Whether you are looking for ways to increase your savings for retirement or to increase your current income, investing your money in the stock market will be a great way to achieve financial stability and even get richer.
However, it is not as easy as it seems.
Just like any other businesses, stock investing has its own risk and not doing research properly before investing can result in you losing money rather than earning more.
So, you must know what to invest in to make the most of it. In this post, I'll dive into different types of investment vehicles that you can use to create multiples sources of passive income.
Section 1: ETF Investing
If you’re ready to make money in the stock market, but don’t know the first thing about how to get into stocks, this is your opportunity to learn the basics of ETF (Exchange Traded Fund) investing.
Whether you’ve bought and sold the occasional stock in the past, are an old hand at mutual fund investing, or are looking at stocks for the very first time, you can learn everything you need to know about how to invest in ETFs, regardless of your current knowledge or previous experience.
Everyone is a beginner when they start their investment education, but with a little focus and determination, you’ll soon become a confident investor, ready to reap all the financial benefits that ETF investing has to offer.
What is an ETF?
An Exchange Traded Fund (ETF) is simply a collection, or portfolio, of various assets, such as stocks or bonds, that is traded as a single unit on the stock market.
When you participate in ETF investing, you buy shares in a broad range, or index, of companies or financial securities.
This gives you the advantage and convenience of owning small pieces of a wide variety of businesses, instead of having to research, buy and manage shares in a large number of individual stocks or bonds.
For example, iShares Core S&P 500 ETF (IVV) - this is an ETF that's designed to track the overall performance of the S&P 500 index.
When you buy this ETF, you are buying a portfolio that includes the 500 largest businesses in the United States.
Unlike mutual funds, ETFs don’t require the active management of a financial advisor to help them offer higher returns than the average commodity traded on the stock market, because they aren’t designed to beat the market.
Instead, ETFs are specifically created to track, follow and provide returns based on the overall performance of a particular sector of stocks or bonds, or of an entire market such as the S&P 500.
An ETF’s holdings, for example, may range from a group of stocks related to and representing the healthcare sector, to a bundle that includes all the major representatives of the S&P 500 market.
Because iShares Core S&P 500 ETF (IVV) is designed to track the overall stock market, it includes various sectors, such as Technology, Financials, Health Care, etc.
But regardless of an ETF’s specific holdings, its goal remains the same: to provide investors with a diversified portfolio that trades as a single stock, and that replicates and yields the returns of the market it represents.
Exchange Traded Funds are one of the best investments for helping you to build long-term wealth.
ETF prices rise and fall throughout the trading day just like the price of any single stock on the market does, but they tend to trade at higher volumes because they represent a broad group of stocks.
This offers the advantage that your ETF investment will remain more liquid, or easily sold, than the shares of any single stock may on its own.
But although you can quickly and conveniently buy and sell ETFs on the stock market, you don’t have to.
ETFs are a great investment vehicle for buying and holding for the long-term because of their minimal management requirements, and they should ideally make up a significant portion of your investment portfolio.
ETF is the best investment vehicle for building your long-term wealth!
In fact, ETFs account for the largest proportion of my portfolio. As a beginner, you may want to invest at least 40% of your money in this type of investment.
ETFs are Much Better than Mutual Funds!
Exchange Traded Funds are essentially the same as mutual funds in that they both hold diverse portfolios of financial securities, designed to track the performance of specific indexes.
But as we will see, there are three major advantages to investing in ETFs instead of in mutual funds:
- Less risky fund management
- Lower trading and holding costs
- Higher trading convenience
Mutual funds are actively overseen by portfolio managers who are constantly buying and selling fund-owned stocks in an ongoing attempt to hold the best possible collection of financial securities.
The goal of these managers is to beat the market average in terms of investment returns and as a result, they are always on the look-out for stocks that they think will outperform the market.
But while market knowledge and trading expertise can go a long way toward knowing what to look for in terms of a stock’s potential, the bottom line is that there is no guaranteed method for choosing high performance stocks with consistently high profit yields.
Those who value the supposed advantages of an actively managed fund are willing to pay the high fees demanded by mutual fund investing, but ETF investors benefit from a far more passive management style.
These funds require that a manager make only minimal and occasional asset adjustments in order to keep a portfolio in line with its given index.
So, instead of investing in a fund manager, who will always put you at risk in terms of their investment decisions, when you buy shares in an ETF, you will be investing in the power of the stock market itself.
One of the biggest advantages of ETF investing is that its passive management approach means you will pay very low fund management fees.
While traditional, actively-managed mutual funds generally demand fees of anywhere from 1-2% or higher, ETF fees by comparison usually fall in the range of 0.1% to 1%.
