Welcome to the Motley Fool’s “Beginner’s guide to investing in ASX shares”.
If you’ve decided that you want to start investing in shares, congratulations! There is no more reliable way to create long-term wealth than through ASX share investments.
Why do we think investing in shares is a good decision?
Over its history, the S&P/ASX 200 Index (ASX: XJO) index has produced annualised returns of about 10% including dividends and franking credits.
This means that every $1,000 you invest in the ASX 200 could be worth more than $6,700 in 20 years, $17,400 in 30 years, and $45,000 in 40 years. And if your shares do better than the overall market average, your investments could grow even faster.
Let’s take this a step further. If you invest money repeatedly over your lifetime, relatively small sums of money could turn into millions. Let’s say that instead of investing $1,000 once, you invest $500 every month in perpetuity.
After 20 years, you could reasonably expect to have about $344,000. In 30 years, you could have investments worth nearly $1 million. In 40 years, $2.6 million. You get the idea.
You may have heard stories about older people who never made much money from their jobs but are sitting on millions. The share market is a common way they got there.
Ready to dive in?
This is a long post, so to help you navigate your way around, feel free to use the links below to jump to your area of interest. Or, read all the way from top to bottom. The investment in your time will be well worth it (see what we did there?)…
How much money do you need to invest in stocks?
Despite the common misperception, you don’t need a ton of money to get started investing in shares. Brokerage fees have dropped significantly in recent years, so it’s practical to buy your first individual stock with just a few hundred dollars.
You are also spoilt for choice with a nice selection of exchange-traded funds (ETFs) (don’t worry, we’ll get to what those are later), so you can literally get exposure to a group of shares (local or international) or commodities (like gold) with very little outlay.
In short, if you’re ready to start investing in shares, a lack of investable capital shouldn’t necessarily get in your way.
Are you ready to start investing in stocks?
All other factors being equal, the best time to start investing in shares is as soon as you can. Your money will never have more long-term compounding power than it does right now.
Having said that, there are a couple of financial tasks to handle before you put any of your money into the share market. It’s important to get rid of your high-interest credit card debt and to establish an emergency fund, so you can be sure that your investment dollars can be put to work as effectively as possible.
Pay off high-interest debt
Under nearly every set of circumstances, the best use of your cash is to pay down high-interest debt (rule of thumb: interest 10% or higher). For most, that means credit card debt.
It’s very easy to underestimate the power of compound interest combined with time.
A 20-year-old lucky enough to invest $10,000 and achieve the historical share market average of 10% returns would be a millionaire before age 70. That’s multiplying your money by 100!
Unfortunately, that math works the same way in reverse. If you’re accruing 10% interest, $10,000 in credit card debt becomes $1,000,000 before age 70. At an all-too-common 20%, that dubious milestone is hit well before your 50th birthday.
Obviously, this doesn’t happen in practice — by making even the minimum payments on your credit cards you will generally prevent your debt from snowballing out of control, but the mathematics sure is scary!
Ideas to help you get rid of your credit card debt as fast as possible include transferring your debt to a card offering an interest-free period, or obtaining a personal loan to lower your interest expense.
Establish an emergency fund
Stuff happens — stuff that requires money to fix. (Think job loss, car transmission issues, medical bills, or anything else that Murphy or life throws your way.) If you don’t have that money on hand, you’ll have to improvise to make ends meet, which could mean patching over the problem with an expensive solution like a credit card (see above) or worse.
That’s why everyone should have an emergency fund — a cash hoard you can raid if unexpected expenses show up. Your emergency fund needs to be readily accessible in a high-yield savings account.
Don’t expect to make a killing on this investment — the interest you can get on most savings accounts won’t even keep up with inflation — but the peace of mind it will buy is priceless.
How big should this essential investment be? Here are some basic guidelines:
Then your emergency fund should cover living expenses for …
Have no dependents relying on your income
3 to 6 months
Are the sole breadwinner or work in an unstable industry
6 to 12 months
Are retired and living on a fixed income
While those suggestions may seem excessive, following them will put you in a position to stay the course in your investments, no matter what unexpected expenses come your way. It’s better to have it and not need it than need it and not have it.
Even beyond an emergency fund, because of the volatility of the share market, any money you might need in the next five years DOES NOT BELONG in the share market.
That money belongs in places like basic checking and savings accounts, high-yield savings accounts, money market accounts and funds, term deposits and government bonds.
