5 Steps to Start Investing
How to start investing? Where to start investing? What is the best way to start investing in stocks? These are the three question I get asked the most often by friends and family members, and I assume that there are many people out there who are wondering the same thing. That’s why I decided to share with you the 5 most important things to do when you start investing. This is my opinion, but it has worked very well for me and I wanted to share this with you.
Step 1: Make a Budget
Before you consider starting to invest you should have a good understanding of your current financial status. This means gathering information on all your assets and liabilities that you currently have. The following are some examples of important elements that you should definitely know before investing:
Any real estate you own.
The current value of your car(s).
Jewelry or gold.
Cash.
Value of checking and savings account.
Retirement plans (employer sponsored, IRA, 401K, …)
Student loans.
Mortgage.
Car loans.
Any other large cash inflows or outflows.
In addition, you should also have a good grasp of your average spending habits throughout the month, these could include rent, insurance, eating out, entertainment etc. as well as income. This allows you to create an average spending and income number for the month, that you can then use for your budget. It is important to have a budget for a few reasons:
You will learn about your spending habits and discover positive or negative trends.
You will discover where and on what you are spending the most money.
You will find out where to make cuts in order to have more money left to invest.
Once you have made your budget you will see what amount you have left over after all your expenses are covered. This will be different for everyone depending on your lifestyle, personal preferences, geographical location, and age. Therefore, it is difficult to say what percentage you should have left over at what age.
This step is crucial because you should only invest with money that you can afford to lose. The reason I say this is because if the investment moves against you and all of a sudden you need that money in order to pay of bills, then you will be in a lot of trouble and might even have to file for bankruptcy, something no one wants to do. Therefore, when you invest you should know that there is a possibility that you will lose that money. The last Covid-19 drop in the stock market was an excellent example. Solid companies with good financials took a hit and if all of a sudden you had medical bills to pay and you were relying that money, you were out of luck.
This budget can also be used to set goals for yourself and to develop your investing strategy. For example, do you tend to invest the money that is left over after you’ve bought your necessities and spend some money on entertainment? Or, option 2, do you first spend money on your necessities, then invest a certain amount, and whatever is left will go toward entertainment and fun activities. This is something you have to decide for yourself. I will also address this in a later post.
Step 2: Find your broker
After you’ve made your budget and know exactly what amount you can and are comfortable investing, it is time to find a broker. As an individual investor you will need a middleman to connect you to the market and to place the orders for you. There are many different brokers, each with their strengths and weaknesses. The fellas at Stockbrokers.com have done an excellent job breaking down the differences between the brokers. You can find a summary of their breakdown below. If you want a more detailed description, click here.
TD Ameritrade
Excellent trading platform thinkorswim. After spending hundreds of hours testing desktop platforms, I give thinkorswim my top recommendation, thanks to its modern feel and outstanding trader tools. That includes the mobile app, which is my favorite for active traders.
Great for beginner investors. TD Ameritrade has the largest selection of educational materials in the industry by far, with over 200 instructional videos covering every investment topic imaginable. Furthermore, the whole learning center is gamified, tracking your progress as you go with quizzes bringing concepts together at the end of each course.
Robust research. TD Ameritrade provides customers access to its own TV Network and trader magazine. Depth is across the board, as TD Ameritrade also uses proprietary data to analyze millions of tweets to power its Social Signals tool.
Industry-leading technology. TD Ameritrade is the only broker to offer customers the ability to access their accounts from Twitter, Apple Chat, Facebook, and Alexa. Technology and innovation are core parts of TD Ameritrade's DNA.
Fidelity
Terrific for investment research. Research at Fidelity stands out for its 16 equity research reports, excellent in-house market analysis, and quotes experience that is meticulously crafted for maximum usability.
Great for new investors. Behind TD Ameritrade, Fidelity is my second broker recommendation for beginner stock traders. Fidelity offers investors the perfect blend of ease of use, excellent research tools, as well as a great education center.
Excellent mobile app for everyday investors. The Fidelity mobile app is a winner for investors because it is easy to use, packed full of market research, and includes a wide variety of trading tools.
Charles Schwab
Excellent market research. Schwab boasts a full lineup of 26 in-house experts who provide numerous articles, known as Schwab Insights, on a variety of market topics throughout each week.
Leader in retirement services. Charles Schwab shines with its Schwab Intelligent Portfolios (robo-advisor) and Schwab Intelligent Portfolios Premium (human advisor) services.