While that may not sound like a very big difference at the outset, over the long-term it can add up to an enormous amount of cash that is far better off in your pocket, than in that of a mutual fund manager who gets paid regardless of how well their stock choices perform.
In addition to their higher management fees, mutual funds can also be difficult to trade.
Most investors have to rely on their financial advisors for assistance with this, making mutual funds more costly in an entirely different way, since many ETFs can be traded easily and commission-free through online stock brokers.
ETFs are 10-100 times cheaper and easier to trade than mutual funds!
So you should stay away from mutual funds. If you are looking for a way to diversify or build your long-term wealth, ETF will be your best choice!
Where is The Best Place to Buy ETF?
1. SPDR ETFs
SPDRs (Standard & Poor’s Depository Receipts), commonly called “spiders”, are Exchange Traded Funds that specifically track the S&P 500 stock market.
SPDRs are managed by a company called State Street Global Advisors (SSGA), and are available in various bundles of stocks.
You can learn more about everything SPDRs have to offer at the SSGA website: https://www.spdrs.com/.
2. iShares ETFs
iShares are a large group of ETFs, managed by a company called BlackRock.
These funds track a variety of stock and bond market indexes, and like most ETFs, they can be purchased directly through an online brokerage account.
In comparison with more costly mutual funds, iShares claims to have outperformed as many as 90% of actively managed funds in the S&P category over the past five years.
For details on this and many other ETF strategies and advantages, you can visit the iShares website at: https://www.ishares.com/us/.
3. Vanguard ETFs
Vanguard operates as both a brokerage firm and a fund management company for their ETFs.
They launched the very first index fund for individual investors, and they continue to offer a variety of stock, bond, sector, and even international funds.
You can learn more about Vanguard ETFs, and trade them commission-free, at the company website: https://investor.vanguard.com/etf/.
How and Where to Research ETFs
All of the ETF provider websites mentioned here are great resources for learning more about how to invest in ETFs, and for researching specific funds you can invest in today.
Many ETF providers offer investors a wide range of fund options that allow you to choose from those designed to track a particular stock market, a specific stock market sector, a bond market, a real estate market, or other types of financial securities.
Once you’ve identified some ETFs that pique your interest, you can use the following criteria to help you evaluate their investment potential.
Investment Criteria: What to Look For When Investing in ETFs
1. Low Expense Ratio
The annual fee that ETFs charge all their shareholders is known as the Expense Ratio, and this figure is expressed as a percentage.
The Expense Ratio includes the fund management fees we’ve already discussed, as well as other administrative fees and various fund operating costs.
Obviously, the lower an ETF’s Expense Ratio, the better it is for you, since it will translate into more money in your pocket at the end of every year.
For the best-case scenario, you should look for ETFs that offer an Expense Ratio of less than 0.30%.
2. Strong Financial Performance
How can you evaluate an ETF’s potential for continuing to provide you with the best possible returns in the future?
The best way to determine a fund’s prospective financial performance is to confirm that it’s demonstrated good performance in the past.
You can accomplish this by studying an ETF’s 3-year cumulative return.
Ideally speaking, this figure should be greater than 25% in order for you to enjoy annual returns of about 8%, but it goes without saying that the higher the ETF’s return, the better it will be for you over the long-term.
3. Look for Top ETF Providers
It’s important that you only consider buying ETFs from the largest and most widely traded providers on the market.
These companies have already demonstrated their abilities as the most reliable investment sources, with the best financial performance, and their funds have been accurately built to match well-established stock market benchmarks.
Choosing a top ETF provider with a proven track record, rather than being tempted by the questionably high returns promised by an unknown fund company, will allow you to feel far more secure about exactly who you’re investing your money with.
My Best Tips For Investing in ETFs
As an effective and relatively inexpensive way to achieve portfolio diversification through market index tracking, Exchanged Traded Funds can be hard to beat.
Whether your approach to ETF investing is more of a buy-and-hold strategy, or one that involves active trading techniques, you should keep the following points in mind when considering how to invest in ETFs for the greatest and most consistent returns.
1. Time is the Key to Investment Success
A hands-off approach to ETF investing hinges on the fact that these funds offer a great way to implement the buy-and-hold strategy.
Because they passively track major stock market indexes, and provide relatively reliable corresponding returns, when you hold them in your portfolio for the long-term, you can avoid the stress of worrying about day-to-day market fluctuations.
And while ETFs do often charge a commission fee when they are bought or sold, with little investor trading required for a passive approach, these fees will have a minimal impact on your returns over time.
