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 At one time everyone is a beginner, even the most skilled investors started out that way. So if you're one of those persons that have decided that they now have an opportunity to put some money away in terms of a real investment portfolio, here is one of those lessons dedicated to investing for beginners that can help you with the basics.
We're going to first cover some of the basics of investing - including the concepts of risk and return. Then we're going to follow up with a recommendation on how a beginner should really get their feet wet in the investment world.
Investing Fears
Certainly one of the things that most first time investors fear is that they will make the wrong investment choice. Others think that creating a small portfolio of stocks is a good way for beginners to start investing. Most people just starting to invest usually do not pour a lot of money into the stock market, so they think it's a good idea to start out slowly by buying a couple of shares of stocks in big name companies. All of the above examples are not very good strategies for anyone that is new to investing.
Risk and Reward
Most beginners believe that the stock market offers them a chance for higher returns on their investment. That's why they're thinking about moving their money from safer accounts - such as money market accounts - into riskier area such as the stock market.
The fact that they recognize the relationship between risk and reward is a very good thing. There are winners and losers in the stock market everyday. The long term rewards of the stock market are traditionally much higher than safer investments such as bank accounts - but it should be that way. Those same investors are taking on more risk with their investments.
The lesson here is quite simple, greater investment rewards do come with greater risks.
Risk for Beginners
The thing that many beginners don't realize is that there are two forms of risk that reside in the stock market - market risk and individual company risk.
Market Risk
Market risk is something that everyone investing in the stock market is exposed to. This is the general risk that the entire market is moving up or down. It is the general direction that the market moves whether it is a reaction to international political events or interest rates. There is very little an individual investor can do about market risk.
A refinement of market risk is industry risk, whereby all companies competing in a certain area all experience a downturn in their outlooks. One could argue that suppliers of telecommunications equipment all went through this several years ago when none of the telecommunications companies were making investments in their infrastructure.
An investor has some control over industry risk because they can steer clear of certain industries - especially if they are selecting individual stocks. But by selecting companies you're taking on a second risk - the risk that the company you've selected will falter.
Individual Stock Risk
The good news is that investors can do something about the risk of an individual company. This risk can be mitigated by investing in a portfolio of stocks - generally ten or more companies - thereby insulating themselves from individual company risk. So if one of the companies you've selected underperforms relative to your expectations, there is a chance that another company you've selected will outperform your expectations.
That being said, there are two ways to build a portfolio of stocks that can effectively lower your investment's exposure to individual stock risk. You can create your own stock portfolio or buy into one that has already been created. Both of these options offer you diversification and that lowers your risk.
How Beginners Can Create an Investment Portfolio
Most beginners investing in the stock market simply do not have enough money to efficiently create a portfolio of stocks themselves. And it's probably not a good idea for someone just starting out in the market to create their portfolio - there is simply too much information to learn before taking that big step.
Instead these beginners are much better off buying into a portfolio by purchasing shares in a mutual fund. But before we talk about mutual funds, let's look at a quick example to explain why building a stock portfolio yourself is expensive.
Stock Portfolio Example
As mentioned earlier, the beginner would need around ten different stocks to diversify away individual stock risk. In order to hold down the transaction costs / fees associated with buying stocks, it is necessary to purchase 100 shares of each company.
If the investing strategy is to purchase blue chip stocks like those appearing in the Dow Jones Industrials, each share of stock will cost the investor an average of around $35. So calculating the total cost of the portfolio we have:
10 companies x 100 shares of stock x $35 = $35,000
In our opinion, $35,000 is a lot of money for a beginner to invest in the stock market - it's simply impractical to expect someone new to this process to put that much money at risk.
Beginners and Mutual Funds
A much better approach is therefore purchasing shares of a pre-assembled portfolio - a mutual fund. Mutual funds offer investors many advantages including:
- Diversification - A mutual fund is a portfolio of stocks, bonds or other securities that are sliced thinly and sold to individual investors. Even if you only have $1,000 to invest, you buy a slice of a mutual fund.
- Flexibility - You can buy and sell fund shares over the Internet, by telephone, or even via snail mail.
- Selection - There are literally thousands of mutual funds an investor can choose from.
- Expert Management - Most beginners are simply not equipped to forecast future earnings per share or prices of individual companies. A mutual fund pays a fund manager to do this job on your behalf.
So it just makes a lot of sense for the beginner to start their investing adventure into the stock and or bond market with mutual funds.
Fortunately, we've got a large store of information on mutual funds; in fact we have an entire section dedicated to this topic. A couple of good beginner articles would include buying an index fund, mutual fund loads and our four part series on buying mutual funds. These articles will help the beginner gain a better understanding of the mutual fund market before making a purchase.
About the Author - Investing for Beginners
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