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How to Invest in Stocks and Other Investing Basics

Want to know how invest in stocks? Read this comprehensive report on everything from how stocks work to how to calculate return to how to limit your losses.

by Timothy Lutts, Chairman and Chief Investment Strategist, Cabot Wealth Network

Investing in the stock market can be intimidating. Unless you majored in finance or are in the investment industry yourself, you may not feel confident enough to invest on your own. So you leave your annual contribution in the mutual funds you selected so many years ago or hand your account over to a professional financial advisor.

It’s certainly understandable—at least you’re saving, right? But there are much better options available than set-it-and-forget-it or hiring a high-priced financial advisor.

You can invest on your own. It’s not as difficult as it sounds. Before you begin investing, it’s important to understand what a stock is: a stock is an equity investment that represents part ownership in a company. When you invest in a stock, you own a share (or shares) of that company.

When investing on your own, the most common way to buy a stock is through a brokerage firm. Thanks to the internet, using a brokerage firm to invest is easier—and more affordable—than ever. There are a variety of popular online discount brokerage firms—TD Ameritrade, E*Trade, Fidelity— and none of them charge more than $10 every time you make a trade (and some of them no longer charge a dime!).

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Now, you can choose to invest in just one or two stocks; that’s all some people can afford, and that’s fine. But for those who can afford it, an ideal portfolio consists of about eight to 12 stocks from a variety of industries (technology, banks, housing, retail, energy, etc.). It also makes sense to invest in different types of stocks—growth stocks, value stocks, dividend-paying stocks, emerging market stocks. More on the different types of stocks later.

However you spread out your investments, the goal is to put together a portfolio that’s diversified enough that you aren’t overly susceptible to a collapse in any one industry. For instance, if you have all housing stocks and the real estate market suddenly collapses like it did during the subprime mortgage crisis … you could lose all the money you’ve invested very quickly.

How to Calculate Return on Investment

Before we get into more investing tips, it’s important to know how to calculate your return on investment. It’s simple really: your return is the percent that your investments have gone up.

Let’s say you bought 10 shares of Apple (AAPL) back in the day, when it was trading around $50 per share (for a total of $500). About a decade later, Apple’s stock price rises to $257 per share, giving you a total return of 414%. Thus, the $500 you invested in Apple has turned into $2,570!

If you own eight, 10 or 12 stocks, calculating your return on investment can be a bit more arduous. Fortunately, your online brokerage account does the calculating for you. These days, all you need to do is log in to your brokerage account, and it will show you the total return (or loss) on all your investments in real time.

Of course, you can also track the prices of all your stocks during a trading day (Mondays through Fridays, from 9:30 a.m. to 4 p.m. ET) by looking up their ticker symbols on either Yahoo! Finance or Google Finance. It will give you up-to-the-minute prices on any stock, no matter how small or obscure.

Now that you know how to invest in stocks, and how to calculate your return on investment, let’s talk about ways to invest successfully.

First, let’s review some of the different types of stocks you should most concern yourself with as a new investor.

Four Types of Stocks

Growth Stocks

Growth stocks are the glamor investments on Wall Street.

They are the reason all those talking heads on CNBC have jobs and what makes Jim Cramer ramble on as if he’s just chugged five Red Bulls. (Maybe he has.) Growth stocks often outpace the market, and the best ones can earn triple-digit returns in investment in a short amount of time. So it’s no surprise they generate so much excitement and endless chatter.

Of course, there’s a caveat to investing in growth stocks. Unlike time-tested dividend growers or bargain-basement value plays, growth stocks carry plenty of risk. The companies are less mature, often are subject to greater potential competition, and typically don’t pay a dividend. Thus, the stocks can be very volatile.

For many investors, however, the risks of investing in growth stocks are worth the potential rewards. Apple, Amazon.com (AMZN), Netflix (NFLX) —all of them started off as growth stocks before they became some of the market’s most coveted stocks. Those who got in early earned triple-digit, even quadruple-digit, returns.

There are several keys to finding the right growth stocks:

• Invest in fast-growing companies. It’s a rather obvious prerequisite. But it’s important to know what fast-growing means. It means investing in fast-growing industries, where revolutionary ideas and services are being created. Any little-known stock that provides a product that is essential to that budding industry makes for a good growth stock. Rapid sales and earnings growth is seen among most big winners before their stocks take off.

