3 Things to Know About Investing in Stocks

Some Basics Every New Investors Should Know About Investing in Stocks

3 Things to Know About Investing
There are three important basics you should remember before you begin investing in stocks. By arming yourself with this knowledge, you stand a better chance of growing your capital and doing something foolish. DNY59 / E+ / Getty Images

It's no secret that investing in stocks has been one of the best ways to accumulate wealth; that stocks, as an asset class, tend to trounce everything else on an after-tax inflation-adjusted basis provided you have constructed your investment portfolio intelligently due to the productive nature of the underlying operating companies.  Nevertheless, many investors don't seem to intrinsically understand how investing in stocks works.

 This causes them to become their own worst enemy as they misguidedly treat shares more akin to lottery tickets than proportional ownership in a real operating company with sales and earnings they can enjoy, some of which arrives in the form of a cash dividend.

Let's take this opportunity to clear up three things you need to know before you acquire your first share of stock.  By laying the misconceptions out on the table, you have a better chance of arming yourself against risks you may not even realize you are taking as well as tempering your expectations to more reasonable levels.

1. Stocks Follow Their Earnings Over the Long-Term But Can Fluctuate Wildly Over the Short-Term

Over time, a company is only worth the profit it generates for the owners. Stock market bubbles can’t last forever and even the worst economic depression comes to an end.  Academics such as Dr. Jeremy Siegel has proven that most of the inflation-adjusted returns from owning stocks come from profits paid out to owners as cash dividends.

One way to protect yourself is to make sure you don’t pay too much for a stock relative to the earnings by looking at the earnings yield.

Nevertheless, the stock market is a giant auction at its core.  This means that from time to time, investor sentiment and structural challenges may result in equity prices deviating substantially from the real, underlying intrinsic value of a firm.

 I'm always a fan of using real-world illustrations to drive a concept home so let's consider something I wrote about on my personal blog - an investment in shares of PepsiCo, one of the world's largest beverage and snack conglomerates.

Imagine that on the day I was born in the early 1980's, you invested $100,000 into shares of PepsiCo.  Excluding reinvested dividends, today, you'd be sitting on more than $6,600,000 in wealth consisting of ownership in two different companies thanks to a tax-free spin-off.

What few people realize is the journey it took to get there.  Specifically, they fail to consider time experiences such as Black Monday.  In case you aren't familiar with it, it's time for a refresher.

When you went to bed on Friday, October 16th, 1987, you would have been sitting on $229,425 in PepsiCo stock at its then-current quoted market value.  Specifically, you would have held 6,900 shares at $33.25 each.  When the market opened on October 19th, with little to no warning you would have watched your ownership stake collapse to $148,350.  Before you had time to fully understand what was happening, more than 35% of your equity value had gone up in smoke.  That's $81,075 of PepsiCo wealth obliterated from your balance sheet.

 For the long-term owner, it didn't matter.  It was a meaningless distraction because Pepsi was still selling just as many cases of Pepsi and Diet Pepsi.  Customers weren't suddenly giving up their favorite carbonated beverage.  The cash registers at corporate headquarters will still ringing as the number two soda company in the world brought in earnings from the four corners of the map.  The p/e ratio and owner earnings were still attractive.  The dividend was still growing.  This was nothing like the later overvaluation experienced at the turn of the millennium when price drops were justified by the prior excessive optimism built into equities.

If you had panicked and sold your PepsiCo ownership at this time, you never would have turned your $100,000 into more than $6,600,000.  In fact, were you to reinvest your dividends, that drop would have made you even richer because of a phenomenon that I spelled out in an article I once penned on shares of the oil majors.

If you invest in stocks, you will experience something similar.  It cannot be avoided.  It's the nature of the equity markets.  Rather, you stick to either a valuation or systematic approach to accumulation and stay the course through thick and thin, making sure your portfolio weightings remove a lot of the risk.

2. Do Not Borrow Money to Invest in Stocks.  This Includes Only Holding Your Stocks in a Cash Account.

Another mistake new investors make is using borrowed funds to pay for stocks.  This is almost always a terrible idea that can lead to catastrophic real-world consequences.  We've talked about the dangers of margin debt in the past, reasons you shouldn't use margin debt even if the interest rate is low, how margin calls work, and even the reasons you should put your stock investments in a so-called cash account and not a margin account.  

It mostly comes down to the fact that when you borrow money to invest in stocks, you are inviting another person or institution which may not have your best interest at heart into the decision-making process; a person or institution that can force you to liquidate your wonderful ownership stakes at terrible prices when it is quite literally the worst possible moment to do so all because you were greedy to get a little richer a little faster.  In an extreme case, you get a situation like Joe Campbell.  The guy had around $37,000 in an account at E-Trade and shorted a stock that he believed was destined for bankruptcy.  He turned out to be right.  The company did go bankrupt.  Only, before it did, the stock price increased exponentially, he found himself $106,445.56 in debt after losing the entire $37,000, and his broker closed out his position so he didn't have the ability to hold until the ultimate wipe-out that would have caused him to turn a profit.  It is not wise to live this way.

This principle goes beyond buying stock on margin.  It includes prudent debt management in your personal finances.  You simply cannot get ahead, even investing in stocks, if you have credit card debt. Even though this doesn’t fall within the purview of investing for beginners, I’ve written about credit card debt on my personal blog, including some ways to avoid it and the surprising fact that 55% of all households in the United States have no – absolutely zero – credit card debt. The bottom line is you can’t get rich paying 20% interest on your debt, while collecting only 3% dividends from your stocks.  It isn't normal to be in credit card debt.  One popular financial expert has been known to remind people that the very first month a bill arrives that you can't pay in full, you have a problem. I wholeheartedly agree with that.  Get out of debt.  Stop all of the nonsense about "good debt" and "bad debt" and realize that risk reduction is sometimes more important than your compound annual growth rate.

3. Stock Splits Are Economically Meaningless.  A $50 Stock Can Be Cheaper than a $300 Stock.

Sometimes new investors get excited over stock splits.  It makes no sense.  Other than making shares more affordable for poorer investors, a stock split is a meaningless accounting transaction; equivalent to getting two $10 bills instead of a single $20.  As a result of past stock split and capital structure decisions, it is entirely possible for a stock trading at $10,000 to be less expensive than a stock trading at $15 per share.  To help walk you through the math, I wrote about this in an article called How to Think About Share Price you might want to check out when you have a moment.

More Information About Investing in Stocks

To learn more about investing in stocks, take a few minutes to read the comprehensive guide I put together for new investors called The Complete Beginner’s Guide to Investing in Stocks. It contains dozens of articles and resources to take you through the fundamentals.