Editor’s note: This article was first published in September 2021. Its question whether the bubble will burst “this 2022” was written in 2021, and its mention of treasury bonds paying even 1% reflects the 2021 interest-rate context.
These are a few very condensed tips that every investor should know before they start investing in the stock market. They may seem simple, but forgetting them is what leads you to make the most common and serious mistakes in stock market investing.
These are the starting points I would recommend to any investor, so they can later go into each one in more detail.
I also recommend this more complete and advanced article, where we explain the most common and serious mistakes in stock market investing:
See also: The mistakes you should avoid when investing in the stock market
14 things you should know before investing in the stock market
1. With equities there is never 100% certainty
The only certainty in investing is that there is no certainty. These are equities (variable income, as it’s called in Spanish), so there is no such thing as a safe investment, however sure of ourselves we may be. Even so, you have to take risks if you want high returns, but always from a place of humility, never from a sense of perfection, because you are not perfect. That’s why the usual advice is to invest money that:
- You don’t need to live on.
- If it came to it, you could afford to lose.
The thinking of the Stoics applies here.
2. When you invest is everything
As in any business, you make more money when you buy than when you sell. It’s not about what you buy, it’s about what you pay for what you buy. The moment you buy can make all the difference to the return on your investment.
Buying at the peak of a bull market, when a stock trades at 40 times earnings, is not the same as buying that same stock at the bottom of a bear cycle, when it trades at just 12 times earnings. To understand timing, I recommend taking a look at the phases of a financial bubble. There we explain how smart investors invest at the ideal moment, which is usually when everyone else is afraid to buy.
3. In the stock market, the margin of safety is everything
Getting in when a stock is extremely cheap gives you priceless peace of mind later, when, much higher up, the stock is struggling to break through technical resistance levels. With a reasonable margin of safety, your question won’t be whether or not to cut a loss. It will be whether or not to take your profit now.
And again, this comes from choosing the moment you buy into a company. We can say we are buying with a good margin of safety when a stock’s intrinsic value stays the same (or rises) while its share price falls. The wider that gap, the bigger the margin of safety in our investment.
4. The market is never wrong. The investor is
When you speculate on what a stock ought to do given events, you should know that the market, the stock and investors can stay wrong for longer than your pocket can hold out. (Keynes said this.)
However smart you are, when you think a company or a market is going to rise, on the other side there is a bearish investor, probably smarter than you, who after their own analysis and outlook has reached the exact opposite conclusion.
In the stock market you have to follow two principles:
- Nobody has any idea whether the market will go up or down in the next 5 minutes, 3 weeks or 5 years.
- In the long run, the stock market tends to rise because the economy has been growing at 9% a year.
All we want you to understand is that, although the market will go up, in that intellectual battle between bears and bulls, whoever gets a short- or medium-term “bet” right will only have done so because they had a bit more luck this time, not because their arguments were more or less correct. Anything could have happened. In the end, only the market will be right. And the market is never wrong.
5. In stock market investing, being a contrarian pays best
The most successful investors tend to be contrarians, while the rest either lose money or insist that a sensible return from investing is 8% a year.
Staying away from popular opinion has historically produced excellent results and higher returns.
(Read: How Warren Buffett analyses stocks before investing)
6. There are no shortcuts or magic methods in stock market investing
Investing in the stock market is not as easy as some make it look, nor as complicated as others would have you believe. One thing is clear: there is no magic formula or method that will have you making profits every day while you travel the world in your private jet on the way to the mansion you’ll drive to in a Ferrari (all thanks to the trading course you just bought).
The numbers were worked out long ago. 90% of traders consistently lose money, and most of those who do make money earn lower returns over a 10-year period than diversified long-term investors following a passive investment strategy.
If you’re thinking of getting into the stock market through day trading and you disagree with what we’re saying, don’t worry. You’ll end up agreeing. Others have already been where you are right now, and you’ll end up going through what they went through.
7. Don’t forget about dividends
When people talk about investing in the stock market, for some reason they forget the returns you get from investing in companies with a high dividend yield. Plenty of fallacies have sprung up around dividends, but dividend investing is still one of the most profitable strategies there is.
Bear in mind that we don’t just benefit from the appreciation of the shares in our portfolio over time; we also collect dividend payments throughout that time, which helps increase the total return on our investment portfolio.
