Investing in Stocks 101 | The Who, the Why, the How
Investing in stocks was formerly an expensive and time-consuming undertaking that entailed researching companies in a local library, spending hours on the phone with your broker, and paying steep commission fees.
But the digital age has democratized investing. Stock investing is now more accessible and affordable than ever, and, because of our increasing lifespans, it’s more necessary than ever as well. Getting started in the stock market today can technically be as easy as putting together some dough to invest with and signing up with an online investing service—be it an automated service like Wealthsimple, or a self-directed platform like Questrade.
* Before you begin investing, there might be some terms you should know.
In This Article:
Why Invest in Stocks?
When they’re ready to dip their toes into the investing pool, many people aren’t certain where to invest their money. Some look at investing in bonds, others consider the potential returns of investing in stocks compared to real estate. That being said, the reason people invest in common stocks is to earn additional income via three primary means: capital gains from speculation, dividends, and compounding returns to maintain buying power. That was a mouthful, so let’s break each concept down into terms that are easier to understand.
Speculation for Capital Gains
When we sell a stock for more than we paid, we “realize” a capital gain. Capital gains are very favourably taxed compared with earnings from a job, so they’re a tax-efficient way to build wealth, since more money stays in your pocket.
Many established companies pay dividends, and they tend to increase their dividends annually; think of it like getting a raise every year. Shareholders get the cash at the same time that the share price (hopefully) rises, and these dividends are usually better than what you would get on a GIC or savings account. From a tax perspective, dividend income is taxed more favourably than salary or rental income (but not quite as favourably as capital gains), so again, your wealth grows faster.
Investing in stocks is still one of the best ways to maintain buying power over the long term, particularly in retirement when we no longer receive inflation-adjusted earnings. Even low inflation gradually eats into our savings. If our investments don’t keep up with the rate of inflation, we fall behind. Investing in stocks is better at beating inflation because of its historical out-performance compared to GICs, savings accounts, or government bonds.
Step-by-Step Guide to Investing in Stocks
Technology has made stocks more attainable today, but this at-your-fingertips access combined with the sheer volume of available investment options can also make the investment process intimidating. Here’s a digestible, step-by-step guide you can refer to so that you stay steady and on target throughout your investing journey.
Step 1: Assess Your Financial Resources and Goals
Divide your money into three buckets:
- Money you need in the short term (within 1-3 years)
- Money you need medium term (3-5 years)
- Money you won’t need for a while (5+ years)
Among the money making up the funds in the first two buckets should be a reasonably sized emergency fund, held in cash. If you have funds for the first two buckets in place, the funds in the 3rd bucket can then be directed toward investing in stocks.
Now ask yourself: Why am I investing in stocks? Is it to fund a child’s education? For a mortgage down payment? Saving for retirement? Just for fun? Identifying your personal financial goals lays the groundwork for investing, because it determines how much you’ll need to invest and how high or low your risk tolerance is. People say, “I have a high tolerance for risk.” What they actually mean is, “I have a high tolerance for making a lot of money, fast.” They are not the same thing. In general, younger people have a longer investment runway and can usually afford to take on more risk than those closer to retirement.
Step 2: Dip Your Toes in with a Robo-Advisor
It’s a good sign that you’re anxious to invest—you should be! The sooner you start investing the more you’ll earn over time. But if you’re just learning the ins and outs of the market, it’s best to start investing with a robo-advisor rather than jumping headfirst into investing independently.
Robo-advisors use algorithms to automatically manage an investment portfolio, usually comprised of ETFs (see ‘Types of Stocks to Invest In’ below). The three big advantages with robo-advisors are:
- The robo-advisor decides how to invest your money and allocate your assets based on your self-identified risk tolerance, financial goals, and time horizon. This takes the onus of deciding where and how to invest off your shoulders.
- Robo-advisors automatically rebalance an investor’s portfolio when the portfolio’s performance deviates from the investor’s specified risk tolerance.
- Robo-advisors have few, if any, restrictions on investment size. This makes them ideal investment tools for those starting out their investment journey, with less money to invest.
Wealthsimple is an example of a popular Canadian robo-advisor with no minimum investment amount. Those who open a Wealthsimple account from our GreedyRates link can get a $75 bonus if you fund your account with a $500 minimum.