2. Use ETF Investing as a Way to Diversify
Because their potential for returns is based on tracking broad representative groups of stocks in various markets or market sectors, ETFs are the ideal investment vehicle for introducing convenient diversification into your portfolio.
Traded like regular stocks, they allow you to buy, sell and hold shares in a variety of companies, without having to research and purchase those shares on an individual basis.
ETF diversification can yield both higher returns and lower risk, since strong performers will tend to balance out weaker ones at any given point in time.
3. Look for ETFs with a Low Expense Ratio
An ETF’s expense ratio is based on the portion of assets it must allocate to operating expenses, including management fees.
Although activity is minimal compared with most mutual funds, ETFs do require a certain level of management to keep their holdings in line with the index they are meant to represent.
To make the most of passive ETF investing, you should consider those funds with lower expense ratios since, over time, even small management fees can impact your returns.
4. Step Back from Unnecessary Trading
Because the point of passive ETF investing is to avoid trying to fix something that isn’t broken, you should steer clear of unnecessary trades.
While it’s important to monitor your holdings and the market in general on a regular basis, impulsively engaging in active trading is often a misguided emotional response to market panic or greed, and it can end up costing you in both short-term fees, and long-term strategy benefits.
5. Only Trade Highly Liquid ETFs
Exchange Traded Funds have become very popular because they offer the more active investor a diversity that’s as convenient to trade as stocks.
Because of this, ETFs are inherently more liquid than many individual stocks, with some more naturally liquid than others.
To maintain your ability to easily trade in and out of ETFs, you should look for those with a daily trading volume of more than a million shares.
When that’s not possible, do at least make a point of avoiding those funds that trade at an average volume of less than 100,000 shares.
6. Always Place Limit Orders
Limit orders allow you to place a buy or sell order for a specific ETF by deciding in advance how much you are willing to pay out or accept for it.
They can help to take some of the emotion out of ETF investing since you can set their price points based on your research and analysis, rather than on an impulsive reaction to market activity.
The downside of using limits is that your order may go unfilled if your price is not met, or if there is insufficient share volume available to support it.
7. Always Set a Price Target
You can help to protect your investment holdings, even when you’re temporarily unavailable to keep a watchful eye on market activity, by taking advantage of something called a stop-loss order.
This order will trigger the purchase or sale of an ETF once a pre-determined price target has been reached.
Like an insurance policy for your portfolio, stop-loss orders can serve to protect you from both large losses during a declining market, and from missing out on large, short-term gains during a quickly rising market.
8. Consider Using Dollar Cost Averaging
When considering how to invest in ETFs using a more aggressive approach, the advantages offered by dollar-cost averaging should be carefully weighed against the disadvantages.
While a regular and systematic purchase of ETFs can help to smooth out their naturally fluctuating prices, this strategy must be executed properly, through the investment of larger amounts less frequently, in order to prove effective.
Commission fees can add up quickly with frequent ETF trading, so it’s important that you determine all the cost implications of this technique ahead of time.
9. Take Advantage of Inverse ETFs
Inverse ETFs can help your portfolio to profit from falling prices because they are specifically designed to take advantage of a decline in the various markets and sectors they track.
Essentially another form of short-selling — the method that allows you to ‘borrow’ market shares to sell high and then re-purchase at a lower price for profit — these ETFs can be a source of high returns for the more aggressive and risk-tolerant investor.
Inverse ETFs also offer a viable option for helping to balance out the returns from your various portfolio holdings.
10. Handle Leveraged ETFs with Care
Leveraged ETFs are not for the faint of heart.
Because they use leverage, or debt, to match investor dollars in their share purchases, these funds allow investors to benefit from double the potential returns, but also suffer from double the losses.
While these ETFs are available for most indexes, and are set up with the goal of maintaining a consistent leverage ratio, they should be approached with both caution and a healthy dose of analysis before buying in.
Final Thoughts About ETF Investing
Investing in Exchange Traded Funds is quite simply one of the best ways for you to build your long-term wealth.
Not only do they provide an effective way to diversify your investment holdings, by spreading your money across an industry group or an entire market, they are also one of the safest stock market investments since they help to reduce the unpredictability of your portfolio’s performance.
As a new ETF investor, the best way for you to enjoy the most successful results is to take the time to invest in your own education before investing in an actual fund.
Before Buying Your First ETF
Before you buy your first ETF, make a point of learning as much as you can about the Exchange Traded Fund investing approach.
You can start with the ETF provider websites referenced in this article, but don’t be afraid to search further afield for less biased content.
ETFs have become a common investment vehicle, and there is no shortage of information about them on financial websites, in business magazines, and in the literature provided by many investment and brokerage companies.
