Welcome to our 7 step guide to understanding the stock market. This easy-to-follow beginner’s guide will help you learn to invest in the stock market– by leaving out all the confusing Wall Street jargon and explaining things in simple terms.
For more, click to download the (free!) 7 Steps to Understanding the Stock Market PDF, complete with real-life examples and links for additional resources.
Before we get started, here is a breakdown of the 7 categories for this guide (Click to Skip Ahead):
1. Stock Market Basics: Why to Invest
2. Understanding How the Stock Market Works
3. Learning How to Invest in Stocks
4. Learn About Stocks With the P/E Ratio
5. Two Stock Market Factors To Trade On: P/B and P/S Ratios
6. Finding the Best Stocks for Beginners: Looking for Dividends and Growth
7. The Best Way to Avoid Risk and Putting it all Together!
1– Stock Market Basics: Why to Invest
Let’s imagine a life without investing first. You work 9-5 for a boss all your life, maybe get a couple raises, and a promotion or two. You saved some money for retirement but never invested it.
Let’s say you saved $1400 a month for 26 years. This would leave you with $403,200 to live on, which on a $60,000 a year lifestyle would only last you 6.72 years. You’re retiring at 65 only to go broke at 71 and you’ve been a good saver all your life.
Let’s look at the same numbers but add investing in the stock market into the equation.
Again, lets say you saved $1400 a month for 26 years. BUT, you invested it into the stock market and got just average stock market returns. The same $1400 a month compounded annually at 10% turns your net worth into $2,017,670.19 in 26 years!
This is because over the last 100 years, the average annual return for the stock market has been about 10% per year. If you buy and hold stocks for the long term, you can easily earn at least this 10% per year average.
The story gets even better.
With this large sum of money at your retirement, again conservatively assuming a 3% yield on your dividends, you can collect $60,530 a year to live on WITHOUT reducing your saved amount.
Stock Market Basics: It’s All About Compound Interest
By letting the power of compounding interest do the work for you, you can unlock the magic of the stock market and slowly build wealth over time.
It’s not some mystified secret or get rich quick shortcut; this is a time tested method to become wealthy and be financially independent, and it’s how billionaires like Warren Buffett have done it all their life.
Understanding investing means understanding compound interest, because that will be the key to your success with investing.
2– Understanding How the Stock Market Works
In order to understand investing, you must understand how the general principles behind the stock market work.
Before I started researching and reading about investing, the only things I knew about the stock market are what I saw on the news or heard on TV, and it was never positive.
All you need to know:
A share of stock represents part-ownership of a business. When you own a share of stock, you get a claim to part of the profits of a business because of that part-ownership stake.
The stock market is simply a place where ownership stakes of real-life businesses are traded; where you can buy or sell shares of stocks.
By investing in the stock market over the long term, you can participate in the growth of the economy over the long term, because the stock market contains some of the biggest businesses in the economy.
The simple idea:
If you think humans will continue to innovate, and the economy continue to grow, then your investment in the stock market will continue to grow in value.
That said, there’s more to understanding how the stock market works– you have to beware of its very real dangers because it’s easy to lose if you don’t learn to invest in the market the right way.
Warning for Beginners: The Stock Market is Overdramatized
I remember hearing about disasters with IPOs, the failures of Freddie and Fannie Mae and how stocks tumbled afterwards, and the great dot com bubble that burst in 2000.
With each stock market crash or failure, I remember hearing emotional stories about everyday people losing everything they had or big, greedy corporate leaders succumbing to the fall of their empire.
Hollywood depicts Wall Street as this extreme roller coaster ride where fortunes are won and lost every instant, when in reality this isn’t the case.
Yes, the stock market has ups and downs, there is risk involved, and some people do get burned badly, but the majority of successful investors take very boring and safe strategies straight to success, because they understand the basic principles and are educated with how to stay out of risky investments.
Warning for Beginners: The Market Moves Up and Down ALOT
The S&P 500 is a list of the top 500 stocks in the U.S., and is widely accepted as the benchmark for all stock investments; analysts consistently compare performance to that of the S&P 500.
When you hear people refer to “the market”, they usually are referring to the S&P 500.
Now, the worst one day loss for the S&P 500 in 2008 was only -9.03%. In total for the year, the S&P 500 lost -38.49%, which was the worst year the index has ever had.
If you think about these numbers for a little bit, anyone can clearly derive that investors lost less than half their worth during that year. But as you can see from the graph below, the S&P quickly recovered lost ground after the ’08 fall and in fact, periods of time where the price falls are common.
We saw a similar thing after the crash during the pandemic, where after a time of great fear the market recovered quickly and continued to more closely follow the economy (notice too how much the market had risen since its last recovery, from its 2008/2009 lows in the chart above).