• Buy stocks that are outperforming the market. Companies can promise all kinds of financial growth. But is that growth potential translating to a rising stock price? The best investing tips come from the performance of the stocks themselves; a rising stock tells you the smart money is accumulating shares.

• Use market timing. Never underestimate the power of the market to move stocks. You don’t want to invest in a growth stock just as the market is topping out, as three out of four growth stocks will follow the trend of the overall market. If you’re in a bull market, you can afford to be aggressive in buying stocks that are more speculative.

• Be patient. Not every growth stock will advance exactly when you want it to. Very few will, in fact. Even Apple had plenty of fits and starts on its way to becoming a trillion-dollar (!) market-cap company. In the investment world, time is your friend. If you get out of a stock too early, you may miss out on some big gains months down the road.

Growth stocks were the basis upon which Cabot Wealth Network (formerly Cabot Investing Advice) was founded in 1970. Our founder, Carlton Lutts Jr., gave up a career in engineering to pursue his passion for stock selection and market timing.

Now half a century later, we offer much more than growth investing advisories. But growth stocks—and helping individual investors earn big profits from them—are still at the heart of what we do via our flagship newsletter, Cabot Growth Investor.

Investing in growth stocks can be tricky. Finding a hidden gem that has yet to be fully discovered by the market is exciting, but requires lots of discipline to handle it correctly. Look for up-trending earnings growth, improving profit margins, and booming industries. If done right, investing in growth stocks can be both highly satisfying and highly profitable.

Dividend Stocks

Investing in stocks can be like buying a lottery ticket. You can have a very good reason to believe that a stock is going to rise. But ultimately, it amounts to speculation.

Investing in dividend stocks is less speculative. It’s a good way to build long-term wealth.

A dividend is a sum of money a company pays to its shareholders, typically on a quarterly basis. The higher the dividend payment, the higher the yield, which is calculated by the total annual dividend payout per share by the current stock price. So, if a company pays $2.00 per share per year, and has a stock price of $60.00, it has a yield of 3.3%. And any yield above 3% is considered good.

Dividend stocks aren’t solely dependent on their share price rising or falling. When you buy a dividend stock, you know for sure that you’ll receive a steady stream of income—again, generally on a quarterly basis. If the market crashes and the share price begins to fall, you at least have a nice 3% or 4% yield (or higher) to soften the blow.

More often than not, you can trust a company that pays a dividend. Dividends are a measure of a company’s success and its commitment to shareholders. The companies that consistently grow their dividends are the ones whose sales and earnings are also growing. Companies that lose money or fail to grow are unable to consistently pay a dividend.

When a company pays a dividend—and especially if it makes an effort to increase that dividend every year—it shows that it cares about rewarding shareholders. Paying a dividend is also a savvy way to attract investors, which is why shares of these stocks typically appreciate over time.

Dividend stocks aren’t going to make you rich overnight. But they can significantly build up your nest egg if you buy and hold them for years, or even decades.

Not all dividend payers build wealth. You need to search for investments with timelessness and longevity—companies that are sure to not only be around 20 or 30 years from now, but still thriving. Dividend stocks become more powerful, and usually make up a larger part of your annual return, the longer you hold on to them.

For example, if you had bought Wal-Mart (WMT) in April 1990, your current yield on cost would be about 19%. That means you’d be collecting 19% of the value of your original investment every year from dividends alone!

With investments like these, it’s best to let your money work for you as long as possible.

That can mean riding out some tough times. Wal-Mart declined 23% during the 2000 bear market, for example. Selling would have saved you some money in the short term, but you also would have forfeited that 19% annual yield.

When buying dividend payers, you have two options. You can either collect the quarterly income or reinvest it to buy more shares. The latter is called a dividend reinvestment, and is an easy way to increase the value of your position without having to do much. You can always start collecting the dividends down the road when you need the income.

To help you find the best dividend stocks, we offer Cabot Dividend Investor, a service that gives you regular dividend stock recommendations—and the tools to find some of the market’s best dividend-paying stocks on your own. Click here to join.

Value Stocks

Notice any stocks that are getting pummeled as a result of embarrassing headlines or negative rumors? They might be the next great value stocks.

Value investing isn’t as simple as that. But that’s sort of the mentality.

“Be greedy when others are fearful,” legendary value investor Warren Buffett once said. His advice still rings true.

Sometimes good companies get wrongly punished by the stock market, often to the point where they become undervalued. But not just any company receiving a bit of bad news qualifies as a good value play. Instead, value stocks typically share a couple of key characteristics.