It’s often a good idea to try picking a few promising ETFs, and tracking their progress over a period of time.
This exercise will not only provide you with a practical, ‘hands-on’ approach to learning more about how these funds perform and operate, it will also give you the opportunity to practice your ETF selection strategies before you invest any actual money.
Section 2: Dividend Investing
It can be difficult to know just how to get into stocks if you have no prior experience with the stock market.
Fortunately, dividend investing is not only a relatively straightforward method for getting your feet wet in the market, it can also be a very effective way to introduce passive income into your investment portfolio.
When you buy shares of stock in a dividend-paying company, you become entitled to receive cash payouts several times a year that are based on the profits generated by that company.
And if that same business continues to perform well, and experiences positive financial growth, the amount paid out in dividends often increases alongside company earnings.
In order to understand how to invest in dividend-paying stocks for your best chance of success, you should have a thorough understanding of exactly what a dividend is, why companies pay them to their shareholders, and how you can make the most of them to build a solid and diversified investment portfolio.
What is Dividend Investing?
The focus of dividend investing is to generate both passive income and a positive cash flow within your portfolio, from stock dividends.
In its simplest form, a stock dividend is an amount of money, usually in the form of cash, which a company pays out at regular intervals to those investors who hold shares of its stock.
When you buy shares in a dividend-paying company, you are effectively buying a very tiny fraction of ownership in that company, and as a partial owner you are entitled to share in any profits.
Many companies issue lump sum payments on a quarterly basis, or every three months, and when a business produces strong and stable earnings over the long-term its dividends not only remain consistent, but often benefit from regular increases as well.
But how can you know if a company’s annual dividend amount makes it worth considering as a potential investment?
Payouts fluctuate from business to business, so what size of a dividend should be considered attractive?
Just because two different companies both pay out dividends of $1 per share every year, it doesn’t make them equitable in terms of potential investments.
You need to know how much you will be earning from each dollar you invest in a company’s shares, and the best way to discover that is to consider the stock’s dividend yield.
The dividend yield is simply an amount, represented as a percentage, which indicates your return on investment (ROI) in much the same way that a bank account paying you 2% interest, equates to earning an ROI of 2 cents for every $1 you keep in the bank.
For example, Company A pays $1 per share every year, and its shares are selling at a price of $20 each, the dividend yield would be 5.0%, as follows:
If, on the other hand, Company B also pays $1 per share every year, but its shares cost $40 each, the dividend yield would be far less at only 2.5%.
Therefore, all else being equal, to earn the highest level of income possible from dividend investing, you should make a habit of looking for those companies that offer the high and steady dividend yields.
Why do Companies Pay out Dividends?
But why do companies pay out dividends in the first place?
Not all companies offer stock shares that entitle the owners to regular dividend payouts, so it’s obviously not mandatory for every business with public shares to do so.
Stocks that pay dividends are meant to serve as a signal to potential investors that a company is financially strong and stable, and that it expects to remain so over the long-term.
Essentially, dividends are a real-life indicator of a company’s financial health, and they indicate that the business is confident in its ability to perform well consistently enough to earn a regular profit.
Many people like you who are looking to generate passive income through the stock market, will choose dividend-paying stocks over other types for this very reason, so it’s a great way for a mature and stable company to attract new investors and sell more shares.
After all, it’s partially through investor dollars that a business continues to fund its operations and growth activities.
And there’s the added benefit for a dividend-paying company that any increases it can make to its dividends will lead to a correlating increase in its stock price, and to its overall value in the eyes of potential investors.
So why doesn’t every company offer a dividend to its shareholders?
There are two main reasons why a business may choose to forgo offering a dividend payout on its shares.
1. The fluctuation in dividend payouts may affect its stock price
First of all, some companies believe that offering a dividend is irrelevant to many investors, since those looking for a reliable income vehicle for their portfolios will often turn to bonds for their regular and stable interest payments.
Stock dividend amounts can fluctuate, and while decreasing or cutting out a dividend is the last thing any company would choose to do, because of the potentially negative repercussions on its stock price, it can happen; especially when business earnings or the economy in general take a turn for the worse.
2. The company wants to retain its profits for future growth
Secondly, those companies that forgo dividends understand that they are taxed more heavily in the hands of the investor than long-term capital gains.
Rather than paying out excess earnings directly to investors, some companies prefer to increase the value of both their business and their stock price by reinvesting those funds back into their own growth.
This strategy can help to support such valuable activities as opening new branches or departments, purchasing additional assets or companies, and implementing better marketing initiatives.
But for our purposes in exploring the great potential offered by dividend investing, we will only consider stocks that pay dividends.
