Investing for Beginners

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At one time, everyone is a beginner. Even the most skilled investors started out that way. This article is going to cover the topic of investing for beginners. This information should provide beginners with a foundation in the fundamental concepts of investing.

In this publication, we're first going to cover some of the basics of investing. This includes the concepts of risk and return. Then we're going to follow up with a recommendation that allows beginners to get started in the investment world.

Investing Fears

Additional Resources

Certainly one of the factors that most first time investors fear is that they will make the wrong investment choice. Some individuals believe that creating a small portfolio of stocks is a good way for beginners to start investing. Others feel you need to start big, and invest a lot of money into the stock market. Finally, others 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 investments, such as money market accounts, into riskier investments, such as common stocks.

The fact that they recognize the relationship between risk and reward is a good sign. There are winners and losers in the stock market every day. The long-term rewards of the stock market are traditionally much higher than safer investments such as bank accounts. The lesson here is quite simple, greater investment rewards do come with greater risks.

Risk for Beginners

Some beginners don't realize there are two forms of risk that reside in the stock market: market risk and individual company risk.

Market Risk

Everyone investing in the stock market is exposed to market risk. This is a large scale risk that the entire market either moves up or down. The stock market may move in either direction due to external factors such as 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 industry experience a downturn in their outlook. One could argue that suppliers of telecommunication equipment 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. By selecting individual 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. If one of the companies selected underperforms relative to expectations, there is a chance that another company will outperform 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 overall investment risk.

How Beginners Can Create an Investment Portfolio

Most beginners that want to start investing in the stock market do not have enough money to efficiently create a portfolio of stocks. It's also not a good idea for someone just starting out to create their portfolio. There is simply too much information to learn before taking that big step.

Instead, beginners may be better off buying into a portfolio of stocks by purchasing shares in a mutual fund. Before we talk about mutual funds, let's look at a quick example that helps to explain why building a stock portfolio 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

Clearly, $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 the process to put that much money at risk.

Beginners and Mutual Funds

A more efficient approach involves 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, and other securities that are sliced thinly and sold to individual investors. Even if you only have $1,000 to invest, you can buy a slice of a mutual fund.
Flexibility - investors can buy and sell fund shares over the Internet, by telephone, or even using snail mail.
Selection - there are literally thousands of mutual funds that an individual can choose from when investing their money.
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.

It makes a lot of sense for the beginner to start their adventure into the stock, and or bond market, with mutual funds.

Fortunately, we have a large store of information on mutual funds; in fact we have an entire section dedicated to this topic. Several good beginner articles include: buying an index fund, mutual fund loads and the four part series on buying mutual funds. These articles will help the beginner to gain a better understanding of the mutual fund market before making a purchase.

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