E-Trade
Excellent web platform that is a winner for options trading. Our favorite web-platform again this year, Power E*TRADE, combines the best of both worlds: ease of use with fantastic trading tools. While just decent for stock trading, Power E*TRADE is terrific for options trading.
Full-featured mobile apps. Among all the online brokers we track on StockBrokers.com, E*TRADE offers the most mobile app features in a well-designed, easy to use experience.
Interactive Brokers
Excellent for professional traders. Interactive Brokers offers customers an arsenal of 63 different order types, the most in the industry by a landslide. Margin rates are also the lowest in the industry, across the board.
Great for day trading. Interactive Brokers does not accept payment for order flow (IBKR Pro only). This makes it's already low pricing even better because there are no hidden execution costs.
Global access. The most diverse offering by a landslide, Interactive Brokers offers trading in 26 countries and over 125 market centers.
Again, all credit where credit is due. This information is copied from Stockbrokers.com and they provide a much more in depth analysis on their website.
I personally use Interactive Brokers because I do my own research and I don’t have the need for the tools offered by TD Ameritrade and Fidelity. However, I did start off using Fidelity since they provided a lot of research material. This gave me an idea what professional analysts are looking at, but as I developed my own methodology I transitioned to Interactive Brokers. I prefer IBKR because of the low costs and the access to some developing markets that the other platforms don’t offer.
Step 3: Start small
In my post on investing myths I talk about the advantages of starting with a small amount. In essence, when you start investing you are still learning and gaining experience. During this time, it is normal to make mistakes and become emotional about some of the investments you made. It is always better to make these mistakes with small amounts, this takes less of a toll on your emotions and it allows you to build up this experience. Many successful investors say that one of the best things to have happened to them is to make a lot of mistakes early in their career and learn from them.
Also, what I would suggest is to try to make a relatively “safe” investment as soon as possible, if such a thing exists (I’m not talking about 10-year US treasury bills, I am not a big fan of those). What I mean is, look for an ETF that follows the market. The two most famous examples are:
SPY
VOO
IVV
At this point, you will follow the market and at least your money is already making money for you. Also, as you know from my post on investing myths again, it is very difficult to beat the market in the long run anyway, so why not follow it and beat 92% off the professional investors out there. Therefore, an index fund by Vanguard or a stock market index that follows the S&P 500 index are always a good asset to any portfolio.
Once you’ve made that ETF investment, then you have some time to start researching your first investment opportunity. The following 2 steps will cover the most important skills to conduct that research and some helpful books. Currently, I am also working on some articles that will cover how to find your investment niche as well as how I personally research a company or find my investment ideas. So be on the lookout for those.
Step 4: Start building the necessary skills
You will do better than 90% of the investors, if you just invest in an index fund that tracks the stock market. However, if you do want to venture into individual stock picking (which I applaud and support because it is just so much fun), the following three skills are critical and will have the highest return on investment (ROI).
Financial Accounting
You don’t need to be super intelligent in order to invest and be successful, but one area you can’t ignore is accounting and more specific, financial accounting. Below are some thing you will need to know:
What are assets, liabilities, and shareholder equity?
What are the financial statements and how are they connected?
What is depreciation and how does it affect accounting earnings?
Different accounting techniques for different items
There are just too many to list here, and please known that just knowing some ratios is not enough for investing purposes. These ratios are easy to manipulate; therefore, you will need to know how they are constructed and whether or not they make sense. Also, different industries have different standard ratios. Don’t fall for any guru that claims to know what ratios are the most important and how to make money using just these ratios. Ratios are helpful, but they are only 5% of the entire investment research and process, and I’m being generous with my percentages here.
Below I’ve listed some ratios that I think could be important. Not to base your investment decision on, but as a starting point to start investigating the company.
P/E: I don’t like to overpay for a stock and if the market is giving crazy high valuations, that’s a red flag for me.
Liquidity ratios: I think it is important to know how a firm is positioned to pay off its liabilities in time of need.
Cash ratios: I like to know if a firm has cash at hand in case they need it, but also not too much cash which means they are probably missing some investment opportunities.
Earnings ratios: A firm needs to have sufficient earnings in order to exist in the long term.
Another potential use of ratios is to use them as a filter in stock screeners. For example, one of my personal tenants is that I don’t want to invest in companies that harm the environment, so I filter based on ESG scores. In addition, as I mentioned before, I don’t like to pay too much, so I don’t invest in companies above a certain P/E ratio. This ratio differs depending on the industry.
