CityFALCON’s goal is to provide our users with digestible data to inform investment decisions. For those who are beginning their journey into value investing, we would like to extend our welcome by helping you start off in the right direction.
A preliminary question: what is value investing? If you’d like a longer explanation, see our in-depth article here. For now, it is enough to know that value investing seeks out undervalued stocks for the sake of capital appreciation. Finding the undervalued stocks is only half the battle because staying firm in your decision is difficult as the market winds its way through time.
Here we’ve compiled a list of 10 of the most common questions about how to invest in the stock market.
1. What is an appropriate amount of time to spend on research? How to start investing in stocks?
To answer this question, it is first necessary to decide your strategy: trading or investing. If you’re day-trading, you will probably spend much less time researching fundamentals and more time on technical analysis of charts. For trading, though, you will likely spend your day glued to the markets, so you will have to determine if the income you earn at trading is greater than a day job. The day-job consideration is less applicable if you trade foreign markets with a large time difference.
On the other hand, if you will invest long term, you will need to spend more time on researching the fundamentals. This may only be a couple hours to several days per company. Note that it is unwise to invest “on a hunch”. Stock markets are complex systems, and there are myriad factors that influence pricing. With long-term investing, you are freed from the consideration of “does this earn more than my day job” because ideally you can keep your regular job and do research at your leisure.
Comparisons of important ratios, like P/E and short interest, a thorough analysis of the financial statements, and digestion of news and management concerns of the company may take several hours to several days, depending on your familiarity with the industry, your experience with analysis, and the visibility of the company (lesser known companies may be harder to research). In value investing in stocks and shares, since you are looking for undervalued companies, this could take a long time. Stock screening is a good method for sifting through the mountain of potential picks.
2. I bought a stock at £100 and now it’s hovering around £80. What should I do?
Do. Not. Panic. That is one of the most important pieces of advice anyone can receive when learning stock market basics. Panic leads to poor decisions, and poor decisions usually lead to money lost. There are two steps you should take when you realise your investment is not appreciating: validation of your investment thesis and adjustment of your strategy.
First, a price depreciation of 20% is a non-issue if your strategy is a long-term, dividend producing one. You can simply consider your investment a long-term, illiquid one, so you have to wait a long time for the price to rise again. Furthermore, if the company continues to pay an acceptable dividend, there is little reason to sell.
If you are invested for capital gains, you should validate your investment thesis before you sell. Read recent events and try to determine what caused the price decline. If it seems more psychological than fundamental – and psychology plays a huge role in day-to-day market movements – there is little reason to worry. An efficient market will eventually turn rational, and a solid investment thesis will prevail. Price corrections are also a common element of price movements, so do not feel that prices are moving in response to important news; they may simply be cooling off after a rapid rise.
If your thesis is still valid, consider buying more. This will lower your average entry price, which will mean more overall gains in the future. Conversely, if your thesis is no longer valid, you should exit. Emotional trading is a losing strategy. If your logical thesis is wrong, do not deny it: take the loss, exit the stock, and reinvest the remaining capital in a stronger candidate. Admitting failure and preserving your capital is better than saving face and losing your capital.
3. What if my thesis is invalid? My stock is down 80%. How much more could it fall?
Theoretically, it could fall to zero. But that’s rather unlikely unless there is an impending bankruptcy. At 80% value lost, you can only salvage 20% of your capital. If you recently determined your thesis to be invalid, exit the trade. There is no shame in adhering to your rules, and even if you’ve lost most of your investment, it is better to leave. It is very important to remain logical and detached from your investments. Diverging from strict adherence “just this once” is a dangerous game to play.
However, when validating your thesis, keep in mind that changing fundamentals may lead to an adjusted thesis. If your new thesis suggests the stock is currently undervalued, there is no reason to sell it. Ask yourself – would I buy this stock today? For example, if your first thesis suggested a 20% drop, you are down 80%, and your new thesis suggests a 50% drop (from the original), there is still plenty of room for the stock to rise again. Invalidation of the original thesis requires adjustment, not mechanical selling. If you are confident about your new thesis, this may even be a good time to increase your position at a low price.