Keep in mind that one type of account may not best serve all of your short-term savings needs. For example, cash earmarked for a home down payment that you plan to make in a few years is ideal for something like a term deposit, while your kid’s summer camp tuition is better off in a high-yield savings account.
We realise at this point, your head might be spinning with all the choices. If it is, take a few minutes to read our guide to asset allocation. It slows things down and answers questions like exactly what percentage of your money to put into shares.
Once you’ve deployed your funds for near-term needs, it’s time for the share market!
Understand your investment goals
Another important thing to do before you get started is to get a general sense of “who you are” as an investor. There are a few important questions to ask yourself, such as:
- Why are you investing?
- What is your risk tolerance?
- What is your investment priority?
- How much time do you want to spend on your investments?
Why are you investing?
One of the important things to do before you get started is to understand why you’re investing. This can play a major role in your investment style, risk tolerance, and more.
For example, if you’re saving for retirement, you should be less inclined to take risks than someone who has a substantial nest egg in a superannuation account but is simply investing to try to make some additional money. The same can be said if you are investing for a specific goal, such as to pay for your kids’ education.
What is your risk tolerance?
Assessing your risk tolerance is more of a personality question. Are you a risk-taker that is willing to ride out some turbulent moves in share prices in order to potentially achieve better long-term returns? Or, would large swings in the value of your portfolio make you nauseous?
There’s tremendous variety within the share market when it comes to risk. Just to name a couple of examples, a company like CSL Limited (ASX: CSL) that has a long track record of profitability and a young and unproven but high-potential stock like WiseTech Global Ltd (ASX: WTC) represent two different ends of the risk spectrum.
What is your priority?
This is another question that can help you choose stock investments that are right for you. If your priority is to grow your money, for example, you don’t need to focus on dividend-paying shares.
On the other hand, if you plan to rely on your stock investments for income, you may want to focus on higher-paying investments only. This is even true if you decide that you’re best suited to invest in index funds.
For example, an investor whose main priority is long-term growth might choose an ETF like the Vanguard Diversified High Growth Index ETF (ASX: VDHG), which has a 90% allocation towards growth assets and 10% to income generating assets.
On the other hand, an income-reliant investor might choose the Vanguard Australian Shares High Yield ETF (ASX: VHY), which aims for exposure to companies with higher forecast dividends relative to other ASX-listed companies. An investor who falls somewhere in the middle might choose the iShares Core S&P/ASX 200 ETF (ASX: IOZ) which tracks the ASX 200 index and charges a reasonable management fee of 0.09%.
How much time do you want to spend on investing?
This is the main question that will tell you if you should buy individual stocks, or if you’d be better off focusing on ETFs and mutual funds. To be sure, there’s nothing wrong with the latter option. Index funds can ensure that you do as well as the overall market, which, as we saw in the introduction, is quite good over time.
If you want to pick individual stocks, we absolutely encourage you to do so. However, there’s a caveat. You need to commit enough time to thoroughly and effectively evaluate stocks before you buy them.
At a minimum, we’d suggest only investing in individual stocks if you have at least a couple of hours each week to learn about investing and to evaluate potential investment opportunities.
Opening your brokerage account
A brokerage account is similar to a bank account, with the key difference of being able to buy shares, bonds, mutual funds, and ETFs. There are several great online-based brokerages with lots of features to help you analyse stocks, reasonable commission structures, and user-friendly trading platforms.
SMSFs vs taxable accounts
When you open your brokerage account, you’ll have to decide what type of account you want. You have a few options, but for first-time investors, there are generally two main ways to go – standard or SMSF.
A standard brokerage account (under your name or joint with your partner) is your basic, everyday investment account. Generally, any profits you make are subject to capital gains tax (CGT), while losses can be used to offset your future CGT liability. On the other hand, dividends are taxed as income, just like your wages.
Another option is to start a self-managed super fund (SMSF) and open a brokerage account under this structure. We won’t go into detail about whether an SMSF is right for you as the best person to give you that advice is your accountant.
But if you do buy and sell shares under an SMSF, the income you generate is usually taxed at a concessional rate of 15% – and that’s usually well below the tax rate for most standard accounts.
The advantage of a standard account is that you can deposit as much money as you want and withdraw your funds whenever you need to.
You should also be aware that there are costs involved in setting up an SMSF and maintaining it, so you should talk to your accountant about what these are before deciding.
