Stock Investing: A Practical Guide for Beginners

Since 1926, the S&P 500 has delivered an average of approximately 10% per annum, and 7% per annum, net of inflation. This figure tends to be cited far more often than actually seen, as the index has produced returns within 2% of its mean only 6 times out of 93 years of calendar returns. Most years saw returns significantly higher or lower than the average, which is the core characteristic of equity markets over long horizons – volatility.

None of this is meant to frighten one off the prospect of investing in the stock market; rather, the aim is to ensure an investor is properly informed about the potential risks and rewards of participating in any market. The focus is not on attempting to predict the market, which is a futile exercise to attempt, but on gaining an understanding of the asset under consideration, ways to evaluate it, and what behaviors have served successful investors to great effect.

Any investment in the stock market comes with two specific risks – risk, and volatility, both of which are often conflated although the difference is substantial. Risk is the probability of any loss of capital, and volatility is the deviation from an expected direction, or value, over a certain period of time. The former is an investor’s worst nightmare, and the threat from it should dictate the approach to any investment. Volatility, while not as pleasant, is a part of the journey, which is where the two are often confused. For example, new investors might think that a 15% drawdown in the value of their portfolio means that they lost 15% in capital, which is not the case.

Historically, the market data on risk and volatility is also extremely informative. Using the S&P 500 as an example, any 20-year rolling period of returns finished positive, including the periods that began in late 1929, on the eve of the crash. Naturally, those who purchased in 1998 saw a similarly positive trajectory for the next two decades, although not necessarily as attractive as the ones that began in the late 1940s. While there is no indication that the upcoming 20 years will follow a similar pattern, as no asset has an established period of performance, the two types of risk are clearly visible on the graph. Time horizons are the primary force that differentiate the two concepts of risk and volatility. Put another way, any significant drawdown is to be considered a threat to those who need to liquidate their assets in the short term, but a minor fluctuation for those that do not have to do so for years to come.

A share of any company is a fraction of the actual entity and not something akin to a coupon for a prize at the end. The purchase of a share of common stock provides the investor with voting rights and a claim on the company’s assets and profits in the form of dividends; preferred stock sells some of the claims in favor of fixed dividends and voting rights in the event of bankruptcy. For most investors, common stock is the preferred choice, and preferred stock, at least for them, is more akin to a bond.

Some investors, however, do not like estimating the value of individual holdings. Exchange-traded funds, or ETFs, are essentially bundles of different securities, with funds offering exposure to dozens, hundreds, or even thousands of different ones. They trade like stocks, and their very existence is to allow exposure to a broad market without having to analyze each constituent or buy them individually. Their popularity is due to a confluence of factors, including the ability to spread risk across many holdings, and a dramatic decrease in their management costs. In 2020, it is possible to purchase shares of a broad index fund for less than 0.1%, compared to several funds that saw their expenses increase over the past decade.

Opening your first account is reminiscent of booking a flight without deciding on your destination, and the main reason behind it is the lack of financial awareness. Before opening a brokerage account, it is vitally important to calculate one’s true capabilities, based on the knowledge of one’s income, liabilities, and disposable income. Any amount of money that might be required in the year ahead should not be invested in the stock market, and the same logic is applicable to all other time frames.

After selecting the appropriate account, the second phase of the learning process begins; understanding the orders is crucial to executing the trade. At the most basic level, the first two order types can be described as market orders and limit orders. The former are executed immediately at prevailing prices, whereas the latter is placed at a specified price per share, either above or below the current one. The market order provides certainty of execution, while the limit order provides control over the entry/exit point. The stop order is different, as it is placed below (or above) the current stock price, and it functions as a market order once that point is reached; it is mostly used to limit downside risk.

It is also essential to adhere to the principle of dollar-cost averaging before entering the market. It refers to allocating equal sums of money at regular intervals, which can reduce the risks substantially during volatile periods. It does not provide certainty of a low entry point, the concept of which is illusory at best. It does, however, remove the guesswork from investing, as a fixed amount, transferred regularly, will always be sufficient to purchase a certain number of shares. It is this principle that makes 401k plans as effective as they are, as an equal amount of money is allocated to the retirement fund every month, regardless of income or any circumstances.

Identifying value is not about finding gold, or any secret information, but about applying one’s analytical skills consistently.

Like in all human activities, there are patterns in finance, which are often repeated by successful investors. For an investor, identifying value is a matter of finding a security that offers a combination of quality and price. The price of a given security is not what it says; it is always found in the future, when the stock has already delivered its value. A given price is only valuable in context, because it is the expectation of investors that it reflects future performance, or, rather, a certain version of it. As a result, an investor should think of value as a combination of quality and price; the former is the potential value, and the latter is the margin of safety.

Market capitalization is the simplest way to determine what category the company falls into, and it is the most straightforward. There is no established agreement on the dividing lines, so some authors use the $10B threshold to denote large caps, while another group would put companies worth $2B to $10B into the category of mid caps. Those with a market value of $2B or lower are small caps.

Within this framework, the differences between the three categories are also easily observable. Large caps typically have less room for growth and are slower in their development, while small caps do not possess that luxury. The lower market value translates to increased risks, and those who opt to buy smaller companies tend to sell at lower prices.

It is also evident that the risk/reward characteristics of these categories differ, but there is no superiority between them. A portfolio that consists of solely large caps is just as narrow as the one that contains only small caps.

There is no shortage of reasons why patience is a virtue in the markets, but this is the point when it actually pays off. If any shares are sold within a year of purchase, the tax liability accrues at ordinary income tax rates. These are, simply put, the highest rates for income from any source, up to 37% at the federal level. On the other hand, if shares are held for more than one year, the tax liabilities are dictated by the long-term capital gains tax, which rarely exceed 20%, and, depending on the taxpayer’s income, can even be 0%.

This discrepancy exists to reward patience, as investors who bought and held onto their investment for a long period of time are being compensated with lower tax liabilities. It is another factor that tilts the scales in favor of long-dated investing, with all of the benefits that it entails.

It is no surprise that a significant portion of an investor’s time is spent trying to beat the market, especially with the rise of indexing in recent years. While it requires no effort to participate in the index returns, the evidence suggests that most investors will underperform their funds, even those that they purchase directly. According to Morningstar research, published under the title “Mind the Gap,” those who invested in mutual funds underperformed their holdings by approximately 1.2% per year for the decade that ended in 2024. Effectively, they surrendered 15% of the potential value of their portfolios over the specified period. In 2024 itself, which saw a strong year for stocks, the S&P 500 delivered 25.4% total returns, with the average equity fund investor only realizing 16.5%, according to DALBAR.

The issue was not the funds themselves, but the actions of the investors, as buying after the rally and selling during the downturn is the most common manifestation of behavioral patterns. This is the rationale behind the suggestion that the majority of investors do not benefit from timing the market; investors must adhere to a strategy, not the other way around.

Investing well isn't about predicting what happens next; nobody reliably does that, professionals included. It's about understanding what you actually own, sizing your bets to your own timeline and temperament, and staying invested through the volatility that's always been part of the deal. History doesn't promise the next ten or twenty years will look like the last ones. But it does suggest that the investors who do best tend to be the ones who understood what they were holding, and then largely left it alone.

This article is for general educational purposes and isn't personalized investment, tax, or financial advice. Investing involves risk, including the potential loss of principal, and past performance doesn't guarantee future results. Consider talking with a licensed financial advisor or tax professional before making investment decisions.