5 Things You Need to Know Before You Start Investing in the Stock Market
It is imperative to set aside a portion of your earnings in order to build long-term wealth. These savings should be used to invest in instruments that will help you derive inflation-beating returns. While the bond yields are near record lows, equities remain the most attractive asset class right now.
However, investing in the stock market carries significant risks especially if you don’t have the required expertise or knowledge to buy quality companies. It is advisable to hold stocks with a long-term horizon so you need to identify companies that have the potential to grow revenue and earnings at a healthy pace over time. Let’s take a look at a few guidelines you need to follow if you are a stock market investor.
Have a disciplined approach
You need to be disciplined if you are looking to invest in stocks. It means you need to invest regularly in equity instruments to take advantage of market lows and highs. For example, it is better to invest £1,000 each month for a year rather than allocating £12,000 all at once. Also known as dollar-cost averaging, an investor basically splits his savings into smaller tranches and invests these amounts periodically.
For example, the markets were extremely volatile in 2020 due to the onset of the COVID-19 pandemic. While the S&P 500 lost 36% in market value in less than six weeks, it also rebounded to end the year at a record high. If you invested £1,000 at the start of each month in this index your investment would be worth £14,354 at the end of 2020, indicating an annualized return of 19.61%. In case you would have invested £12,000 at the beginning of the year, your annual return would be lower at 16.1%.
Focus on diversification
Diversification is the key to minimizing investment risk. Investors need to purchase stocks across industries and avoid sectoral concentration. For example, if you would have had exposure only to the tech sector when the dot-com bubble burst, your portfolio value would have been impacted negatively.
Similarly, companies in the energy, retail, airline, and hospitality sectors underperformed the markets amid the pandemic. However, companies in tech verticals such as gaming, streaming, e-commerce, and cloud crushed broader market returns in 2020.
In order to diversify your investments, you can also look to buy exchange-traded funds or ETFs such as the S&P 500. In the last five and a half decades this popular index has returned 10% annually and created massive wealth for long-term investors. It provides you with exposure to the top 500 companies in the U.S. Investors in the U.K. can gain exposure to this fund by purchasing the Vanguard-based S&P 500 UCITS ETF (VUSA).
Focus on blue-chip companies
In case you want to generate steady returns over the long term you should allocate a majority of your capital towards blue-chip companies. Generally, blue-chip stocks are companies that have a competitive advantage, a huge economic moat, and enjoy a leadership position in the markets where they operate.
These companies have strong fundamentals, a robust business model, and enviable balance sheets that allow them to perform well across business cycles. The ideal blue-chip company will generate predictable cash flows and will reinvest a part of these to diversify operations and expand their base of cash-generating assets. It should also distribute a portion of its profits to shareholders via dividends.
In a nutshell, a blue-chip company should increase earnings and revenue consistently which will allow it to increase dividend payments over time and increase shareholder wealth. Dividend-paying blue-chip companies allow investors an opportunity to earn a steady stream of recurring income as well as benefit via long-term capital gains.
Follow the stock market closely
The stock market is always volatile in the near term and is impacted by macro-economic events, market sentiment, and economic cycles. You need to track news that will potentially drive stock prices higher or lower and capitalize on these movements.
Publishing platforms such as Plus500 provide investors with a plethora of information that will help you make an investment decision. Plus500’s market news covers business, politics, and economic events that move global markets. Following these publications will help you understand the impact of global events on the stock markets as well as equip you with the required information to purchase or sell a particular stock.
Invest in what you understand
For a very long time, Warren Buffett did not buy tech stocks as he believed this sector to be extremely disruptive. A leading technology company today may become a laggard within the span of a few months. We have seen shares of Canada-based BlackBerry and Sweden-based Nokia crash and burn as they were impacted by the entry of Apple and Samsung in the smartphone space.
You need to follow and buy stocks of a company that is part of an industry that you understand, making it easier for you to analyze its business model as well as the key trends and drivers which impact the long-term prospects of these companies.
The key takeaways
While the stock markets have the potential to create long term wealth they can also destroy your savings if you are reckless and ill-equipped with limited understanding. You need to focus on portfolio diversification which will lower overall risk and have a disciplined approach to investing while having the required expertise to buy quality stocks that can outpace the broader markets over time.