. Except it’s not like a typical market. Ebay, for example, is a typical market. It connects buyers and sellers. But a stock market is different. In the stock market, you normally have somebody in the middle, called a market maker. This person’s job is to provide liquidity.
With ebay, you can only buy widgets if somebody is willing to sell them. And you can only sell widgets if somebody is willing to buy them. A market maker’s job is to be on the other side of a trade, so you can buy and sell whenever you want. A market maker makes money like the rest of us – by buying low and selling high. The difference between the bid price and the ask price is the bid/ask spread.
Liquidity Is a Big Benefit
Liquidity is one of the reasons why the stock market is so great – they’ve made it easy to get in and out of stocks. Think of buying and selling a house. It’s a difficult and a time-consuming process because it’s so hard to match the buyers and sellers. Unless the market is really hot, it could take months to sell a home, even though you may need the money right away. The same problem exists with cars. Unless you’re willing to take a big hit, you need to find somebody willing to buy your car, for the price you’re asking for.
Obviously houses and used cars are difficult to price because each one is unique, but it highlights how useful it can be to have somebody in the middle making trades. The liquidity may not seem like such a big deal normally because there are millions of people trading every day, but it’s a godsend in situations like the financial crisis and you’re trying to get out quickly, or if you need to sell stocks quickly to pay for medical bills or put a down payment for a home.
Opening a Brokerage Account
If you want to get in on the action of buying and selling of stock, you’ll need to open up a brokerage account. A brokerage account is required because first of all, they need to ensure you actually have the funds to buy stock. Also, they need to establish ownership. The Securities Exchange Commission (SEC) needs to confirm who’s buying and who’s selling stock to make sure nothing illegal is going on, like insider trading.
A brokerage account is required to trade stocks, but it can also be used to buy and sell ETFs (Exchange-Traded Funds – see below), and mutual funds.
If you’re looking to open up a brokerage account, I recommend Ally Invest. At $4.95 per stock and ETF trade, it’s among the lowest in the industry. Ally also offers discounted trades at $3.95 if you have over $100k in your account, or make more than 30 trades per quarter. That may seem like a lot now, but if you following this site, we’ll try to make that $100k balance a reality!
Overall though, there’s not much of a difference in pricing between all the players. I also wouldn’t worry about pricing too much since a few dollars per trade won’t have much impact in the grand scheme of things. Don’t focus on the research that each brokerage provides, because they all suck.
How Much Do I Need to Open an Account?
When you invest, you’re going to need to make one trade to buy a stock and one to eventually sell. If you’re a long-term investor, you may not sell for a very long time though. In general, it’s going to cost you $10 for one complete trade, so it doesn’t make sense to invest $20, since half your money would get eaten up in trading costs!
I think $100 is a good starting point to begin investing. A diversified portfolio generally contains 10-20 stocks, so with $100, you don’t have enough money to create a portfolio. This is why I believe at this level, you’re better off buying an ETF (see below).
$1,000 is closer to the minimum you need to start buying individual stocks. I think $200 is the minimum you need to invest in a single stock because at $5/trade, that means you’re spending 2.5% just on transaction costs alone. With another 2.5% to sell, total transaction costs are 5% of the initial amount you put in.
If you have $1,000 and put in $200 for each stock, you would only own 5 stocks, below the 10-20 I suggest for a diversified portfolio. However, I would expect the number of positions to grow over time as you continue to put more money to work.
How to Invest?
If you’re just learning how to invest, the easiest thing to buy are ETFs (exchange traded funds). Here’s a post that goes into more detail about ETFs vs. mutual funds. I like ETFs because the expense ratios are low and they provide instant diversification, especially if you buy one linked to the S&P 500. Note that ETF expenses are different from trading costs. The trading costs go to your brokerage. Expense fees are deducted from the value of the ETF and go to the firm that creates the ETF, like Vanguard.
If you’re interested in picking individual stocks, I recommend buying solid blue chip companies. Look for household names, preferably ones that pay a dividend. A dividend is a cash payout the company pays to shareholders, generally every quarter. I talk more about dividend-yielding stocks here. It’s not that I prefer dividend stocks, but these tend to be stable companies and owning a stock that moves +/- 50% is not the right stock to own if you’re new to investing (at least the -50% part).
If you’re dead set on buying individual securities and are ready to look at valuation, think about Free Cash Flow (FCF). FCF is how much cash a business generates after taking into account investments. At the end of the day, the cash that a business creates is what you’re really paying for when you own a stock.
You’re on the Path to Success
I remember when I first started learning about how to invest in stocks. It was so scary and exciting at the same time! As soon as I bought a stock, I couldn’t stop checking every 5 minutes to see how it was doing (this isn’t healthy, in case you’re wondering.) It’s a little ironic that I now watch stocks all day.
If you’re looking to achieve financial security, you’ll need to have your money working for you. Owning stocks has been one of the most consistent creators of wealth for many generations, so you’re on the right path!