Just the same, it’s important to be aware that not all dividend-paying stocks are created equal, and that not all of them are good candidates for helping to earn passive income.
Later, we will explore how to pick the most profitable dividend stocks to invest in for this purpose.
How to Be Eligible For Receiving Dividends
Because a company sets up regular payout dates for its dividends each year, it’s crucial that you understand the various dates associated with dividend investing in order to avoid buying a stock at the wrong time, and missing out on the dividends you were expecting to receive.
1. Declaration Date
The Declaration Date is the date on which a dividend-paying company announces the next dividend to be paid out to shareholders.
Typically, this legally binding declaration describes the amount of the dividend, the date on which it’s to be paid (the Payment Date), and the dividend’s Date of Record (see description below), which lets investors know the deadline for buying or selling shares in order to be eligible to receive the dividend payment.
2. Settlement Date
The Settlement Date for a stock trade is also called its "closing date", and it’s the date on which the sale or purchase of a security is finalized.
A typical trade takes 2-3 business days to complete, and once the transaction has been finalized, it means the buyer becomes the new official owner of record for that security, and the seller gets paid.
In terms of dividend-paying stocks, the Settlement Date becomes important when trades are conducted just prior to a stock’s Date of Record, since it’s only the owner of record who will be entitled to receive the most recent dividend declared for that stock.
3. Date of Record
The Date of Record is the "cut-off" date on which you must officially own a particular stock in order to receive its most recently declared dividend.
This means you can either buy and settle, or simply hold onto, eligible shares of a dividend stock by the Record Date, and you will be entitled to receive its declared dividend.
Similarly, if you sell shares of an eligible stock before the Record Date, you will remain the official owner of those shares, and will still receive the relevant dividend, as long as the sale of those shares does not settle before the Date of Record.
4. Ex-Dividend Date
The Ex-Dividend Date is the most important of all the dividend stock dates.
Ex-dividend means “without dividend”, and the Ex-Dividend Date is effectively the deadline for buying shares with the attached entitlement of receiving the most recently declared dividend.
A stock’s Ex-Dividend Date is generally set 2-3 days prior to its Record Date, in order to allow time for any associated trades to settle.
This means that as long as you buy your shares before the Ex-Dividend Date, your trade will settle by the Record Date, and you will receive any attached dividend; if you buy them on or after the Ex-Dividend Date however, you will not qualify, and their seller will receive the dividend.
Conversely, if you sell your eligible stock either on or after the Ex-Dividend Date, you will remain entitled to receive its current dividend.
But if you sell your shares before this date, that entitlement is sold along with them, and the buyer will receive the dividend.
5. Payment Date
The Payment Date for a given stock dividend is also known as its distribution date, and is simply the date on which all dividend payouts are transferred to those investors who were on record with the company as official shareholders on the Date of Record.
Most companies pay out dividends on a quarterly basis.
In summary, you must own shares of a given stock before its ex-dividend date in order to receive the next dividend that’s been scheduled to be paid to shareholders, and there are two ways you can do this.
You can either purchase or hold company shares before the ex-dividend date, or you can sell shares you already own on or after this date.
In either case, you will be eligible to receive the dividend in question, since you will be the shareholder of record on the stock’s established record date.
Investment Criteria: What to Look For When Investing in Dividend Stocks
Step 1: Looking for Stocks that Pay Out Regular Dividends
Dividend investing for the purpose of building a passive income stream is really only effective when you look for stocks that pay out regular dividends to shareholders.
At the same time however, companies that pay out too large a portion of their earnings as dividends run the risk of coming up short in terms of having the available resources to fund their future growth.
And it’s a company’s continued growth that provides the basis for regular dividend increases.
Ideally, you should look for those businesses that retain a minimum of 40% of their annual earnings to reinvest in their own development, and as an investor, this means seeking out those stocks with a dividend payout ratio of 60% or less.
Step 2: Looking for Financially Strong Businesses
Companies that are mature, stable and financially strong provide the best chance that an investor will continue to receive consistent dividends that offer good potential for increases.
As such, you should only consider solid businesses that have a history of strong financial performance, and that have demonstrated consistent growth in both their net income, and their cash flow.
In practical terms, this means looking for low-debt businesses with a debt-to-equity ratio of less than 50%, since the more debt a company carries in relation to its assets, the more income it must put toward supporting that debt, and the higher the risk that this liability will begin to cut into its dividends should earnings drop off for any reason.
Step 3: Considering a Business’s Future Prospects
Beyond just maintaining dividend payouts, companies selected for passive income investment purposes should ideally be striving to increase those payout amounts, on a regular basis, through earnings growth.