An important aspect of investing is knowing that stock prices do fluctuate up and down but when held over long periods of time, the chances of gains are almost guaranteed.
Smart Investors Don’t Listen to Noise
Please don’t forget that a stocks are meant to be a long term investment.
It will pay you dividends that over time will compound and multiply; if invested in a good company the share price should rise substantially as well.
As financial guru Dave Ramsey simply puts it, “The only people who get hurt riding a roller coaster are the ones that jump off.”
Once you gain the confidence to have convictions in your investments– knowing that they will recover when hit badly, you will easily be able to avoid selling your stocks at the worst possible time, when the market has a temporary crash and it seems like everyone else around you is doing it.
3– Learning How to Invest in Stocks
For Part 3 of this guide, I will show you the absolute best strategy you should always use when investing and will help you overcome the biggest hurdle beginning investors face: buying your first stock.
Buying just 1 share of your favorite company when buying your first stock is like taking your first step into the market.
I can’t stress enough how important buying your first stock is, as you can read and read until your eyes turn blue but you won’t start to see progress towards your results until you take action.
Trust me from a guy who has been there before, buying your first stock gives you a sense of empowerment and excitement of being part of the stock market.
Before going over buying your first stock, I am going to reveal the absolute best stock strategy you can use. It is called: Dollar Cost Averaging.
Instead of “trading”, Use Dollar Cost Averaging
What do investing greats have to say about dollar cost averaging? The godfather of value investing and Warren Buffett’s mentor Benjamin Graham wrote in his book The Intelligent Investor that dollar cost averaging:
enables you to put a fixed amount of money into an investment at regular intervals… You buy more – whether the markets have gone (or are about to go up), down, or sideways.
Dollar cost averaging is simply investing the same amount of money every month, year, or week, into the stock market– with the effect of forcing the investor to buy more when stock prices are lower and buy less when stock prices are higher.
By dollar cost averaging, the investor is always invested and will not be devastated by the losses that come with trying to time the market.
Warning for Beginners: Don’t Time the Market
Beware the people who claim they know the exact time to buy low or sell high. In retrospect everyone believes they would’ve been able to predict the highs and lows of the market, but in reality it is in fact impossible.
Trying to profit from timing the market will drive you nuts and always leave you regretting your decisions. Most investors will sell too early and miss out on bigger gains or will sell because stocks have fallen significantly, which is the absolute worst time to sell.
Or, investors will often feel good about their investments when they are doing well and will as a consequence buy a lot more at the time where stocks are very high already and there is very little upside.
Dollar cost averaging gives you the necessary, patient discipline you need to stay in the market for the long term and through the ups and downs.
This tried and true, and often repeated message, encapsulates it perfectly– burn it into your memory:
Time in the market beats timing the market.
Time for Action: Buying Your First Stock
My next recommendation is getting your feet wet and taking the first step towards obtaining control of your future by buying your first stock. Long time fans of the podcast and blog (since 2013!) know that I’ve recommended Tradeking for years for its low $4.95 commission fees.
When Ally acquired Tradeking, I continued to use their service for the Roth IRA I used for the Real Money Portfolio of The Sather Research eLetter, and still recommended them. However, things have changed. After several horrible customer service experiences, I’ve changed my tune.
I don’t want to waste your time here with the details, but you can look for our “Brokers to Avoid in 2020” episode on The Investing for Beginners Podcast if you’re curious about some of the ways Ally has not given the kind of customer service one should expect.
You really can’t go wrong with either of those three — they all offer commission free trades!
Whichever brokerage you decide to go with, make sure that the company is SIPC protected (which is different from FDIC on checking accounts). That could protect your assets during the next financial crisis.
These days, the process to sign up for a brokerage account is SO easy, that there’s no excuse to not get started today. Let me go through some of the basic account types.
Individual brokerage account:
- Taxable, not used for retirement. Deposit as much as you want, withdraw whenever.
- Contributions are pre-tax. Used for retirement, early withdrawals come with fees.
- You can only contribute with post-tax money, but are never taxed on capital gains or dividend income. Early withdrawals also have fees but with some exceptions.
Just Do It: Go Buy a Stock!
I always say that the key to investing is just getting started.
You could over-analyze the situation until your face gets blue, but you won’t make any progress until you open an account and actually buy at least 1 share. There’s nothing like having skin in the game, so think of a company you like, go buy its stock and see what it’s like.
You might be surprised how easy it really is.
4– Learn About Stocks With the P/E Ratio
Arguably the first thing you should learn about individual stock picking is how to calculate P/E ratio from a company’s financials.
The P/E, or Price to Earnings, ratio simply measures how much you are paying for a company’s earnings.