There are several perks of working for yourself, but unfortunately, superannuation isn’t one of them as many sole-traders and small business owners are not compelled by the tax system to contribute to their retirement savings.
This often means they won’t have enough to retire on unless they force themselves to put money aside every month for their super. If an SMSF isn’t an ideal option for you, then signing up for a super account run by an industry fund or a private financial organisation is probably be the way to go.
However, you will need to do your homework as fees and investment returns can vary greatly between funds. Some funds also give you greater control over how your savings are invested.
No matter what you decide, you have to make it a habit to put aside a part of your income into the super account – even if it means cutting back on your pub crawls.
How to choose the best broker for you
It’s important to do some quick comparison shopping when it comes to brokers, as there are some significant differences.
Some offer tons of educational features, as well as access to high-value research reports. Some even offer branch offices across the country, which can be great if you ever want face-to-face assistance; while others are light on features but offer some of the cheapest commissions in the industry.
Once you’ve decided which broker best fits your needs, opening a brokerage account is typically a quick and painless process.
Should you invest in individual stocks or are funds the better option?
Here’s the key point: if you have the time, knowledge, and desire necessary to invest in individual stocks the right way, we absolutely encourage you to do it.
If not, there’s absolutely nothing wrong with building a portfolio of low-cost ETFs and mutual funds to take the stock-picking challenge out of the equation.
In fact, Warren Buffett said that the best way for the majority of investors to get exposure to the stock market is through low-cost passive index funds.
With that in mind, if you decide that you’re better suited to invest in stocks through funds, here are a few things you need to know.
Mutual funds vs ETFs
There are two main categories of funds you can use to invest in the stock market — mutual funds and exchange-traded funds, or ETFs.
A mutual fund is an investment vehicle that involves a bunch of investors pooling their money to invest for a common purpose.
For example, investors might contribute $100 million to a “large-cap growth” mutual fund, and the fund’s managers would then take that money and build a portfolio of stocks that meet that description.
You can invest in a mutual fund through your broker, but you invest a set dollar amount, and mutual fund transactions only take place once per day. In other words, if you choose to invest $5,000 in a certain mutual fund, you would place your order and the broker would fill the order after the share market closed for the day.
Exchange-traded funds, or ETFs, are similar in some ways. Specifically, they are a pool of investors’ money for a common goal.
However, they trade on major exchanges like stocks, so you would buy a certain number of shares, not a fixed dollar amount. And ETFs trade throughout the day, so if you place an order, it will be executed at the current market price.
Active vs passive management
If you’re planning to invest in funds, it’s important to make the distinction between passively managed index funds and actively managed funds.
Index funds simply are designed to track an index and replicate its long-term returns. For example, an S&P/ASX 200 index fund would invest in the 200 ASX stocks that make up the index, and with the appropriate weights. If the ASX 200 increases by say, 10% in a given year, the fund should do the same.
Because they don’t require any stock-picking expertise, these funds don’t have to employ active managers. This keeps costs much lower, as we’ll get into shortly.
On the other hand, actively managed funds hire investment managers to construct a portfolio. The big difference from an investor’s perspective is that index funds are designed to match the performance of a benchmark index. Actively managed funds are designed to (hopefully) beat a benchmark index. The downside is that active management costs more.
To be clear, this doesn’t mean that if you invest in an actively managed mutual fund that you will beat the market.
In fact, numerous studies have shown that the majority of actively managed funds underperform the share market. Some actively managed funds can be worth the cost, but be sure the fund has a well-established history of beating its benchmark index.
As a final thought about funds, it’s important to know how much you’re paying. If you look at a quote of any mutual fund or ETF, you should see a number called the expense ratio, which tells you the fees you pay as a percentage of your investment each year.
For example, if you have $10,000 invested in a fund with a 1% expense ratio, you’ll pay $100 in investment fees this year.
There’s no set rule as to what’s too expensive. For index funds, anything in the 0%–0.25% range is quite normal, while we’d consider actively managed funds with 0.5%–1% expense ratios to be reasonable.
How much of your money should be in stocks?
First off, this refers to the amount of your invested money. Obviously, things like your emergency fund shouldn’t be in stocks. So, it’s important to learn the basics of asset allocation. For beginners’ purposes, we can narrow this down into two basic categories — shares (equities) and bonds (fixed income).
It’s a smart idea for beginners to read through our guide to asset allocation, but for the time being, there’s one main idea you need to know. Stocks have higher long-term return potential, but also have more short-term volatility.