4. Adding stop losses to value investments?
Stop losses are useful for traders who have a low-risk tolerance because they make many trades. For long-term investors, though, you don’t want to set tight stop losses. Daily market noise will trigger the stops, even if the overall trend is not downward. Moreover, value investing (and particularly deep value investing) is often a contrarian trade. This means you should expect the market to disagree with you and be prepared for the stock to continue falling. As long as your thesis is valid, there’s no reason to exit the trade, even on downswings.
5. How should I buy when the market seems like a “falling knife”?
As value investor, a falling knife could be a good time to buy. Remember the Warren Buffett adage: “Be fearful when others are greedy and greedy when others are fearful”. Panic selling is definitely a fearful reaction. Rapid onset of a falling market is not necessarily a reason to buy, though. If you don’t have time to do research, do not enter a market simply because it is down.
If you already have positions in stocks that are falling quickly, after ensuring your investment thesis is still valid, you should consider buying more. Each investor should set their own schedule, but buying more stock when the stock is cheaper lowers the entry point. One strategy is to buy a certain dollar amount of stock whenever the price is down a certain percentage. Another is to buy a percentage of your target exposure whenever the stock is down a certain percentage.
The first strategy may manifest as follows: the stock is down 15% for the week, and you buy $500 worth. The second strategy manifests differently: the target exposure is 500 shares, so every dip of 10%, no matter what the current price, you should buy 100 shares. The former strategy allows for a variable number of dips to full exposure but a constant investment amount. The latter strategy is just the opposite: a constant number of dips to full exposure, but a variable investment amount. Your strategy is dependent on which one you want to control. If your available capital is tight, it is better to employ a constant amount strategy. If you are more focused on hitting your exposure target, the constant dips strategy is better.
6. What are some stocks I should avoid?
Low liquidity stocks, which are very often over-the-counter (OTC) stocks. OTC stocks are also known as pink sheets or unlisted stocks. The most famous kind of OTC stock is a penny stock.
The low liquidity makes it very difficult to exit a trade, and you may not even be able to buy a decent number of shares without moving the market yourself. The information and analysis on these companies may be difficult to find except for information published by the company itself, which raises conflict of interest concerns.
Furthermore, penny stocks are highly susceptible to pump-and-dump schemes. The low price and liquidity allows fraudsters to buy low, and their trades may be the only recent buys. They then engage in a misinformation campaign, largely on forums and websites that cover penny stocks, which entices people to buy the stock, increasing liquidity and the price. The fraudsters exit when they sense a lull in interest and the price collapses with no fundamentals to prop it up. Due to the limited information available, many people experience FOMO, buying at the peak then losing during the crash. Unfortunately for penny stocks, the crash is rarely a correction. It’s a return to rational price levels, which are low for a reason, and they never return to the peaks.
Low liquidity OTC stocks may be good for gambling, especially on biotechs awaiting FDA approval or some other regulatory bottleneck. But it is just that: gambling.
7. How many stocks should I buy?
Do not overextend yourself when investing in stocks and shares, especially if you’re a beginner. Since you need to periodically monitor your investments, and in times of turmoil you may want to keep closer track of all of them, investing in too many stocks will result in confusion. While diversification is important, it is difficult to obtain on your own. Simply due to transactional costs, it is better to use ETFs and mutual funds to obtain diversification.
The investment thesis requires periodic validation, and from Question 1 in this article, you know it may take significant time to update yourself on the status of the stock. If you find follow up research requires two hours a week, do not buy twenty different stocks. That’s a full-time job just reading and processing new information, not looking for other investments or enjoying life.
We have an entire article dedicated to portfolio allocation, which will help you understand the best way to allocate your capital in a beginner’s portfolio.
8. Am I better off investing in ETFs and Mutual Funds (MFs) or directly?
For the beginner, using ETFs is a really good way to achieve diversification without the significant time and capital costs involved. As detailed in the above-linked allocation article, a three fund portfolio consists of three broad-exposure indices: one in bonds, one in domestic equity, and one in international equity. In fact, gaining quality exposure to foreign markets may be very difficult for retail investors, so ETFs and MFs are the perfect mirror asset.