Funds invested with a robo-advisor can be held in a variety of account types, including registered accounts like TFSAs, RRSPs, and RESPs, as well as non-registered accounts. For most investing scenarios it’s highly recommended that you try to max out your registered account contributions completely before directing money into a non-registered account.
Robo-advisors are based online, so fees are competitive compared to regular financial advisors. However, it’s important to remember that the investor also pays the cost of ETFs themselves. Add up the portfolio management fees and the ETF management fees and the total comes in around 1%—better than most mutual funds, but not super cheap. Once you’re far enough along in your investing education you can save money on fees by making the jump from a robo-advisor to trading independently via a self-directed online brokerage.
Step 3: Learn Everything You Can About Investing
After your money is invested via a robo-advisor, take some time to gradually give yourself an investing education and learn more about the following:
- Patterns and trends in market cycles
- Different securities that can be traded
- Diversification of investments
- Metrics that can be used to assess a stock’s value
- Terminology used in executing trades
- Investor patience, discipline, and emotionality
An investing education not only prepares you to make trades on your own, which can be more cost effective than using a robo-advisor; it can also improve your overall logical reasoning and analytical ability, which will benefit many other aspects of your financial life.
Step 4: Start Trading Independently
Once you’ve got the hang of these investing fundamentals you can open a self-directed account with an online brokerage and start investing on your own terms. These platforms differ from robo-advisors in that investors independently construct their portfolios by choosing which securities they’d like to trade; the online broker platform facilitates the buying and selling of the securities, but the investor makes all the decisions about what to actually buy and sell. Trading with an online broker can ultimately be less expensive than investing with a robo-advisor, because unlike robo-advisors, online brokers typically don’t charge managements fees; fees are instead charged on a per-trade, commission basis (and sometimes per quarter).
If you still have cold feet about making the jump from investing with a robo-advisor to making self-directed investments, you might elect to start slowly by funding a self-directed account with just the bare-minimum investment that the broker allows. You can leave the bulk of your investments in a robo-advisor while gradually experimenting with making trades and getting comfortable with the self-directed platform. Some online brokers even allow you to test out a practice account, in which trades are made virtually and no real money is risked. Low-cost, discount brokerages typically don’t give financial advice, but they might provide online resources like webinars, analyst reports, and market news. As you become more confident in your investing know-how you can gradually move more and more of your money away from the robo-advisor and into your own hands as a trader.
One of the most popular online brokers in Canada is Questrade, which charges between $4.95–$9.95 for stock trades (depending on the number of shares traded), and doesn’t charge commission fees for purchasing ETFs. This allows new investors to potentially build a portfolio of ETFs without paying any fees, and gives you a chance to experiment with the platform without forking over too much of the cash you have to invest.
Step 5: Consider a Financial Advisor
Another option for high net worth individuals is to turn to a financial advisor. A financial advisor will assess your risk tolerance and your investment goals and then build and execute an investment plan for you. But it’s not an accessible option for everyone—typically you need a minimum investment amount from $250K to $1M or more to get their attention.
Types of Stocks to Invest In: Individual Stocks, ETFs, and Mutual Funds
You can invest in stocks by buying shares of publicly-traded companies; through pooled funds like mutual funds; or through ETFs (exchange-traded funds). Here are a few pros and cons to look at for each of those routes.
|Common Stocks||- Benefit directly from company's growth|
- Save brokerage costs with DRIP
- Full control of the investment
|- Takes long to diversify the stock portfolio
- Higher risk of losses
- Lack of knowledge to choose investment-worthy stocks
- Analysis paralysis
|ETFs||- Can use leverage and buy on margin|
- Cheaper than mutual funds
- Provide instant diversification
|- Overwhelming variety of ETFs to choose from
- Risk of over-trading
|Mutual Funds||- Potential for above-average returns|
- Professional management of portfolios
|- Higher fees
- May have to wait the following day to trade and the price may change
- Capital gains payouts are paid annually (less tax efficient)
- May have under-performing managers
Investing in Common Stocks
When you buy shares of a public company, you become a proportional owner. And like any business partner, you’re entitled to a share of the company’s growth, which can come from a rise in share price, dividends, new shares from spin-offs, a merger, or share-splits. You also receive voting rights on company matters.
- You’re a direct beneficiary of the company’s growth.
- If the company has a DRIP (dividend reinvestment plan), the company issues additional full or fractional shares instead of cash payments, saving you the brokerage cost.