The higher the ratio, the more expensive the company. A higher P/E ratio generally means a company is more popular and more people are buying this stock. P/E ratios vary based on industry and market conditions, and you can tell when the market is more expensive because the average P/E ratio in the market is high.
An average P/E ratio over time has been about 17.
But a company’s P/E can depend on other factors such as its growth, interest rates, and perceived risk or sustainability of earnings.
That all said, the P/E is one of the best shortcut tools for quickly measuring how expensive or cheap a stock is—how generally optimistic or pessimistic the market is on a stock.
To calculate P/E, you take a company’s market cap and divide by their earnings:
P/E = Price / Earnings
You have to do this either on a per-share basis, or by company total. You have two options for this:
- (Per share) P/E = Price per share / Earnings per share
- (Total Company) P/E = Market Capitalization / Earnings
Let’s use a handy website called quickFS to show one way to calculate the P/E ratio. I’ll use one of my favorite companies Microsoft for this.
Entering the company’s name into the search bar, we see the following:
You can divide the price per share, or “share price”, by the latest Earnings Per Share to get:
P/E = $285.26 / $8.05
P/E = 35.4
Microsoft has a higher than average P/E because it has higher than average growth, yet its P/E isn’t something crazy like 100.
Knowing Microsoft’s P/E helps us understand how much the market likes the stock.
Warning for Beginners: P/E Ratio Disclaimer
Please keep in mind that the P/E ratio, and any of the ratios presented here, are not a panacea.
Just because a ratio looks good doesn’t mean the stock will be a great investment. These ratios are tools to help you, as an investor, get perspective on how cheap a stock is based on numerous factors, but you have to look at the whole picture to get the best results.
To really get a good grasp on the ins-and-outs of P/E, read my Price to Earnings Guide for Beginners.
5– Two Stock Market Factors To Trade On: P/B and P/S Ratios
From the 1951-1994 time period, there have been two single ratios that have performed very well in 1-year time periods.
Buying the lowest Price to Book (P/B) and Price to Sales (P/S) ratios have done far better than any single one parameter when bought as group, held for a year, and then sold and re-bought (or held) the next year.
As James O’Shaughnessy showed in his book What Works on Wall Street, when these single ratios are implemented with various other strategies, downside risk can be greatly reduced, while also leading to great annual returns.
These ratios are great for teaching because they are very easy to understand and can tell a more complete picture of a company’s price in the market than just a P/E ratio can.
Low P/B and P/S = Potentially Undervalued Stock
These ratios can be more reliable indicators than P/E ratio because revenue (sales) and book value fluctuate much less than earnings do.
Earnings and earnings per share can be more easily manipulated by companies depending on accounting practices. There have been instances where companies were caught manipulating their earnings after the fact.
However, sales and book value are harder to manipulate– another reason these two ratios can be so useful.
The Price to Sales ratio is usually calculated on a total company basis, with the following formula:
P/S = Price to Sales
P/S = Market capitalization / Revenue
In general, a lower P/S is better especially if you are looking at high growth stocks, and the historical average across the stock market has been around 1.55.
The P/B Buy Low Strategy
The P/B ratio, or Price to Book Value, has worked as a pillar of many conservative value investing strategies. Benjamin Graham popularized the use of P/B ratio and successfully amassed a fortune while teaching countless investors how to do the same.
The basic premise behind buying stocks with low P/B ratios involves buying a company that is selling close to or below their book value, with the idea that you are buying a stock with very little downside because book value can represent a company’s “liquidation value”.
In other words, if a company were to close tomorrow and sell all of its assets at fair value, investors would expect the company to receive its book value, which is its assets minus its liabilities.
This strategy has also been shown to work in various back tests. Going back to James O’Shaughnessy’s work, he found that investing in the companies with the 50 lowest P/B ratios and then rebalancing your portfolio every year, over a period of over 40 years, would’ve given you the second highest performing portfolio compared to any other one single variable.
When combined with other limitations to reduce risk, a low P/B ratio can become a great ratio to use as a prudent value investor attempting to build a safe portfolio, especially if you are looking at stocks in the financial industry which are commonly evaluated with Price to Book Value.
To calculate P/B ratio, simply divide price by book value. It can be calculated both on a per-share basis or total company basis:
- Per share P/B = Price per share / Book value per share
- Total Company (P/B) = Market Capitalization / Book Value
A company’s Book Value is easily calculated from the consolidated balance sheet, and equals total assets minus total liabilities. It is also known as Shareholder’s Equity.
6– Finding the Best Stocks for Beginners: Looking for Dividends and Growth
The simple fact of the matter is:
A dividend creates compounding interest.
Receiving a dividend and reinvesting that dividend is a fantastic way to fully utilize the power of compounding interest. Dividends are a guaranteed return on investment, and companies with good dividend track records tend to grow their dividend payouts every year.
