Whether you are just starting out with a little bit of money or have a sizeable chunk of cash to invest, understanding some key investing principles can have a dramatic effect on your overall return.
Below I’ll run through everything from how you can actually get started and purchase your piece of the stock market, to what returns you should expect and what you should focus on.
My aim is to help demystify the process of how you can invest in the stock market so people aren’t frightened by the prospect of doing it themselves. It only takes a small amount of knowledge to get started and help set yourself on a path to a brighter and more affluent future.
What is a Stock?
A stock, which can also be known as equity, is a piece of a company. Owning stock in a company entitles the owner to a proportion of the company’s assets and profits. Individual units of the stock are known as shares which are mainly bought and sold on stock exchanges, although can also go through a private sale.
How Do You Make Money in Stocks?
When you own shares in a company, you can earn a profit either when the share price rises or profits a company makes are distributed in the form of dividend payments. The profits you receive from a dividend are based upon the number of shares held in the company.
Each company can choose how much of a dividend they are going to distribute to their shareholders. Some companies have very high dividend payouts of over 5%, with others choosing to not pay a dividend at all.
Typically high growth companies have a lower dividend or even zero and is usually based on whether they can reinvest the money to generate future growth, helping the stock price increase.
Companies like Amazon, for example, have never paid a dividend as they have been investing that money back into the company for continuous growth. This has resulted in a growth of approximately 39% per year over the past 10 years, so quite a good investment for those people that have benefitted along the way!
I just want to note that this is not a common trajectory and does come with a lot of risk, which is why some investors prefer to invest in dividend stocks as they’re often more stable and provide more predictable returns. It’s all based on your appetite for risk and what returns you’re hoping to make, which we’ll go into shortly.
How Does a Stock Price Go Up and Down?
The stock market works like an auction where the price of a stock will fluctuate based on demand. The stock price will increase when there are more buyers or decrease when there are fewer buyers.
There isn’t always a perfect correlation between how well a company is doing and the share price. It’s driven by how many people or organisations want to own the stock at any given time, which can be based on a number of factors, including emotion. However, as a company starts performing better, in general, more investors will want to own the stock, driving up the prices. The same is true the opposite way if a company starts performing poorly, reducing demand from investors and the stock price goes down.
What is a Bond?
A bond is a loan to a company or country that has a fixed rate of interest which is fixed for a specific period of time. You can think of these like an I.O.U where the bondholder is given a fixed amount of money on predefined dates in exchange for their money. The issuer of the bond will then repay the face value of the bond at the end of the term.
There are a number of different categories and varieties of bonds, although to keep it simple, bonds are issued by governments and corporations. Each bond has specific terms to align with the needs and wants of the issuer and investor. This can be around their interest rate (coupon rate), the original purchase price (principal amount) and payment dates (maturity dates).
How can an Investor Make Money by Buying a Bond?
You can either buy a bond directly from an issuer, such as the government or from a broker that buys a number of bonds and lists them for sale on the market.
To earn money from bonds, you can either hold the bond and collect the interest (coupon) payments or benefit when the bond price rises within the market.
In the market, bonds have an inverse relationship to interest rates. When interest rates go up, bond prices decrease and when interest rates go down, bond prices increase. This is caused by an equalising effect of the demand from investors wanting the best return on their money based on their risk appetite.
As an example, if a bond were £1,000 and it received a coupon payment of £20 per year it would have a 2% interest rate. If the interest rates within the market dropped to 1.5%, this would make this bond an attractive investment as investors could be making more money holding the bond than they could get elsewhere in the market.
As a result, the demand for this bond rises, pushing the price of the bond higher. This demand will keep pushing the price up until has equalised with the market rates, at which point there is no further incentive to buy the bond.
In order for the bond to have a 1.5% interest rate, the bond price would have to rise to £1,333.33 (£20/1.5%), giving the investor a nice profit in the process. However, there are many other factors that can influence the price of a bond, such as their investment grade, which is an indicator of the level of risk of the issuer, as some issuers might not be able to pay you back! So always best to do your research.
What is Cash?
Cash is literally as it sounds, just having money set aside to either help with the stability of a portfolio as the total won’t change or money held ready to make a particular investment when the time or price is right.
I also want to note that when holding cash, unless it is earning interest then it is actually losing value due to inflation. Inflation is the gradual increase in the cost of goods and services over time, so £1 today is worth less than £1 a decade ago. UK inflation is around 2% a year, which means every year, your cash loses around 2% in purchasing power. This is why making that money work for you and investing will help prevent your money losing value being stuck in a bank at little to no interest.
What is a Fund?