- You have control of the investment. You decide when to buy or sell.
- It can take a long time, or an initial large lump-sum of money, to build a diversified stock portfolio.
- Buying individual stocks exposes you to bigger losses should one or more of the companies falter.
- You may currently lack the skills or the confidence to choose investment-worthy stocks. (Note that anyone with average intelligence can be a successful investor, but building skills and experience takes time.)
- Emotional attachment to individual stocks could impair rational decision-making.
- Subject to “analysis paralysis” when choosing individual investments
Investing in Stock ETFs
Unlike a mutual fund, ETFs (Exchange-Traded Funds) are passive investment products that hold a basket of stocks that mirrors an index, like the S&P/TSX Composite, for example.
- Shares can be traded throughout the day exactly like stocks.
- Like all common stocks, market price is transparent and changes throughout the trading day.
- Can buy them on margin (using leverage) or buy options on them (these are more advanced investing strategies)
- Usually cheaper than mutual funds
- Index-tracking ETFs provide instant diversification. For example, the Vanguard Total World Stock ETF owns more than 8,116 stocks from around the world!
- There’s a large and potentially confusing variety of ETFs to choose from, some of which are very niche and expose a novice investor to considerable risk.
- The ease of trading ETFs could lead to over-trading, which could harm returns.
Investing in Stock Mutual Funds
Mutual funds are investment pools containing money from a large group of investors. They can invest in a broad stock market index like the S&P/TSX Composite, or based on a specific mandate, like “oil and gas companies in Canada.” Most mutual funds are actively managed by portfolio managers who aim to provide an above-average return.
- Potential for above-average returns compared to general stock market benchmark
- Professionally and actively managed by portfolio managers
- Higher fees than most ETFs. Canada has some of the highest mutual fund fees in the world.
- Mutual fund investors must buy or sell units of the fund directly with the fund company, not the stock market. Unlike stock and ETF prices which change throughout the trading day, a fund’s unit price, called NAV (net asset value) is only calculated once a day after the markets close. If you want to trade units, your order will go through on the following day, when the price may be higher or lower than the previous day. This makes mutual funds less efficient for investors who trade frequently.
- Less tax-efficient than stocks or ETFs because mutual fund holders are obligated to receive capital gains payouts annually—whether they want them or not—and must pay tax on them. (Individual stock and ETFs owners can trigger tax when they, not the fund managers, choose.)
- Surveys show that most active managers do not consistently outperform the market after fees.
- Some fund managers are “closet indexers.” They charge higher fees for active management but copy their benchmark index, such as the S&P 500. This means the investor will get index-like returns, minus the higher fees.
How Risky Are Stocks?
Stocks are called “risk assets” for a reason. Unlike savings accounts or government-backed bonds which guarantee interest payments and then, at maturity, return the original investment, stocks make no such promises. A stock’s price could, theoretically, go into the stratosphere—or it could go to zero. Here are some of the major risks when you invest in stocks:
- Financial Risk: You lose money if the company isn’t successful or is out of favour with investors.
- Interest Rate Risk: If interest rates rise, investors may shift their money to risk-free assets, like GICs, instead.
- Market Risk: Market prices rise and fall constantly. Prices may drop when you need to sell.
- Liquidity Risk: If you buy stocks that trade infrequently, you may not be able to sell them when you need to, at the price you want.
- Foreign Exchange Risk: If the company you invest in is exposed to foreign markets, the exchange rate differential could hurt your investment return.
- Emotional Risks: Because stock prices change frequently, you could make irrational investment decisions based on fear or greed.
- Short-Term Risk: Stock markets tend to rise over the long term but can drop precipitously in the short term.
Who Should Invest in Stocks?
If all of the below statements apply to you, then it’s time to start investing in stocks.
- You have a medium to long-term time horizon of a minimum of 4-5 years.
- You have the patience to let capital and dividends compound. For example, if your rate of return is 7% annually, your investment will double in value in approximately 10 years.
- You are willing to learn more about the basics of stock market investing, including how financial markets work, economic cycles, and how to evaluate stocks. This article, though a very good start, should be just that: a start.
- You understand your risk tolerance and goals.
Who Shouldn’t Invest in Stocks?
- You will need the money in the short-term, within 1-3 years.
- You can’t tolerate financial risk.