Posted over 4 years ago

Basics of the Stock Market for the Beginner (And the Expert)

Before we start, if you’re skeptical about investing in the stock market because you don't really understand what it is, read my previous post on the Stock Market. 

Now that you know what the stock market is, let's learn how to take full advantage of the market returns. After reading this post you will be able to;

  • Buy a stock or fund.
  • Allocate your own portfolio.
  • Understand what index funds to buy for your allocation.

Let us start with the fundamental question; how do I buy a stock or investment fund? This is a simple one, to buy stocks on any major trading platform one must either own a seat on the platform, like the NYSE, which can be expensive and overkill for our purpose, or use a broker/brokerage service like Etrade, Charles Schwab, or Vanguard. Once you have established an online account you can buy/sell stocks, bonds, mutual funds, etc between the hours of 9am-4pm ET Monday-Friday. The brokerage service will charge commission for each trade, with the online brokerage service offering the lowest fees. These fees can range from $9.99/trade to 3% of the trade value.

Example: You want to buy 10 shares of Apple (AAPL) and they're currently trading at $100/share, a $1,000 investment (10 shares X $100/share). However, the commission may be $30 (3% of the $1,000 investment) if you use a personal broker (Case 1) or $9.99 if you're using an online brokerage service (Case 2). Therefore the total needed for the trade is $1,030 for Case 1 and $1,009.99 for Case 2. AAPL rises in value over the next three months to $110/share, making you $100 (10 shares X $10/share increase). You decide that a 10% gain in three months is pretty good so you want to sell your 100 shares at $110, making your net proceeds $1,037 for Case 1 and $1,080.02 for Case 2.

How did I come up with those numbers? Remember, you have to sell the stocks at some point to make your money, costing you another trade fee. The total fees then would be $63 ($30 + $33 (3% of $1,100)) in the first case or $19.98 ($9.99 X 2) in the second case. This needs to be factored in to your rate of return calculations. So when you thought you had a 10% gain you actually had a 3.6% gain ($37/$1,030) in Case 1 and a 7.9% gain ($80.02/$1,009.99) in Case 2. Learn more about how detrimental fees can be to your returns here.

This is why beginners and day traders prefer an online brokerage service, to save money. Saving $10 or $20 each trade can add up to a great deal of money at the end of the year. Although a personal broker is more expensive, he/she will give you advice and guidance on which stocks to buy/sell and when to buy/sell. As I have mentioned before, broker advice is about as useful as a one legged man in an ass kicking contest, but it makes people more confident when they know a "professional" is telling them what to buy/sell (a piece of behavioral finance I don't want to get into).

What brokerage service do I use to buy stocks? I now use Vanguard's online brokerage service, although I used Etrade's online system for years prior. They had the Etrade baby, how could I not use their service? I switched to Vanguard after I found out Etrade was charging ($9.99/trade) for automatic monthly investments (dollar-cost averaging), amounting to hundreds of dollars in commissions a year.
Vanguard Logo

Vanguard has the best low- or no-commission system I am aware of. Jack Bogle, the founder of Vanguard, was adamant about eliminating small fees that eat away your investment gains over the years. He has created a great system for investors who are looking to get rich slowly but surely, opposed to the get-rich-quick investors.

Regardless of whose system you prefer, what type of stocks or funds should you buy to maximize your gains? Portfolio allocation (the composition of stocks, bonds, etc. that make up your total portfolio) isn't standardized across the investment community. Ideally there would be a "one size fits all" allocation allowing us to maximize our gains in the market but that's just not the case in the real world. There are several factors that go into determining an individual’s asset allocation; goals, risk tolerance, and age (main three).

Your biggest goal should be when you want to retire, or begin withdrawing money, and how much money you want to draw from your investments. Trust me, this is easier than it sounds with the new Freedom Calculator.

Once you have determined how much money you need to save for retirement, or a personal goal, there's a quick and easy calculation I use to determine monthly contribution. $100/month invested for 30 years, growing at 8% will become $150,000. For example; if you want to save $1.5 million ($150,000 X 10) in 30 years then you will need to invest $1,000/month ($100/month X 10). If you double your monthly contribution over 30 years to $2,000/month then your final investment will be $3,000,000 ($1,500,000 doubled). Use this only as a fast guideline, the Contribution Calculator will give you a more accurate picture

Now that you know the amount you need and the monthly contribution, you can determine the best asset allocation. As I mentioned before, there is no "one size fits all" allocation. A good baseline is an old rule that's still popular; the percentage of your portfolio in bonds equals your age. Example: A 35 year-old should have 35% in bonds and 65% in stocks (100% - 35% = 65%).

