Investing in Stocks 101 | The Who, the Why, the How
Investing in stocks is easier than many people think, and, because of our increasing lifespans, it’s now more necessary than ever. For those who are just beginning to explore stocks, 2019 might be an excellent year to start. This is the Chinese “Year of the Pig”, which is considered especially auspicious for making money through investing. Here’s what you need to know about investing in stocks—in this, or any other year!
Why Invest in Stocks?
People invest in common stocks in order to earn additional income via three primary means: capital gains from speculation, dividends, and compounding returns to maintain buying power. That was a mouthful, so let’s break each concept down into terms that are easier to understand.
Speculation for Capital Gains
When we sell a stock for more than we paid, we “realize” a capital gain. Capital gains are very favourably taxed compared with earnings from a job, so they’re a tax-efficient way to build wealth, since more money stays in your pocket.
Many established companies pay dividends, and they tend to increase their dividends annually; think of it like getting a raise every year. Shareholders get the cash at the same time that the share price (hopefully) rises, and these dividends are usually better than what you would get on a GIC or savings account. From a tax perspective, dividend income is taxed more favourably than salary or rental income, (but not quite as favourably as capital gains), so, again, your wealth grows faster.
Investing in stocks is still one of the best ways to maintain buying power over the long-term, particularly in retirement when we no longer receive inflation-adjusted earnings. Even low inflation gradually eats into our savings. If our investments don’t keep up with the rate of inflation, we fall behind. Investing in stocks is better at beating inflation because of its historical out-performance compared to GICs, savings accounts or government bonds.
How Risky Are Stocks?
Stocks are called “risk assets” for a reason. Unlike savings accounts or government-backed bonds which guarantee interest payments and then, at maturity, return the original investment, stocks make no such promises. A stock’s price could, theoretically, go into the stratosphere—or it could go to zero. Here are some of the major risks when you invest in stocks:
- Financial Risk: You lose money if the company isn’t successful or is out of favour with investors.
- Interest Rate Risk: If interest rates rise, investors may shift their money to risk-free assets, like GICs, instead.
- Market Risk: Market prices rise and fall constantly. Prices may drop when you need to sell.
- Liquidity Risk: If you buy stocks that trade infrequently, you may not be able to sell them when you need to, at the price you want.
- Foreign Exchange Risk: If the company you invest in is exposed to foreign markets, the exchange rate differential could hurt your investment return.
- Emotional Risks: Because stock prices change frequently, you could make irrational investment decisions based on fear or greed.
- Short-Term Risk: Stock markets tend to rise over the long-term but can drop precipitously in the short-term.
3 Steps to Take Before You Invest in Stocks
Investing in stocks has never been easier, more accessible, and more affordable. But before you dive in, here are some essential action items you need to check off.
- Set financial goals. Why are you investing in stocks? Is it to fund a child’s education? For a mortgage down payment? Saving for retirement? Just for fun?
- Identify your risk tolerance. People say, “I have a high tolerance for risk.” What they actually mean is, “I have a high tolerance for making a lot of money, fast.” They are not the same thing. In general, younger people have a longer investment runway and can usually afford to take on more risk than those closer to retirement.
- Make your financial bucket list. Divide your money into three buckets: 1) Money you need in the short-term (within 1-3 years); 2) Money you need medium-term (3-5 years); and, 3) Money you won’t need for a while (5+ years). The funds in the 3rd bucket are for investing in stocks. Also, before you start investing in stocks, make sure you have a reasonable emergency fund, in cash.
Who Should Invest in Stocks?
If you can answer “yes” to all of the points below, then investing in stocks is right for you.
- You have a medium to long-term time horizon of a minimum of 4-5 years.
- You have the patience to let capital and dividends compound. For example, if your rate of return is 7% annually, your investment will double in value in approximately 10 years.
- You are willing to learn more about the basics of stock market investing, including how financial markets work, economic cycles, how to evaluate stocks. This article, though a very good start, should be just that: a start.
- You understand your risk tolerance and goals.
Who Shouldn’t Invest in Stocks?
If you answer “no” to both of the statements below, you should invest your money in other more liquid and secure options for now (e.g. savings accounts, GICs, TFSAs, etc.) and reconsider stock investing later.
- You will need the money in the short-term, within 1-3 years.
- You can’t tolerate financial risk.
Still feel like investing in stocks is right for you at this time? Read on.
