January starts with a bang and lots of resolutions for the year ahead. But already, some of those good intentions may be disappearing into memory. What if I had decided to start investing in the stock market for the first time? I would take advantage of the current market to make that resolution a reality.
Specifically, here are a couple of steps I would take as a first-time investor that, hopefully, could improve my chances of financial success.
1. Learn all about valuation
Think about an item you own. Now decide exactly what it is worth. Not just for you, but objectively.
That exercise sounds easy, but it can be deceptively difficult. Selling the item online might attract bargain hunters who want to pay less for it than it is worth. Getting a dealer to buy it involves them taking a cut.
So the item’s market value might not be what the dealer would pay you for it, as they also need to make a profit. But without access to the dealer’s network, on your own you might struggle to find buyers. Or perhaps lots of other people are selling the same item right now, meaning supply outstrips demand.
The stock market works in the same way. Investors can price the same share very differently over the course of just a few months.
But I think shares are easier than many items to value objectively. After all, they are a stake in a company that will hopefully generate a certain amount of future profits.
One of the most important lessons for a first-time investor is learning how to value shares. If the valuation is higher than the share price, buying could turn out to be profitable. But if the price is higher than the valuation, buying could lead me to lose money. Price tells me what I pay for a share, but valuation helps me understand what it is really worth.
That is vital information needed to succeed as an investor. Exploiting a gap between short-term price and long-term value can be lucrative.
2. Focus on risk over reward
Buying shares is something people do with the hope of increasing their wealth. But they often over emphasise the potential upside without fully processing the risks.
Consider BP Prudhoe Bay Royalty Trust as an example. It offers a 29% dividend yield. If the payout continues at that level, in four years I would have recouped what I spent on the shares in cash – and still own them.
But there is a catch. The trust’s dividends are calculated using a sliding formula that means they will fall over time if the oil price does not keep rising. If the oil price pulls back to a certain level and stays there long enough, the dividends will stop forever under the deed that established the trust.
I think assessing risk matters more than considering reward as an investor. One big risk can wipe out massive rewards in my portfolio. Rather than buying shares for their potentially outsized returns, as a first-time investor I would try not to be greedy.
Instead I would build my portfolio around key principles of trying to manage my risks, such as diversification.