This creates a double compounding effect to your stock investments:
- Compounding as the dividends you reinvest also create their own income stream
- Compounding as your total income stream increases as the company increases their dividend payout
Learning how to calculate a stock’s dividend yield is the first step to understanding how the best dividend stocks can be located in the stock market.
Dividend yield is quite easy to calculate and will often be explicitly stated next to a stock’s price as a percentage. To calculate this Yield %, just divide dividends the company paid for the year by the current share price.
Dividend yield % = Dividend / Share Price
Next, we want to know the dividend payout %. This tells us how much of a company’s profits are being used to fund its dividend.
If a company had too high of a payout %, this could indicate a company being irresponsible. It also commonly warns of a company in trouble who is trying to hide its balance sheet failures while still paying high dividends.
To calculate this, take the dividend paid for the year divided by the company’s EPS (earnings per share found in the statement of income).
Payout ratio % = Dividend / EPS
A healthy dividend yield and dividend payout can reflect a company that is using excess cash efficiently and providing good total return for its shareholders.
Stock Market Basics: Earnings Growth
Earnings are the name of the game for most investors, and therefore can’t be ignored.
This is how a business grows.
A great quote by the legendary investor Peter Lynch explains why earnings growth is critical to understand:
“I can’t say enough about the fact that earnings are the key to success in investing in stocks. No matter what happens to the market, the earnings will determine the results. In thirty years, Johnson & Johnson’s earnings are up seventy-fold, and the stock is up seventy-fold. Bethlehem Steel earns less today than it did thirty years ago, and, guess what? The stocks sells for less than it did thirty years ago”
That said, the type of stocks with the best earnings growth can be very volatile, as minor changes in growth can cause major upswings or downswings because of all the attention on its growth.
A highflying stock with stellar growth may see its growth slow down, and in turn, many growth investors might see this as unfavorable and their selling could drive the stock down very quickly. High growth stocks tend to be much more volatile than other stocks, and it can become a very dangerous place to invest.
To be a successful stock market investor, you have to find companies with good earnings growth that are also trading at a good price.
Earnings growth percentage is calculated by dividing the current year’s earnings by the previous year’s earnings and then subtracting by 1; that decimal can be converted to its growth percentage.
Earnings growth = (Current Earnings / Last Year’s Earnings) – 1
To increase accuracy and get a better feel for how much a company is growing over a longer time period, average the earnings growth percentage over the 3 most recent years.
For example, if earnings growth for a company was:
Then the average earnings growth for the company is (2.4+4.6+3)/3 = 3.33%.
A good earnings growth is around 5-10%, which at least matches or beats average GDP growth, and indicates a stock with a potentially very bright future.
7– The Best Way to Avoid Risk and Putting it all Together!
Congratulations on making it this far in our stock market guide for beginners. In this final step, you will learn what I’ve found to be one of the best ways to discover and avoid risk, to save your stock portfolio from catastrophic losses.
Through many back tests for a formula I created called the Value Trap Indicator, I’ve found common characteristics in companies about to experience substantial stock price drops or bankruptcy.
One simple characteristic was too much debt when compared to shareholder’s equity.
Warning for Beginners: Avoid Risk by Avoiding Debt
Debt to equity is a common measure of risk in investing. If you think about it, it makes sense too. A person more likely to become bankrupt is one with too much debt, and the same is true for companies. If the company considered doesn’t have enough assets to cover their liabilities, or shareholders’ equity, then they have debt to equity ratios that skyrocket.
There are two ways to calculate debt to equity ratio, using Total Liabilities or looking at only Long Term Debt. Most financial website will use Long Term Debt, while I like to use both Long Term Debt and Total Liabilities.
The formula for Debt to Equity using Long Term Debt is:
Debt to Equity = Long Term Debt / Shareholders’ Equity
And to use Total Liabilities instead of Long Term Debt, you can just substitute Total Liabilities into the formula:
Debt to Equity = Total Liabilities / Shareholders’ Equity
For most companies, you like to see a Debt to Equity ratio that is below 1. There are exceptions to this rule, so be sure to read my Debt to Equity Guide for Beginners to fully understand this ratio.
Moving on to Investing in Stocks…
With this final lesson, I’ve equipped you with the tools you need to get started investing in the stock market.
You know how to avoid risk, calculate important ratios, and dollar cost average. I hope you’ve enjoyed this 7 Steps to Understanding the Stock Market guide, as I’ve enjoyed sharing what I know and have learned through various sources.
Think about learning how to invest in stocks like eating a pizza.
You would never eat a pizza all at once, but rather in slices. As you continue in your journey in understanding the stock market and how to invest, try to increase your knowledge slice-by-slice.
You won’t become a master overnight, but as you learn more and more you will get better and better.
Like with your wealth—slow and steady wins the race.