Types of Stocks to Invest In: Individual Stocks, ETFs, and Mutual Funds
You can invest in stocks by buying shares of publicly-traded companies; through pooled funds like mutual funds; or through ETFs (exchange-traded funds). Here are a few pros and cons to look at for each of those routes.
|Common Stocks||- Benefit directly from company's growth|
- Save brokerage costs with DRIP
- Full control of the investment
|- Takes long to diversify the stock portfolio
- Higher risk of losses
- Lack of knowledge to choose investment-worthy stocks
- Analysis paralysis
|ETFs||- Can use leverage and buy on margin|
- Cheaper than mutual funds
- Provide instant diversification
|- Overwhelming variety of ETFs to choose from
- Risk of over-trading
|Mutual Funds||- Potential for above-average returns|
- Professional management of portfolios
|- Higher fees
- May have to wait the following day to trade and the price may change
- Capital gains payouts are paid annually (less tax-efficient)
- May have under-performing managers
Investing in Common Stocks
When you buy shares of a public company, you become a proportional owner. And like any business partner, you’re entitled to a share of the company’s growth, which can come from a rise in share price, dividends, new shares from spin-offs, a merger, or share-splits. You also receive voting rights on company matters.
- You’re a direct beneficiary of the company’s growth.
- If the company has a DRIP (dividend reinvestment plan), the company issues additional full or fractional shares instead of cash payments, saving you the brokerage cost.
- You have control of the investment. You decide when to buy or sell.
- It can take a long time, or an initial large lump-sum of money, to build a diversified stock portfolio.
- Buying individual stocks exposes you to bigger losses should one or more of the companies falter.
- You currently lack the skills or the confidence to choose investment-worthy stocks. (Note that anyone with average intelligence can be a successful investor, but building skills and experience takes time.)
- Emotional attachment to individual stocks could impair rational decision-making.
- Subject to “analysis paralysis” when choosing individual investments.
Investing in Stock ETFs
Unlike a mutual fund, ETFs (Exchange-Traded Funds) are passive investment products that hold a basket of stocks that mirrors an index, like the S&P/TSX Composite, for example.
- Shares can be traded throughout the day exactly like stocks.
- Like all common stocks, market price is transparent and changes throughout the trading day.
- Can buy them on margin (using leverage) or buy options on them. (These are more advanced investing strategies.)
- Usually cheaper than mutual funds.
- Index-tracking ETFs provide instant diversification. For example, the Vanguard Total World Stock ETF owns more than 8,116 stocks from around the world!
- There’s a large and potentially confusing variety of ETFs to choose from, some of which are very niche and expose a novice investor to considerable risk.
- The ease of trading ETFs could lead to over-trading, which could harm returns.
Investing in Stock Mutual Funds
Mutual funds are investment pools containing money from a large group of investors. They can invest in a broad stock market index like the S&P/TSX Composite, or based on a specific mandate, like “oil and gas companies in Canada.” Most mutual funds are actively managed by portfolio managers who aim to provide an above-average return.
- Potential for above-average returns compared to general stock market benchmark.
- Professionally and actively managed by portfolio managers.
- Higher fees than most ETFs. Canada has some of the highest mutual fund fees in the world.
- Mutual fund investors must buy or sell units of the fund directly with the fund company, not the stock market. Unlike stock and ETF prices which change throughout the trading day, a fund’s unit price, called NAV (net asset value) is only calculated once a day after the markets close. If you want to trade units, your order will go through on the following day, when the price may be higher or lower than the previous day. This makes mutual funds less efficient for investors who trade frequently.
- Less tax-efficient than stocks or ETFs because mutual fund holders are obligated to receive capital gains payouts annually—whether they want them or not—and must pay tax on them. (Individual stock and ETFs owners can trigger tax when they, not the fund managers, chooses.)
- Surveys show that most active managers do not consistently outperform the market after fees.
- Some fund managers are “closet indexers”. They charge higher fees for active management but copy their benchmark index, such as the S&P 500. This means the investor will get index-like returns, minus the higher fees.
How to Invest in Stocks
You can choose one (or all) of these 3 ways to invest in stocks.
- D.I.Y: Low-cost discount brokerages don’t give advice, but they do provide affordable trading as well as online resources like webinars, analyst reports, and market news. For a higher commission, full-service brokers offer advice and trade on your behalf. This can actually be cost effective if you don’t trade frequently and require professional guidance.
Hire a Financial Advisor: A financial advisor will assess your risk tolerance and your investment goals and then build and execute an investment plan for you. But it’s not an accessible option for everyone. Typically you need a minimum investment amount from $250K to $1M or more to get their attention.
- Robo-Advisor: These companies use algorithms to manage an investment portfolio, usually using ETFs, based on a client’s risk tolerance, financial goals, and time-horizon. Services are based online with only minimal human contact, so fees are competitive compared to regular financial advisors. However, it’s important to remember that the investor also pays the cost of ETFs themselves. Add up the portfolio management fees and the ETF management fees and the total comes in around 1%—better than most mutual funds, but not super cheap. The big advantage with robo-advisors is that they have few, if any, restrictions on investment size. This makes them ideal investment tools for those starting out their investment journey, with less money to invest.