This means you should look out for those businesses that have a selling advantage over their competitors, or which offer a product or service that will remain in high demand over the long-term, or that demonstrate strong management performance.
Any of these attributes can contribute to a company’s successful future growth, and the details surrounding its management policies and expansion strategies can be found in every business’s annual report.
Final Thoughts About Dividend Investing
Dividend investing is by far one of the best ways to use the stock market to generate passive income and to increase cash flow in your investment portfolio.
Remember that not every dividend-paying stock is useful for this purpose, and you must learn to identify the profitable ones in order to continue to build your wealth.
Before you purchase any investment, you should take the time to become familiar with exactly how it works, and its inherent risks and possible disadvantages.
If you learn as much as you can about the dividend investing approach before you buy your first stock, you will greatly increase your chances of benefiting from regular, long-term passive income, with as little risk as possible.
Section 3: Value Investing
If you’re looking for advice before jumping into the value investing world, you should consider these basic concepts for understanding exactly what a value stock is, and how to determine which ones offer the best potential for your investment portfolio.
Value investing is driven by the idea that there are ways to benefit financially from the events that cause stock market prices to swing up and down.
In fact, by learning how to swim effectively against the current, you’ll soon discover that there are outstanding opportunities in the value investing world that often go overlooked by the average investor.
What Exactly is Value Investing?
Before implementing the value investing approach, you have to understand the basic concepts behind value investing.
On one level, a stock’s value is reflected in its current market price.
Since the market price indicates how much investors are willing to pay for a stock at any given time, it indicates the stock’s market value.
But the key point to note in value investing is that a stock’s market value is not the same thing as its fundamental, or intrinsic, value.
Sometimes businesses can become temporarily popular or unpopular for a variety of reasons that have little to do with the true worth of their revenues, net assets, or their future income potential.
So what exactly is value investing?
In short, value investing is simply a method for understanding how to effectively value a stock in terms of its intrinsic value, in order to determine the best time to buy or sell it for a profit.
To take advantage of the benefits of value investing, you’ll first learn to identify truly valuable companies in order to buy them when they’re undervalued.
Most commonly, the eventual goal of this strategy is to sell these stocks when they become overvalued, or once their prices have returned to a more realistic level.
When a company’s stock is undervalued, it means that it’s selling at a price well below the value of its current and predicted cash flows.
At the same time, a stock that’s overvalued is one that’s selling at an inflated price, well beyond its current earnings value, or even its predicted earnings growth.
In this way, you will often be buying and selling stocks against the natural flow of movement within the stock market.
Since it’s a well-documented principle that investors tend to overreact to both good news and bad news, you can use this truth to look for companies that are currently undervalued by the market, despite their long-term fundamental worth.
Value Investing Tip
If an undervalued company is financially strong, with a solid profit history and promising future earnings, its market price is very likely to rebound after a temporary downswing caused by investor fear or disfavor.
Investment Criteria: What to Look For When Investing in Value Stocks
The best value investing strategy starts with learning to identify fundamentally strong companies.
If you attempt to profit by buying stocks that have simply dropped in price, without first ensuring that they have the underlying ability to eventually recover, there’s a good chance you’ll experience some financial loss instead.
An effective value investing formula dictates that we must first look for strong businesses, buy when their stock is undervalued, and sell when it rebounds or becomes overvalued.
Below are the 3 essential steps to every value investor should follow to become successful in this value investing world.
Step 1: Look for Fundamentally Strong Businesses
Value companies are not named for their positive market values, since every company’s stock price fluctuates on a regular basis in conjunction with individual news events, or occurrences within the market as a whole.
A fundamentally strong business is known as a value company because it possesses actual, inherent worth in terms of its consistent earnings, dividends, and cash flow.
These companies usually have a sustainable competitive advantage over their rivals that keeps them in the game, regardless of what their stock price may be doing from day to day.
And it’s this competitive edge that gives businesses a protective economic moat.
To understand how to identify economic moats, you should look for companies with the ability to remain financially competitive over the long-term.
Even if negative events cause a fundamentally strong company’s stock price to dip, if it can maintain its ability to continue operations as usual, it will generally rebound in time to a market price that is more in keeping with its true value.
Investors tend to have emotionally short memories.
As long as a company continues to demonstrate a consistently growing net income and cash flow, it’s very likely to not only eventually regain its former glory after a price drop, but to become overvalued as investors start to recognize all over again what great value it represents!
When looking for fundamentally strong businesses, some additional factors you should keep in mind are low debt, and the presence of a strong and responsive management team.
Overall, if a company has a history of performing well, you can predict that it will continue to do so over the long-term.