Even better, ETFs allow investors to experience leverage without the risks of using margin. After an investor experiences leveraged losses, s/he is much more likely to regard leverage with the respect it deserves. ETFs allow the investor to experience those losses without the added risk of losing more than the initial investment.
The biggest drawback to ETFs and MFs is the investor cannot actively choose the basket of assets. There is a plethora of ETFs and MFs that track a wide range of sectors and investment strategies, but since value investors are stock pickers by definition, it may be difficult to find severely undervalued picks while using ETFs and MFs.
All in all, new investors should seek standard market returns, which are easily accessible through ETFs and MFs. They can use their extra time to research a few value candidates on the side, and when they finally feel confident in one of their picks, they can reallocate a small portion of the portfolio to the new pick. Overall, though, the vast majority of a beginner’s portfolio should make use of ETFs and MFs.
9. What is the standard market return? What returns can I expect?
The average market return is the return generated by passive investing. In recent years, this has been a very good return, as the markets plunged during the Financial Crisis but have generally moved upwards since. In our article on 2018 Investment Bank Predictions, we noted that active investing is now favoured (in part due to the long bull run’s potential effect on passive investing). Some ETFs are actively managed, but for new investors, simply tracking the market is sufficient to make a return. Investment in simple indices would have yielded the following returns (in percentage points):
And below is a chart showing how much a 1000 currency unit investment would be worth after applying the gains from each year (currency unit can be GBP, USD, EUR, etc.).*The links here lead to the sources. For the Nikkei, we calculated it ourselves, with open-to-open prices.
*same sources as above, but we calculated the output in this chart ourselves
The table above assumes no trading activity at all: a position of 1000 units was purchased on Jan 1, 2011 and never sold or increased. If you want a more granular picture with more adjustment, you can check out this nifty SP500 compound returns calculator.
Of course, 2011 to 2017 was a strong bull market, as seen below. Had you invested in late 2007, you would have to wait until 2012 or 2013 just to break even. Regarding the “falling knife” in late 2008, it should be very clear to anyone in the market that the Financial Crisis was happening. Unfettered panic and extreme uncertainty about the very foundations of the financial system should suffice to make one take a cautious approach to your investment thesis.
All-in-all, a passive approach to investing in a broad-based index will likely net decent returns. Individual stock and ETF/MF picks will certainly offer more reward, but they come at a higher risk.
10. Can I become a millionaire if I invest in the stock market?
Sure. But the better question is: what is a reasonable expectation for my future wealth, based on my current capital, strategy, and timeline? It is easier to make millions in the market if you already have millions, but one should never underestimate the power of compounding returns. If you could somehow pick the top gainer every day, you could probably become a millionaire within a few months, even if you started off with £100. That is exceedingly unlikely, though.
What is much more reasonable is a steady, market rate return on an annual basis. Let’s assume you started investing in 1998 with a 20-year horizon (to 2018) and had an initial capital outlay of £5000. You decided to use the SP500 for your passive investment strategy. Your final return, just on price, would be £13,490.40. If you had reinvested the dividends, you would have £19,415.80. Clearly, you are not rich. However, realize this is a one-time investment of £5,000 in 1998 without ever touching it again. Not too bad, though these are nominal terms (inflation would make this less impressive).
Of course, 2008 hit portfolios hard. It would be considered a “black swan event”, meaning it is exceedingly rare. With the same base scenario but starting in 2011, you would expect to come out with £10,453.75 and £12,000. Still not rich, but £5000 is much less in 2011 terms than 1998 terms, and you would have avoided the global collapse and the associated significant losses.
Therefore, as a passive investor, it is unlikely you will become a millionaire unless you start with a lot of capital. Of course, greater risk means greater reward, and if you manage to beat the market (something notoriously unlikely to happen consistently), you can certainly turn £5000 into much more than £20,000 in a couple years. Active investing theoretically can net considerably more gains, but losses are also deeper or more likely.
Realistically? Expect market return or slightly more, but don’t expect to become a millionaire. It could affect your strategy by making you too emotional.
Investing in the stock markets At CityFALCON, we want to be able to help beginners get started in the stock markets. You could start with our wizard here.
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