Investing in the stock market is widely believed to be one of the best methods of generating wealth. However, everyone knows horror stories of the risks of losing money in the stock market. Many have lost whole fortunes in a very short period of time.
What is the difference between shares and stocks?
This confusing terminology is actually quite simple. A stock refers to a particular company, while shares can be from a variety of stocks.
For a start, you should never invest more than you are prepared to lose. You should save up and emergency fund of about three months of living expenses so that in the event of a 2008-style recession you have time for stocks to recover (which they tend to do quite quickly) and you have time to find a new job if you are made redundant. Cash in the bank generally is a wise idea in case of unexpected costs.
How to Diversify your portfolio
Once you have an emergency fund, the next best thing you can do is invest in index trackers, or Exchange Traded Funds. An ETF tracks the performance of an index like the FTSE 100 or the NASDAQ index of US tech stocks.
These low-cost funds can be made of hundreds of stocks, which brings you one of the most valuable tools in investing which is diversification. By holding a larger number of stocks you are protected from a few performing badly, or collapsing entirely, as they will only make up a small part of your overall exposure.
Instead, as the market grows so will your portfolio since you are exposed to the breadth of companies that are driving the economy. You can have a bit more control over which stocks you invest in with more specialised ETFS like Legal and General’s ROBO Global ETF that is made up of AI and robotics companies.
How many stocks should you have in a portfolio?
Should you decide to either add to your portfolio of ETFs or ignore them entirely, stock-picking becomes and exciting but riskier game. Even if you buy a good portfolio of 10 – 20 stocks in a variety of industries you are still very vulnerable to drops, although gains are also just as concentrated. Star fund managers like Nick Train of Lindsell Train and indeed Warren Buffett himself believe in concentrated portfolios to maximise gains while others say you should have 60 or so stocks to spread your risk. This largely comes down to your personal tolerance to risk and volatility and you should consult a financial advisor if unsure.
How do you value a stock?
This is a debate that has plagued investors for decades. In bull markets – when markets rise upwards like a bull attacking – stocks tend to get overvalued. For instance big tech stocks like Netflix, Tesla and Zoom are often loss-making, but investors remain convinced they will turn highly-profitable in the future. As more investors want a piece of that future pie the stock price goes up. But the underlying earnings of the company remain the same. This is fine as long as markets are confident, but when a bear market strikes – a downward drop like a bear’s attack of more than 20% in the market – investors get cold feet and retreat to more secure territory of profitable companies that may not grow much but aren’t going to go bankrupt either.
A key metric to finding the fundamental value of a stock is the Price to Earnings ratio. This divides the price by the earnings of the stock. A good PE ratio is generally variable depending on country and industry. US stocks tend to be more expensive because of their stronger growth rates. Software and tech stocks especially are higher overall. Banks, insurance and utility stocks tend to be lower since they will probably be making the same sort of returns years down the line. Meanwhile a PE ratio that is very low – maybe below 10 for instance – could suggest a stock that is out of favour with the market for a valid reason. Expensive stocks meanwhile could turn out to be justifiably overvalued if they continue on their growth trajectory.