Once you’ve identified businesses that are fundamentally strong and that have a high intrinsic value, you should add them to your watch list in order to consider buying them if, and when, they ever become undervalued.
Step 2: Buy Stocks When They Are Undervalued
Under normal circumstances, stocks that are financially strong, and that demonstrate promising future prospects, are relatively expensive to purchase.
For this reason, a fundamentally strong business doesn’t always represent a good investment, since its stock value will have little potential to increase if you buy it when it’s already trading at a price that’s more or less in line with the company’s intrinsic value.
In short, it’s important to be able to recognize undervalued stocks, so you don’t end up buying them at the wrong time.
A strong company can become temporarily undervalued for a number of reasons.
These can include one-time events such as internal scandals or negative news reports that cause disillusionment, but that don’t cause the company to lose its competitive edge, or its ability to go about its business as usual.
If you wait for such occurrences as a company failing to meet its projected earnings, a downturn in the economy, a significant change in a company’s business environment, or similar types of bad news, you’re apt to discover that the short-term emotional impact of these events on investors causes a company’s stock price to decline.
This temporary price decrease is your signal that a stock may have become undervalued, and is now a good investment buy for your portfolio.
Step 3: Sell Stocks When They Become Overvalued
Now that you understand that the best time to buy into a financially strong company is when its stock has become undervalued, you also need to recognize when to sell that stock in order to generate a profit.
Although we know that a high quality company can be temporarily affected by negative market news that causes its stock price to plunge, we also know it’s very likely to recover over the long-term.
And in the same way that bad news can cause a company’s stock price to drop, good news can have the opposite effect and cause its price to surge during this recovery period.
In either case, whether a business simply recovers its true value in time because of its intrinsic value, or becomes suddenly overvalued as the result of some positive event like share buyback, it will probably be time to sell your stock and take your profit in the spirit of buying low and selling high.
How to Find Out If a Stock is Undervalued
As we discussed earlier, the real worth of any business is not always reflected in its market price, but can usually be found in its actual or intrinsic value.
A company’s intrinsic value lies in a combination of both tangible factors, such as its assets and earnings, and intangible factors, such as the dynamics of its management team, and its business reputation.
In putting all of these pieces together, you’ll discover how to value a company based on its real merit, rather than on its perceived value in the eyes of the market, and it’s this knowledge that will allow you to make better investment decisions.
At its most basic level, the value investing formula tells us that we should buy stocks when their intrinsic value is greater than their current market value because this is when they are considered to be undervalued.
At the same time, when a stock’s intrinsic value drops below its current market price, it has become overvalued, and should be sold.
Our Rule of Thumbs
- A stock is Undervalued when: Intrinsic Value > Market Value
- A stock is Overvalued when: Intrinsic Value < Market Value
Many investors simply choose to look at the Price to Earnings (P/E) ratio of a stock as an indicator of whether a company is undervalued or overvalued at a given point in time, but this method is not always reliable.
A stock’s P/E ratio measures its current share price against its per-share earnings in order to arrive at a relative value for that stock.
If a stock is currently trading at $10 per share, for example, and its earnings were $1 per share over the past year, its P/E ratio would be $10/$1 or simply 10.
This figure tells you just how much investors are willing to pay for a stock, per dollar of the company’s earnings.
As such, a relatively low P/E ratio may indicate that a company is currently undervalued in terms of its earnings history.
But there are several limitations when using a company’s historical P/E ratios as a benchmark for determining when its stock has become undervalued.
Some of these limitations include the fact that:
- No single analytical measurement is reliable on its own
- Different market sectors grow and are valued in different ways
- A company’s debt can sometimes significantly affect its earnings, and can therefore skew its P/E ratio
Sometimes the earnings figure used in the P/E ratio can be inaccurate to begin with, since earnings reports are often manipulated by companies in an effort to maintain strong stock prices.
Instead of using the P/E ratio, you may want to try some better financial ratios like the PEG or PEGY ratios.
These ratios are considered an enhanced version of the P/E ratio because they provide a closer look at the relationship between a company's earnings and its future growth potential.
However, as a value investor, you would be far better off calculating the intrinsic value of a company by making use of the Discounted Cash Flow (DCF) model.
While the DCF formula is somewhat complex, it involves plugging in the figures that represent a company’s future free cash flow projections, and discounting them to adjust for the time value of money, in order to arrive at an estimate of the company’s present value.
If the DCF value of a company is higher than its current market price, it may represent a good investment opportunity.
Value Investing Tip
How to Build a Diversified Portfolio
The next step to become successful in the value investing world is to build a diversified portfolio.