Bonds, on the other hand, tend to generate lower returns over long time periods, but also tend to be less volatile.
Because of these traits, stocks are better-suited for younger investors while bonds are more in-line with what most older investors need.
Here’s another important concept. All investors should have some combination of the two, with younger investors more stock-heavy and older investors more bond-oriented.
There’s no set-in-stone rule when it comes to asset allocation, but a useful guideline is that you can get a ballpark idea of your stock allocation by subtracting your age from 110.
For example, if you are 38, this implies that you should have about 72% of your portfolio in stocks, with the remaining 28% in bonds. As you get older, you’ll adjust your holdings accordingly.
How to pick your first stocks
Before you start picking stocks, it’s important to build up your “toolkit” that will allow you to evaluate and compare stocks in the right way. With that in mind, here are some of the basic terms, metrics, and other things to know that will make the process easier and more effective.
Basic investing terms to know
Before you can property evaluate shares, you have to speak the language. Here are a few basic investment terms you should know that will help you better understand stock quotes and market commentary:
- Bid/ask — When you read a stock quote, you’ll generally see three prices. You’ll see the last trade price, as well as two other prices called the “bid” and “ask”. The “bid” price is highest price someone is currently willing to pay for a stock. The “ask” price is lowest price someone is currently willing to sell a stock for.
- Market capitalisation — The combined value of all outstanding shares of common stock for a company.
- EPS — Short for earnings per share. If a company earned a profit of $1,000,000 during a quarter and has 1,000,000 shares of stock, its EPS would be $1.00. This is important in several of the valuation metrics we’ll discuss in the next section.
- Beta –– This is a good metric to make sure shares fit within your particular risk tolerance. Beta is a measure of how reactive a stock is to market movements. A stock with a beta of 1.00 can be expected to generally move in-line with the broader market. A beta of less than one indicates a lower-volatility stock while a beta greater than one indicates a higher-volatility stock.
Basic investing metrics
There are dozens, if not hundreds, of potential investing metrics you could use to evaluate shares. Obviously, it’s not practical (or necessary) to go through all of them here.
However, there are some basic metrics that are easy to calculate and implement in your analysis that all investors should know.
- P/E ratio — The P/E, or price-to-earnings ratio, is the most commonly used valuation metric in investing. To calculate it, simply divide a company’s current stock price by its last 12 months of earnings per share. A company that trades for $60 and earned $4 per share over the past year would have a P/E of 15. This is most useful for comparing companies with stable profitability that operate in the same industry.
- PEG ratio — For rapidly growing companies, the P/E ratio isn’t always the best metric. The price-to-earnings-growth ratio, or PEG ratio, is a metric that accounts for the fact that companies grow at different rates. To calculate, divide the company’s P/E ratio by its annualised earnings growth rate. For example, a company with a P/E of 30 and a 15% annualised growth rate would have a PEG ratio of 2.0. A lower number is usually better.
- Payout ratio –– This is a must-know metric for dividend investors. A payout ratio is a stock’s annual dividend rate as a percentage of its earnings. For example, a stock that pays $0.60 to shareholders each year and earned $1.00 last year would have a payout ratio of 60%. This can help you determine if a stock’s dividend is sustainable or in trouble, and can show you if the company is prioritising reinvestment in the business (growth) or return of capital to shareholders.
- Debt-to-EBITDA – It’s generally a good idea to avoid companies with excessive debt. While there’s no specific definition of what “too much debt” means, the debt-to-earnings before interest, tax, depreciation and amortisation (EBITDA) ratio can help you compare the debt burdens of companies to put things into perspective. You can find a company’s total debt on its latest balance sheet, and you can find its annual EBITDA on its income statement (and both documents can be found in its latest financial reports).
Value stocks vs growth stocks
There are two main types of stocks you can invest in — value stocks and growth stocks.
Value shares are generally thought of as companies that trade for valuations less than the overall share market’s average, although that’s not a set-in-stone definition. The important point to know is that the goal of value investing is to find shares that are trading for substantial discounts to their intrinsic value.
Growth shares, on the other hand, are generally defined as companies that are growing faster than the market’s average. The idea behind growth investing is to find shares that have the highest long-term potential relative to their current share price.
