Inspired by David’s First Time Homebuying Guide last week, I wrote this post for beginning stock market investors. Ready to buy your first few shares of stock? Here are five sound pointers to help you get started.
Pay off your high interest debt before you invest
Some financial experts say you should pay off all of your debt before ever investing in the stock market. I disagree. Most of us carry student loans with 10-year terms (or longer) and mortgages with 15 or 30 year terms. If we were to follow this advice, we might never start buying stocks.
What I definitely recommend, however, is that you do pay off high-interest debt, like credit cards, before you start investing.
The logic behind my strategy is simple. We invest to get a positive rate of return on our money over time. Although your personal rate of return will vary, historically the stock market returns an average of between six and nine percent a year. Put simply, it makes sense to pay off debts on which you pay an interest rate that’s higher than, say, 6%. There is no point in investing $1,000 in the stock market to earn 9% if you are paying 24% interest on a $1,000 credit card balance. Conversely, however, it may not make sense to pay off a student loan at 4% when you can earn 6-9% in the market.
Find the right broker to minimize fees and trading costs
Your bank isn’t the only financial institution charging fees. You’ll want to avoid fees when you invest, too.
Whether you’re investing in stocks, bonds, or a mutual fund, remember that fees are hazardous to your financial future. Stay away from brokerage firms and mutual fund companies that charge high fees for the “privilege” of investing. Some companies will charge you a fee for everything from mailing paper statements to speaking with a customer service representative.
There is no reason to invest with a company that robs you of your hard earned money. Every dollar that you pay in fees is one dollar that you lose in potential investment returns. There are a number of low cost brokers that charge nominal trading fees which will leave you with more money to invest. Some of our favorite brokers for first-time investors include Scottrade or TradeKing. ShareBuilder offers an attractive alternavite for investors that want to automatically invest the same amount on a monthly basis.
Diversify your portfolio, but not too much
Everyone knows that diversification is the name of the game when it comes to investing. Diversification helps you reduce risk and gain exposure to different sectors of the market. It’s also important to not to overly complicate your portfolio. This is actually known as “diworsification”. Some individuals buy so many different assets that they actually weaken the performance of their portfolio.
A good example of diworsification is owning a large cap stock fund and shares of Walmart, Microsoft, and Exxon. You may think that you are diversified, but actually you’ve investing in the same stocks twice. It’s important to avoid investing in funds that have the same investment strategy or invest in similar companies. This can water down your returns and cause your portfolio to underachieve the market as a whole.
Do NOT over trade
Your broker or financial adviser doesn’t have to be Bernie Madoff to lead you and your investments astray. Unfortunately, there are unscrupulous brokers that will recommend actively trading in order to generate more commissions for them. This process is known as churning. If you fall for it, these brokers’ commissions and fees will quickly eat up your initial investment.
Actively trading your account will also leave you with a substantial tax bill at the end of the year. That’s because investments held longer than a year are taxed at a 15% tax rate, while investments held less than a year are taxed at your ordinary income tax rate…up to 35%.
Research, research, research
Successful investing is like getting good grades in academia; homework counts. You need to thoroughly research every investment before buying a single share. Research the history and track record of a potential company. Check out the company’s management, financial statements, and future prospects.
There are hundreds, if not thousands, of places on the Web to research potential investments, but a reliable starting place is mutual fund research giant Morningstar. Once you have done your due diligence, you are ready to start investing!
What do you think? What essential advice for first-time stock investors would you add to this list?