Those are:

Strong growth prospects. Every stock takes it on the chin at one point or another. The companies whose sales and earnings grow through it all are the ones that consistently bounce back. It doesn’t take much for a stock to get knocked down—a disappointing new product, a scandal involving one of its executives, a bad Super Bowl ad. Those are temporary problems. For savvy value investors, they’re also prime buying opportunities.

Cheap multiples. There are ways to actually measure value stocks. And it’s not as simple as looking at the price to earnings (P/E) ratio, as some analysts might have you believe. Price to earnings is just one of six major valuation benchmarks. The others are price to book value, price to cash flow, price to dividends, price to sales and the PEG ratio, which is calculated by dividing the current stock price by the last four quarters of earnings per share growth. For a company to be considered a strong value stock candidate, at least one of those ratios needs to be low. If several of those valuation multiples are low, and earnings are projected to grow, then you may have found a stock that is trading well below its intrinsic value.

Even with those characteristics in place, successful value investing still depends a lot on timing. You don’t want to invest in a strong value candidate while it’s still in free fall. You want to buy value stocks right around the time they’ve hit rock bottom—or at least close to it.

Determining where that bottom lies isn’t an exact science. Rarely, if ever, are you going to get in at the exact right time. A simple rule of thumb is to adhere to Benjamin Graham’s “Margin of Safety.” Graham, universally recognized as the father of value investing, said the Margin of Safety is achieved by buying a stock only when it’s trading below its maximum buy price, thus minimizing potential losses.

To learn more about value investing, and how to find undervalued stocks, you should consider subscribing to our Cabot Undervalued Stocks Advisor newsletter. In it, analyst Bruce Kaser uncovers stocks that combine elements of value and growth - companies that are growing at a very healthy rate, but are still undervalued by the market.

To join, click here.

Emerging Market Stocks

As Americans, we often get so caught up in our own domestic issues that we ignore what’s going on in the world around us. That leads to a rather limited worldview—and in investing, it can be a costly one.

Emerging market stocks are among the fastest-growing investments in the global marketplace. The nature of emerging markets is what makes emerging markets stocks so enticing.

Emerging markets are economies whose gross domestic product (GDP) is growing at a much faster rate than more developed markets such as the U.S., Germany and France. Consequently, emerging market stocks often grow at a faster clip than the average stock in a more mature market.

China and India garner the most attention. But good emerging market stocks can be found in other, less populous corners of the globe, including South Korea, Mexico, Turkey, Saudi Arabia and South Africa. The options are numerous for investors willing to explore outside their American bubble.

There are myriad reasons to do so. Investing in emerging markets stocks allows you to invest in countries with double-digit GDP growth—or close to it. At a time when America’s economy is expanding in the low single digits, Japan’s economy is struggling and much of Europe is still buried under a mountain of sovereign debt and burdened by the Brexit fiasco, emerging markets are an appealing alternative.

Of course, all emerging markets investing comes with its fair share of risk. The term emerging is really a euphemism for “underdeveloped.”

Many emerging markets are plagued by political instability, inferior infrastructure, volatile currencies and limited equity opportunities. In addition, some of the largest companies in emerging markets are either state-run or private. There are simply more unknowns when investing in a market that is still developing. And the less you know about a company, the more risk you take on when you invest in it.

One way to curb the risk is to invest in American Depository Receipts (ADRs) traded on U.S. exchanges, which subjects the stocks to strict U.S. requirements.

For some investors, emerging markets stocks are simply too risky. But for many, the potential for massive rewards is worth the extra risk.

If you’re part of the latter group, then you should consider subscribing to our Cabot Global Stocks Explorer. In this advisory, analyst Carl Delfeld looks for promising companies benefiting from the rapid growth of emerging market economies - and beyond!

To join, click here.

How to Be a Successful Investor for Life

Successful investing involves much more than just stock selection, so I urge you to read the following tips, the distillation of a lifetime in this business. And then re-read them as necessary over time, so that you can truly make the best use of my recommendations.

Recognize that perfection in investing is impossible. Not all your investments will be winners. Losses are a normal part of the business. Your goal is to ensure that your profits outweigh your losses, and the best way to do that is to have an investing discipline.

Determine whether you’re dealing with a value stock, as recommended by our Cabot Undervalued Stocks Advisor, or a growth stock, as recommended by Cabot Growth Investor, Cabot Top Ten Trader or Cabot Global Stocks Explorer.