A fund is a collection of stocks that are grouped based on certain characteristics. This can be anything from a geographic location such as in the UK or US, the size of the company or even what industry they’re in. When you buy shares in a fund, you are effectively buying all the stocks held within that fund at the designated weightings.
For example, owning shares of an FTSE 100 fund would mean you had effectively bought a very small piece of the top 100 companies on the UK Stock Exchange.
What is a Passive Fund?
A passive fund is where no one is actively managing the mix of companies or investments that the particular fund holds.
Using the FTSE 100 again, a fund that focused on this part of the market would just track all 100 companies whether they were increasing it value or decreasing in value.
What is an Active Fund?
An active fund is where a fund manager and a team of analysis are actively managing what investments are selected for a particular fund. This active management is done on an ongoing basis with the aim of getting the best return for the investor and trying to beat the market.
There are a number of different types of active fund, such as mutual funds or ETFs (Exchange Traded Funds).
Active Funds vs Passive Funds
Active funds often have a higher level of risk as the team are making predictions on what assets they think will increase in value. This is a skill that as you start to learn more about the stock market, you’ll start to understand that even the most sophisticated of investors often fail to beat the market.
Active funds also almost always have higher fees when compared to passive funds which is used to pay for the team and resources used in the active management.
I will go into this in more detail later, although high fees can seriously hinder the returns of your portfolio, so definitely pay close attention to them, especially on active funds. It’s also good to understand that not only does an active fund have to beat the market, they also have to beat the market by over their incremental fee charges to put more money in your pocket.
However, active funds have the potential to beat the market, whereas passive funds usually track a particular index or group of assets based on a specific market or classification.
What is an Index Tracker Fund?
An index tracker fund is a fund that tracks a specific segment of the market which is designed to offer investors an opportunity to gain exposure to an entire index at a low cost. The performance of the fund is then aligned to the collective performance of all the underlying assets within the index.
Popular index funds include the S&P 500, FTSE 100, Dow Jones Industrial Average and the Nasdaq Composite. Investors are often drawn to these types of funds because the majority of investment fund managers of active funds fail to beat the market on a consistent basis so this is an excellent alternative that usually have very low fees.
What is an ETF – Exchange Traded Fund?
One of the main types of funds in an ETF or Exchange Traded Fund. This is a fund that holds a collection of securities, such as stocks and is traded on an exchange much like an individual stock. As a result, the share prices for the ETF fluctuates all day as it is bought and sold.
ETFs can contain any type of investments from stocks, commodities, bonds or even cash. They often follow a specific theme so investors can use them to build up a portfolio that meets their individual needs.
As they are traded on an exchange they tend to be more liquid so you have easier access to your money should be need arise. ETFs can also be actively managed or passive so make sure you pay close attentiuon to the fees as that’s usually a common distinction.
Income vs Accumulation Funds
Many funds give the investor the choice of having an income or accumulation fund, the difference being how the money generated within the fund is treated. With an accumulation fund, the money is reinvested to help deliver future returns with compounding the investment, whereas, with an income fund, the money is distributed to the shareholders of the fund.
For example, if the fund holds shares of individual companies which distribute a dividend, with an accumulation fund this dividend will be reinvested in the fund but with an income fund it will be distributed to the shareholders of the fund.
Those investors that are looking for long term growth will usually be best buying an accumulation fund and those needing a steady stream of income, such as those in retirement may favour the income funds.
How to Start Investing in the Stock Market as a Beginner (how to buy something!)
Right, so now we’ve covered a basic overview of what types of investments you can make, now we can put that knowledge into practice and I’ll show you how you can actually buy some investments.
What you need to do next is set up an account with a broker that will give you the ability to buy assets in the market. There are many brokers in the market, each with their own positives and negatives depending on your personal circumstance.
There are quite a lot of factors to consider, such as platform fees, different trading fees for the types of assets being purchased, percentage fee brokers, flat fee brokers, exit fees, trading frequency, the list goes on.
As a beginner, the key is just to start and then as your knowledge improves in this area you can research exactly which broker is right for your circumstances.
Best Investment Broker to Use as a Beginner to the Stock Market – UK
In my opinion, simple is always better, especially for beginners which is why I recommend that you start with Vanguard.
Vanguard is an investment platform that focuses on low fees and having a balanced portfolio. They have over 75 different funds which you can buy that cover practically every market segment and location across the world.
As a beginner, this is an excellent starting point as all the options available have low fees as well as an incredibly low platform fee of just 0.15% and no charges for switching funds or withdrawing money. This can be quite costly with other platforms and when you’re just starting out you may want to experiment with buying different investments and ideally don’t want to be stung for learning!
To understand all the fees they have a section on their website that goes into a lot of detail that you can access here.
