Below are some research-based principles of buying stocks and shares for beginners. First learning the stock market can be complicated. Sticking to these five basic principles will help to maximize your returns.
Principle 1: Stocks Have High Returns But are Risky (Risk-Return Tradeoff)
For those interested in learning to invest in stocks, the good news is that stock market returns have averaged about 10% per year since inception, which makes them one of the highest-returning investment options for the average person. According to basic economic theory, however, these handsome returns must come with higher risk, which means that their values will fluctuate up and down widely as they trend upward over time. If you can stomach these upswings and downswings, stocks can slowly make you rich. The bottom line is that you must keep a stock portfolio long-term and avoid the urge to sell during market downturns. This is one of the most critical lessons of trading stocks and shares for beginners since the frustration and urge to dump shares can be so strong.
Principle 2: Stock-Picking May be Too Competitive to Get an Edge (Efficient Market Hypothesis)
Nobel Prize winner Eugene Fama published an absolutely pivotal finance article in 1970 called, “Efficient Capital Markets: A Review of Theory and Empirical Work.” He presented convincing data that the stock market is quite efficient, stock prices reflect all available information, and that attempting to pick so-called good stocks to invest in cannot win you larger returns (unless your portfolio is riskier). For example, mutual fund managers that outperformed the market in one period tended to not do so in the next period, indicating the higher returns were purely luck.
There are millions of competitive investors, all with access to the same information (except those doing insider trading, which is illegal), all competing for high returns, making “beating the market” extremely difficult. Picking companies because you like them is not how to invest in stocks: the research shows this won’t work.
In 1973, Burton Malkiel published an investment classic called A Random Walk Down Wall Street. He provided strong evidence that stock prices are random, and has continued to do so. Decades later in the 2007 edition of the book, one study looked at the returns of the 20 top-performing equity funds in the 1980s to see how they did in the 1990s. In the 1980s, the top 20 funds beat the S&P 500 by 3.9 % annually. In the 1990s, these “winning funds” then lost to the S&P 500 by 1.2 % annually, showing that the initial winners were probably just lucky!
This posed a problem for all investors seeking higher than average returns because if stock prices are random, stock-picking would of course be useless! Just like the aforementioned Efficient Market Hypothesis, this argued that no individual investor can do any better than average consistently because stock market predictions are largely impossible.
This is also one of the most important stock market tips for beginners, since most investors want to actively buy and sell “winners,” but the research shows picking “hot” stocks is largely a waste of time.
Principle 4: Keep Costs Low to Maximize Returns
There are a multitude of online stock brokerage firms out there, with widely varying commissions per trade. For mutual funds and ETFs, expense ratios (how much the fund manager is charging you) differ widely as well. As shown in principles 2 and 3, however, if the stock market is incredibly competitive and random, paying higher commissions will only get you lower returns.
As referenced in The Elements of Investing, The Lipper and Bogle Financial Research Center published a study of fund returns from 1994 to 2008, breaking funds into four groups by fees. They found that the quartile with the lowest fees outperformed the quartile with the highest fees by about 2.6 % annually. Firms may promise added value with better research and superior customer service, but the bottom line is that high fees and big expense ratios generally are not worth it. Stick with funds with low expense ratios (such as those offered by Vanguard) and a discount broker such as Options House.
Principle 5: Market Capitalization and Value Characteristics Can Outline Expected Returns (Three Factor Model)
The competitive nature of humans makes most of us search for the best stocks to invest in. One triumph for people wanting to beat the market came in 1992 when Eugene Fama and Kenneth French published “The Cross-Section of Expected Stock Returns,” which showed that in addition to the outperformance of risky portfolios, small cap stocks tend to outperform large cap stocks and value stocks tend to outperform growth stocks. These are great stocks to watch.
Of all these tips on stock market investing for beginners, this one will be the most difficult to grasp at first. To make it simple, a diversified small cap value index fund is a safe way to exploit these returns. One I recommend is VISVX, the Vanguard Small Cap Value Index Fund. From its inception in January of 2000 through December 2012, it returned 110.14 % vs. the S&P 500’s -1.06 %. Read more research about this incredibly useful finding in our post about picking which stocks to buy now.
The above points are a concise guide of how to invest in the stock market for beginners. There is an endless amount of stock market research out there, but if you start with these 5 principles, you will be well on your way to optimizing your returns and minimizing costs.
If you enjoyed reading this article, click below to share.
Fama, Eugene F. “Efficient Capital Markets: A Review of Theory and Empirical Work.” The Journal of Finance 25.2 (1970): 383-417. Print.
Fama, Eugene F., and French, Kenneth R. “The Cross-Section of Expected Stock Returns.”The Journal of Finance 47.2 (1992): 427–465. Print.
Malkiel, Burton G. A Random Walk down Wall Street: The Time-tested Strategy for Successful Investing. New York: Norton, 2007. Print.
Malkiel, Burton G., and Charles D. Ellis. The Elements of Investing. Hoboken, NJ: Wiley, 2010. Print.