Critical research skills
One of the most crucial skills is being critical. You need to keep an open mind when searching for information and data, but always ask yourself, how credible is the source. Personally, I don’t read analyst reports because I don’t trust them for a few reasons.
Analysts get their information from a variety of different sources, including management. Management will always try to paint a better picture.
Analysts rely on their contacts within the firm they cover. Therefore, if they give a negative review a few too many times, the firm will stop communicating with this analyst, halting the flow of information. Therefore, the analyst has an incentive to report positive information on the firm. This is also the reason why there are so many “buy” recommendations, but just a few “sell”
Analysts are also subject to herd behavior and they follow their peers. For example, if everyone recommends “Apple” and it goes down, there is this idea of “How were we supposed to know, this is just bad luck, all the analysts agree that Apple was a good recommendation”. But, if an analyst recommends this obscure stock that does not have a lot of followers, then two things can happen.
The stock goes up and he is proclaimed a genius.
The stock goes down and he is the only one losing money on it, so he’s in danger of losing his job.
Therefore, it is important to build these critical research skills for yourself. The best way to do that is to stay within your circle of competence (your niche), in an area that you have a lot of expertise. A doctor might invest in healthcare and pharma or an engineer in aerospace and defense. When you do this, don’t be tempted to venture outside of your area because currently the other market is a “hot” market. If you do decide to expand, make sure you read and study that industry well.
These are some of my favorite sources to get data and learn about the industries and sectors:
Financial statements of companies within my industry.
The Economist
The Wallstreet Journal
The Financial Times
Published papers in top tier journals
Talking to friends within the same industry (talk to your gamer friends if you are investing in the gaming industry)
Excel & Financial modeling
This is a technical skill that will be beneficial in many aspects of life. Being able to work with excel fluently will set you apart from 80% of the people out there. Many think they have a good understanding of Excel until they actually take the time to study it. Excel is such a powerful and useful tool that speeds up everything (if you know how to use it). Once you become proficient in Excel, the calculations, assignments, and procedures that used to take hours, can be done in mere minutes or even seconds when you learn how to use the macros. This is especially helpful when trying to value a company.
Once you have an understanding of Excel you can start applying this new knowledge to financial modeling. You will have to learn how to do a discounted cash flow model, how to do scenario analysis to test sensitivities, etc. The first thing to start with would be to model the financial statements and try to predict the line items. This can be very frustrating when you are just starting out. However, if you stick with it you will learn so much more. By doing this you will learn more about financial accounting and how the statements are linked. You will learn how to predict revenues and costs the right way, and you will learn about all the sneaky little tricks management can use to manipulate the statements. Once you’ve mastered this, you will start to see a lot of new elements in the statements that you did not notice before.
Step 5: Expand your knowledge by reading these books
There are tons of books I could recommend to you, and in my top lists you can find lists on the 5 best books for a variety of different things, including investing. However, I did want to bring up two books here that are critical to read in my opinion.
Poor Charlie’s Almanack - Charlie Munger
This book is a collection of some of the best speeches and talks by Charlie Munger. It is packed with valuable lessons that when used correctly set you up for investing success. However, this is not a book where you can sit down and read it in one go. If you do this, you will miss a lot of the important lessons. I would suggest reading this book slowly and take diligent notes. Here are some of my key takeaways from this book:
Start with a “don’t-list” this is a list of things that you definitely do not do. For example, one of the things on my list is “I don’t invest in tobacco, weapons, and coal.” By doing this you narrow down your investment field and create your circle of competence.
Learn from other people’s mistakes. You will make mistakes and you will make them often. The key is to minimize the downside whilst maximizing the upside potential. However, there is no need for you to make all the mistakes yourself. You can learn from professional investors or even friends. Investigate what they did wrong and what you can do to prevent it.
The Essays of Warren Buffett: Lessons for Corporate America - Lawrence Cunningham & Warren Buffett
This book consists mostly of letters to the shareholders of Berkshire and they provide an excellent insight into the mind of Warren Buffett. These are some of my key takeaways from the book:
Focus on finding a good business, don’t focus on the market. Warren looks for businesses that are well positioned in terms of cash and name recognition. He also wants the business have some kind of barrier to entry, a moat as he calls it. This should deter new competitors from joining the market.
Once you’ve located these well-positioned businesses, make sure to buy them at a sensible price, meaning below their intrinsic value and with a margin of safety.
Look at management and their track record.
You do not have to wait to start reading these books until you’ve completed the first 4 steps. You can do many of these steps parallel to one another. In fact, it is my opinion that you should start reading books on investing as soon as possible. This can even mean prior to step 1.