They also have a Stocks and Shares ISA which is an excellent way to invest in the UK in a tax-efficient way. You can also start investing with as little as £100 per month or £500 lump sum so is brilliant for beginners.
Many people are also investing in the stock market through their pensions. Vanguard have a SIPP (self-invested personal pension) that you can make use of depending on your personal circumstances.
What is a Stocks & Shares ISA
A stocks & shares ISA is a tax-efficient way to invest if you’re a UK resident and over 18. In 20/21 each person gets a £20,000 ISA allowance, all of which can be used for stocks and shares or can be split among other ISAs, (Cash, Lifetime, Innovative Finance). What’s special about these accounts is all returns generated are tax exempt so you can keep all of the profits.
Visit this link to get a Vanguard Stocks & Shares ISA.
How Much Profit Should I Expect From the Stock Market
There are many factors that influence how much money you can expect to make from the stock market. Two of the main factors include your risk appetite, driving what investment choices you make and whether you reinvest the profits to achieve compound growth.
Historically the stock market has generated about a 10% return on average although there are some analysts highlighting that this may be lower in future years due to having such strong growth over the past decade.
When first starting out, one of the best things you can do is to set up an automated investment plan and stick to it for the long term. If you’re only starting out with a few thousand, the biggest impact to your overall investment pot will be additional money you add to it, especially in the short term.
What is Compound Interest and How Does it Work? (example)
Warren Buffet, one of the most successful investors of all time has described compound interest as the 8th wonder of the world. This is the simple, yet powerful concept is just to reinvest the earnings you make from your investments, allowing those earnings to also generate earnings and so on.
As an example, say you invested £10,000 and got a 10% return, you’d generate an extra £1,000. The next year, if you reinvested that £1,000 so had £11,000 in total and earned 10% again, your earnings would also generate a return and you’d earn £1,100.
Over time this leads to exponential growth and is why you may have heard or read about stories where someone on a standard wage managed to generate millions over the course of their life. Often they didn’t take on abnormal levels of risk, they just consistently invested in the stock market and reinvested the profits to benefit from compound growth.
How Much Risk Should I Take in my Portfolio?
Risk broadly aligns to the level of volatility in an investment, so how much it goes up and down over a set period of time. Risk doesn’t always correlate to reward and some of the best investors of all time continually focus on trying to maximise the level of reward vs the level of risk.
Understanding your appetite for risk is extremely difficult. When the prices are increasing, so you’re generating great returns, it’s all plain sailing and people often happily increase their risk tolerance (sometimes unknowingly). It’s when things take a turn for the worst and prices start dropping that truly indicates your risk tolerance.
When the market drops, many people panic sell their position, usually because they have a portfolio that does not match their risk appetite.
Schroders did some analysis on the UK stock market, specifically around the FTSE index. They showed that if you stayed invested over the past 30 years you’d have earned an 11.6% return per year. They then highlighted that if you missed the best 30 days across the 30 year period, that return would have dropped to just 7%.
The best days often come just after a crash, so when a lot of people panic sell they actually lock in their loss position and don’t benefit from the subsequent rebound. This is why you will always hear the phrase “time in the market beats timing the market”.
So in summary, the level of risk you should have in your portfolio is related to the amount you could see your assets reduce in price and not make any rash decisions. Ideally, you would even continue investing and buying the assets at the new reduced price.
A lot of this is based on your time horizon, if you’re only 25 and are saving for retirement you can have a very long term view and are more than likely going to experience a number of crashes and rebounds before you need the money. However, if you are retired or coming close to retirement, you really should be thinking about being a lot more defensive in your choices to help minimise your level of volatility as you’ll need access to the money soon and may not be able to wait for the market to return if there were a crash.
A Brief Warning About Investing in the Stock Market as a Beginner
When researching any stock, bond or fund you have to always remember that past performance is not a guide for future performance.
Diversification is a key tool that you can use to help spread risk and ideally avoid your whole portfolio being affected if one asset class, company or fund takes a hit. To do this, you can buy multiple different types of assets that have different characteristics, such as geographic location, industry or even size. This is up to you although a lot of the large funds from Vanguard, such as their LifeStrategy range help ensure you have a decent level of diversification, which is great for a beginner to understand how it works.
Set Goals To Stay Focused
One of the hardest parts about investing is taking a long term view and keeping your money invested even through any short term price volatility. What really helps is to set financial goals so you know what you’re aiming towards, so make sure to read this guide on setting financial goals so you’re well equipped.
Overall, understanding how to invest in the stock market is a key skill for anyone that wants to grow their savings over time. As banks keep slashing interest rates, with many of them now at 0%, your money is losing value due to inflation. So it’s even more critical now to put your money to work and help give yourself a more secure financial future.