Things to look for when choosing your first stocks
- Sustainable competitive advantages: One of the most important things to look for when investing are durable competitive advantages in a company’s business. This could mean a valuable brand name, proprietary technology, efficiency advantages, greater scale, or high barriers to entry. The idea is that these types of advantages can help preserve a company’s market share and pricing power, which is essential for a successful long-term investment.
- Solid balance sheet, low debt: We already mentioned that it’s generally a good idea to avoid companies with lots of debt. The debt-to-EBITDA ratio, which was discussed earlier, can help you analyse a company’s debt burden.
As much as we’d like to, we can’t give you all of the tools you’ll need to be a great stock investor in a single article. Learning about investing is a lifelong process, and even the most successful investors in the world still make learning a priority.
Having said that, there are some concepts that you should know if your goal is to become an excellent investor. Here are seven of the best lessons you can learn as you get started on your journey.
Long-term investing is the best way to go
As we mentioned in the introduction, the share market has historically generated total returns in the 10% range for investors over long periods of time (think decades).
However, over shorter periods of time, it’s another matter entirely. Stocks – even those of ultra-stable companies – can fluctuate dramatically in the short term. We’ve seen that in recent months where the ASX 200 has swung wildly along with wider global market volatility due to the COVID-19 pandemic. Trying to time the market’s near-term movement is almost always a losing battle.
The point? Long-term, buy-and-hold investing is the most reliable way to create wealth. Leave day-trading and other short-term techniques to professionals.
Look at market crashes and corrections as opportunities
Nobody likes to watch the value of their investments plunge. Market crashes can be scary, but they are also the best long-term opportunities.
If you’re investing for the long run, the right way to look at share market corrections and crashes is like a sale at your favourite store. If you were shopping, and suddenly you heard an announcement that everything in the store was 25% off, would you panic and run away? Of course not! So why would you avoid the share market when literally the same situation occurs?
Don’t be afraid to sell if something changes
Even though long-term investing is the best way to own shares, that doesn’t mean that you have to hold every stock you buy for decades, no matter what.
Legendary investor Warren Buffett once said that “all there is to investing is picking good stocks at good times and staying with them as long as they remain good companies.”
Pay particular attention to the last part of the sentence. There are plenty of reasons to get rid of shares, especially if something changes with your overall investing thesis.
For example, if one of the reasons you bought a stock was because you liked the management’s debt-averse approach, and the company starts borrowing excessively, it could be a good time to re-evaluate your position.
Don’t invest in a business you don’t understand
If you don’t understand biotech stocks well, there shouldn’t be any of them in your portfolio. Warren Buffett doesn’t understand businesses with a lot of technology, so he tends to avoid them.
As a general rule, if we can’t clearly explain what a company does, how it makes money, and how it could grow in a few sentences, we won’t invest in it.
Don’t follow the crowd
As human beings, our emotions often get the better of us, and that’s especially true in investing. When we see all of our friends making money on the latest “it” stock, that’s when we want to throw our money in.
Conversely, when we see commentators on TV panicking and share prices falling, that’s when we’re inclined to sell before things get any worse.
It’s common knowledge that the main idea of investing is to buy low and sell high, but our instincts compel us to do the exact opposite. In fact, the majority of investors underperform the market over time, and being too reactionary to news and making emotional investing decisions is a big reason why.
Know the difference between investing and speculating
There’s nothing wrong with making a punt every now and then. It’s just important to be aware that’s what you’re doing and to limit your risk accordingly.
In other words, it’s important to know the difference between investing and speculating. If you’re buying a stock and you can make the case that it’ll either triple or go to zero in the next few years, you’re speculating.
To be perfectly clear, speculating is an investing word for “gambling.” Don’t gamble with money you need.
As an example, we generally recommend having about 5% of your portfolio’s value in speculative stocks at any given time, with the other 95% in shares that have a high probability of steady but continuous growth.
The point is that it’s important to know the difference between the two and to know which one you’re doing at all times.
Learning about investing is a lifelong process
We know we keep talking about Warren Buffett, but let’s face it, there isn’t anyone better to learn the rules of successful investing from.
On that note, many investors are often surprised when they find out how Buffett uses most of his time.
He doesn’t spend his workdays in meetings or on calls. Instead, he spends the bulk of his time sitting alone in his office and reading. “Read 500 pages like this every day. That’s how knowledge works. It builds up, like compound interest,” Buffett said.
There is nobody on this planet who knows everything there is to know about stock investing. If you want to become the best stock investor you can be, you need to treat learning about investing as a lifelong process.