If it’s a growth stock, buy only if the stock’s main trend is still positive. If the news is good but the stock’s behavior is not, trust the stock. Remember that the stock market is always looking ahead, and that your best guide to the company’s future news is what the stock itself is doing today.
In healthy bull markets, remain heavily invested, remembering, again, to ignore the news. In bear markets, hold a large cash position, remembering that capital preservation is goal #1. And remember that bull markets always begin when the economic news is lousy, and bear markets always start when the news is good. Again, the market is looking ahead. So learn to trust stock charts.

With value stocks, diversification is highly recommended. Because the timing of their advances is unpredictable, holding dozens of value stocks means the average value of your holdings will appreciate over time. Contrarily, with growth stocks, concentration is advised. Five growth stocks can be plenty, particularly if they are in different industries, while 12 growth stocks is probably the maximum you should contemplate.
Sell your growth stocks in the following circumstances:
a) when the stock’s uptrend ends, as signaled by a substantial high-volume drop below a previous support level
b) when the stock fails to outperform the broad market over a period of 13 weeks
c) when a profit of 100% or more has been cut in half
d) when your loss exceeds 20% in bull markets and 15% in bear markets.
Don’t fall in love with your stocks, regardless of how big your profit or how well you think you know the company. The worst place to focus your investment is your own employer’s stock, as it concentrates your risk.

Five Reasons You Should Invest on Your Own

So now you know how to invest and what stocks to invest in. But I haven’t fully answered the biggest question—the one that has likely prevented you from investing in stocks up until this point: why?

Well, that’s easy—though it’s not a short answer. Let me count the reasons:
1. Self-directed advice is not expensive. Financial advisors usually charge 1% to 2% of your portfolio balance every year. That can really add up. Investment advisories, on the other hand, will tell you exactly what to do to meet your financial goals—at a very small fraction of the cost of a financial advisor.

2. Your circumstances can change. Stop us if this sounds familiar: You meet with a financial advisor to set up an investment account, he or she puts you in a variety of mutual funds that fit your investment goals at the time … then you go years without paying much attention to your account other than to look at the total return listed on your quarterly statements.

But what if your investment goals change? What if you set up the account as a 30-something newlywed just hoping to conservatively save for retirement, and now you’re a 40-something father of two who wants to invest more aggressively to be able to afford to send both of them off to college in a few years?

Those years can sneak up on you if you’re not paying close attention to what you’re actually invested in. If you manage your own account, you’re well aware of what’s in it. You bought and sold all the stocks yourself. And you know whether you want to be more aggressive, more conservative or more diversified. If someone else is managing your investment account, it can inadvertently become an afterthought.

3. Investing on your own is much easier today. Until the Internet came along, things were a lot harder for self-directed investors. Advice was mailed to you, which meant it could be days before you received an alert to buy—or sell—a stock.

Today, online investment advisories provide expert opinions on what stocks to buy and where the market is headed. And online brokerage sites like TD Ameritrade or E*Trade Financial allow you to create and manage your own investment accounts without having to hire a personal broker.

Put simply, the Internet has given self-directed investors more tools to do it themselves than ever before.

4. Not all financial advisors are created equal. Even if you’re willing to spend the extra money to have someone manage your money, you may not be better off. Some financial advisors just aren’t very good. Many fail to regularly beat the market. Others may not have your best interests at heart, convincing you to put your money in stocks you shouldn’t be buying because they take a percentage of every transaction.

There are times when it’s best to keep a hefty portion of your savings on the sidelines. The shadier financial advisors will try to convince you otherwise. And that again brings me back to my original point…

5. No one cares more about your money than you. There are plenty of honest financial advisors out there. But is one of them managing your money? You may never know for sure. When you manage your own portfolio, you—and you alone—decide where your money goes.

The Bottom Line

There’s less mystery surrounding investing in stocks on your own these days. With so much information at your fingertips, do-it-yourself investing is much easier than it was 20 years ago.

And that’s what we do at Cabot Wealth Network—make your job as a self-directed investor easier. With 13 advisories offering a range of investment styles, you can find the advisory that matches your goals today, and change to a different style as your goals change. If you’re willing to invest on your own, we’re here to help—and have been since 1970.

To invest with us, click here.

Investing in stocks isn’t as scary as you think. Investing on your own is empowering and educational, and profitable.

Timothy Lutts is Chairman and Chief Investment Strategist of Cabot Wealth Network, leading a dedicated team of professionals who serve individual investors with high-quality investment advice based on time-tested Cabot systems.