You’ll be told that dividends are a scam. Those arguments are fallacious.
You’ll be told that Warren Buffett doesn’t like dividends. That’s a myth.
And finally, in this article we explain in detail which companies offer the best dividend yields and how to follow a dividend investing strategy.
8. The purpose of all saving should be investing
Holding cash with no plan to invest it (in fixed income or equities) also carries risk. Don’t underestimate how much money loses value when it is exposed to inflation. The goal of saving should be to set money aside for investment.
Choose the type of investment you feel most confident about, but invest. In treasury bonds, even if they pay 1%, in investment savings accounts, in fixed income or equities, but invest.
9. You should know the 3 most profitable types of investment
Stocks are more profitable than bonds, while real estate has been one of the biggest generators of wealth, alongside the stock market.
- Bonds: they tend to offer a good risk/return balance (they are fixed income), at least at certain times. The risks are very low. Bonds represent a financial obligation of a debtor (usually a government) to pay the bondholder within the agreed time.
- Stocks: they represent a share of ownership in a company and a right to part of its profits in the form of dividends, plus the added appreciation of the shares as the company grows and increases its sales and profits.
- Real estate: it represents the ability to use a space, where the property’s appreciation would generate a profit if we sold it later on. It can also generate income in the form of rent, which would be the equivalent of the dividends a stock pays.
Note: the problem with property is that, as a general rule, you need a lot of money to invest in it, since investing in property with the aim of speculating doesn’t mean buying with a mortgage and waiting for the property to rise in value (although that is done too).
(See: The most profitable portfolio diversification for financial success)
10. Diversifying your investments isn’t always advisable
It depends on how much money you want to put to work:
- If you have a large amount of capital (over 1 million euros), you should diversify into large, low-volatility stocks that pay good dividends. Probably with a percentage in bonds.
- If you have a medium amount of capital (90,000–300,000 euros), you should diversify by putting one percentage into low-volatility, dividend-paying stocks and another into stocks that could be considered investment opportunities. Even a small part into riskier stocks.
- If you have a small amount of capital (5,000–10,000 euros), it’s not about aiming at everything that moves, but it’s not about diversifying either. It would probably be a good idea to put all your eggs in one basket, or perhaps in two.
11. You should understand at least the basics of technical analysis
Don’t make any buying decision if you haven’t looked at the chart first, or if you have trouble understanding it. You don’t need to be an expert in technical analysis, but you should at least know enough to see where the stock has come from: where it was, where it is, what its highs and lows were and what resistance levels it will run into.
You can see the most common technical chart patterns here (part 1) and part 2.
12. Your total return is your gains minus taxes
Remember something many investors forget in the excitement of taking profits: the real profit from an investment is what you collect minus taxes. In other words, your net profit is much smaller than your profit before tax. Many people are surprised afterwards.
13. In stock market investing, a little knowledge is no use
In investing, having a little knowledge can actually be worse than knowing nothing at all. Reading a book about Warren Buffett’s investment method doesn’t make you Warren Buffett. Before you jump into investing, try, if not to be an expert, at least to be competent at it.
But let’s not twist things: something is always better than nothing. The problem is that many people have read a little about stock market investing, or listened to someone, and then twist the concepts or apply them in the wrong context. That’s why your level of knowledge needs to match the risk you plan to take on.
14. Learn to recognise what point in the economic cycle you’re arriving at as an investor
Let me explain. We could say that a financial bubble (or a bubble in anything) has 4 stages. In each stage of the market cycle a different type of investor comes in, from the smart one to the reckless one. Most make the mistake of thinking they are “almost” the smart one, but the truth is that reckless investors make up the largest share of investors in the stock market.
There is something much more effective than analysing a chart when it comes to knowing whether the market cycle is about to end or whether we are closer to a financial crisis. It’s called common sense. Will the financial bubble burst this 2022? Nobody knows and nobody can know, but if we look at the charts warning of a financial bubble similar to those before previous financial crises, we would find a certain resemblance.
That’s why there are times in stock market investing when it’s better to stay out. Remember that we are investors, not gamblers. And that means that when the risks already outweigh the possible returns because everything is signalling “danger”, it’s better to keep away from the danger and come back in strongly once the risk has passed.
Featured image: Thomas Richter/user:THOMAS, CC BY-SA 3.0, via Wikimedia Commons.