Although value stocks offer the potential to provide some of the highest market returns and profits, you shouldn’t make the mistake of relying on them as the sole investment vehicle within your portfolio.
"Don't put all your eggs into one basket." - Anonymous
Investing your money in nothing but business stocks involves the inherent risk that the businesses you invest in may collapse, or go bankrupt.
No business, no matter how financially strong it is, is immune to the possibility of experiencing a decline in performance in the future.
Building a diversified portfolio can help to minimize your investment risk exposure, and is an absolute must if you want to become successful in the stock market.
By introducing securities into your investment strategy that include Exchange Traded Funds (ETFs) and income stocks, as well as value stocks, you’ll be well positioned to both spread out any unavoidable risks, and to maximize your returns.
Final Thoughts About Value Investing
Remember that value investing is all about finding value businesses, buying them when they are undervalued, and selling them when their stock prices become overvalued, or more in line with their intrinsic values.
Getting started in value investing is the best way to invest in the stock market, since it offers the greatest chance of generating the highest returns.
But because the entire concept of value investing lies on the foundation of being able to identify undervalued stocks, it’s important that you take the time to learn all you can about how a company is valued and exactly what contributes to that valuation.
Before buying any stock you should have a thorough understanding of its fundamentals in terms of its past financial performance, and its projected future growth and earnings.
Investing Rule: Only invest in businesses that you can fully understand.
Beyond reading all the good things a company may have to say about itself, you should become knowledgeable about the meanings behind such terms as earnings, cash flow, revenues, dividends, and debt load.
The more informed you are as an investor, the more likely you will be to find success in building your long-term wealth.
Now it's your turn to jump into the value investing world!
Section 4: My Best Investing Tips For You!
It isn’t too hard to achieve success with stock investment. In fact, knowing the right stuff can go a long way towards helping you make a profit.
“Know thy enemy to defeat him”, Sun Tzu stated centuries ago, probably while stroking his long beard, sitting on a rock overlooking a valley sipping on tea while his army burned a village down below.
To overcome all the challenges while investing in the stock market, you must have a proper understanding of the stock market.
“Risk comes from not knowing what you are doing.” - Warren Buffett
Once you have acquired it, you can move on to the next step where you can find ways to minimize your risk, avoiding unnecessary mistakes and maximize your profit.
Start implementing these tips and strategies as soon as possible:
The most important asset you have is YOU!
Keeping this in mind, get to know about the human factor when trying to become a successful stock investor. Before putting your money into the stock market, you'll need to determine how risk tolerant you are.
This is what you feel when you face risk and how you cope with it. The level of risk tolerance varies from person to person, based on their background, experience and age.
Once you understand your risk tolerance, you can fully control the way you use your money to invest.
With a clearer head, you will be able to make better investment decisions.
Develop a Plan of Action
Get things organized and set a plan. You cannot succeed if you don't have a trading plan.
“A goal without a plan is just a wish!” - Antoine de Saint-Exupéry
Get to know what you will get from your investment, what goals you have and how much you will have to invest to accomplish those goals. It does not hurt to seek advice from professionals in finance when forming a plan.
Achieving success in the stock market is a long-term effort. Understand why you are investing your money and be committed once you have taken the plunge.
Preset The Limits
Always put a stop loss limit on your trades.
This way, the stocks will be sold off automatically if their price goes below a certain level and this can help you avoid huge losses.
Being human, you will be tempted to waste some of your money on things that are not necessary, so set aside a small portion of your earnings for that and make sure it does not exceed a reasonable limit.
Make a decision and stand by it. Being confused and constantly reversing a position will only add to worry and wastage of time.
The Bottom Line
Investing in the stock market has its own risks, no doubt, but it is one of the most effective and flexible ways to get rich.
It will be worth it and rewarding for you if you know how to take calculated risks and equip yourself with enough skills and knowledge.
Even if you do not possess either of the qualities, you should not be discouraged. That's because investing is a learnable skill.
When I started back in 2011, I was completely in the dark. I knew nothing about stocks and I traded recklessly without a real strategy.
I made countless mistakes and experienced a lot of failures. But I never gave up!
My best advice for you now is that, before starting to invest in the stock market, you must first invest in your own education.
I haven't seen anyone who can succeed without education and hard work. Maybe some of them are lucky, but when it comes to stock investing, you should never bet on your luck.
The stock market will always go against you unless you know how to play safe with it.
So, invest in your own education first, and then put in the work and enjoy the fruits of being an investor!
There you have it! - a detailed guide on how to get started investing in stocks.
Now it's your turn! You can learn how to practice trading stock by using a FREE paper money account from TD Ameritrade.
Leave a comment below and let me know which type of investment you prefer to start with.