The methodology behind this equation is you are more susceptible to risk when you’re closer to retirement. When you're young you can recover from big market swings like 2008 and 2000, but an older person doesn't have the time to make up their losses, so they need to be more conservative. There are three separate phases when saving for retirement;

  1. Growth(<55 years old) - grow your investments to support you and your family in retirement.
  2. Protection(55-65 years old) - the strategy is to keep up with the rate of inflation to protect what you have worked hard to build.
  3. Income (>65 years old) - use the income from your nest egg to live your remaining years comfortably.

Random Walk Down Wall Street

As one can see, the majority of our lives our strategy is to grow our money, until we reach our goal. Thereby we need an allocation aligned with growing our investments. Again, there is no rule that's set in stone. Each investment company or brokerage firm will have their own formula or calculator. I happen to be fond of an asset allocation I read in Burton Malkiel's book A Random Walk Down Wall Street. That book changed the way I view investments, a must-read for you all. Malkiel states an asset allocation for a person in their mid-twenties should be as follows;

  • 70% Stocks- half in U.S. stocks with a good representation of smaller companies and half in international stocks, including emerging markets.
  • 15% Bonds- no-load high grade bond fund, if held outside a tax deferred account then tax exempt bonds are prudent.
  • 10% Real Estate- portfolio of REITs.
  • 5% Cash- ready for an emergency or to move quickly on a great investment opportunity.

You can meet the above allocation in three ways; (1) buy individual stocks and bonds, (2) buy mutual funds, or (3) buy index funds. I prefer the latter, index funds. It is extremely hard to set up a proper asset allocation buying individual stocks with less than $10,000. Another problem buying individual stocks is diversification. You want to spread the risk over several different companies, not put all your eggs in one basket.

While mutual funds are great for diversification purposes, they have high fees that will eat away at your investment returns. Use the True Cost of Fees tool to see how inhibiting a seemingly minuscule 3% fee can be. You can also read the post Objective View of Stocks, Mutual Funds & Index Funds (Clear Winner?) to learn more about the differences between the three investments. In any light, you should buy index funds for proper diversification, allocation and low cost.

The index funds I use for each allocation type are listed in the table below;

  • Fund Name (Ticker Symbol) Asset Class - Percentage of Portfolio
  • Vanguard Small-Cap Growth Index Fund (VISGX) Small Companies - 20%
  • Vanguard Total Bond Market Index Fund (VBMFX) Bonds - 15%
  • Vanguard Total International Stock Index Fund (VGTSX) International - 20%
  • Vanguard Total Stock Market Index Fund (VTSMX) General Market - 30%
  • Vanguard REIT Index Fund (VGSIX) Real Estate - 10%
  • Vanguard Prime Money Market (VMMXX) Cash - 5%

The index funds can be purchased through your brokerage service and they will have a posted description telling you what the fund is investing in, or its purpose. For example; I own Vanguards Total Stock Market Index Fund (VTSMX), I can go to the website in the link above and type in the name or fund symbol and it will tell me everything I want to know. You don't have to own the stock, bond or fund to be able to see the description.

As I mentioned earlier I'm partial to Vanguard because of their low- or no-commission system, which keeps more of my money in my pocket.

Let's recap what we've learned;

  • You can buy stocks, bonds, mutual funds, etc. through a broker or online brokerage service. The fees are less at an online brokerage service but you don't receive personal attention like you do with a broker.
  • To determine the amount needed for retirement use the new Freedom Calculator.
  • An asset allocation for an individual in their mid-twenties should be as follows;
    • 70% Stocks- half in U.S. stocks with a good representation of smaller companies and half in international stocks, including emerging markets.
    • 15% Bonds- no-load high grade bond fund, if held outside a tax deferred account then tax exempt bonds are prudent.
    • 10% Real Estate- portfolio of REITs.
    • 5% Cash- ready for an emergency or to move quickly on a great investment opportunity.
  • The easiest way to achieve the proper percentages is to use index funds instead of individual stocks.

If you have any more questions or something wasn't clear please leave a comment. Remember, I'm not a financial adviser, use what I'm teaching you as a stepping stone and do your own research before making any major investment decisions.