Stock investing for beginners: returns, risk, strategy

I have previously written about different investment instruments in an article (Analysis of investment opportunities) and briefly discussed the different options. For those who want to achieve higher returns and are willing to take some risk, one option is to invest in stocks. That is, buying ownership of individual companies such as OTP shares listed on the Hungarian market or MOL, while on the American stock exchange you can find Tesla and Nvidia shares, to name just two big names.

It is a good question why you should choose stocks among the countless stock market instruments. Perhaps the most important argument in favor of investing in securities that embody ownership is that these instruments can now be accessed very simply and safely through brokers, and you don't have to be afraid of them any more than you would be of buying a government bond or a house. The other is that the average return on stocks stands out from most instruments. Over the past 100 years, it has been possible to achieve a nominal return of around 10% per year, which has surpassed other asset classes, and if you look at a shorter time horizon, the return is even higher.

Other advantages of investing in shares:

• 🛡️As a regulated capital market transaction, you can trade safely
• 💵 You can buy and sell stocks at low cost, with Interactive Brokers charging around $2 per sale or purchase for US stocks
• 🪙 a share can be used to describe countless other instruments, such as gold, commodities or real estate
• 🌍 the range of companies available is very wide, you can buy the better-known names, such as Louis Vuitton shares, on several markets
• 💰 a stock can not only have price gains, but also pay dividends
• 📊 Stock market companies are required to submit reports so companies can be fundamentally analyzed, so you will have data to work with
• ⚡ in most cases, liquidity is very high, shares can be bought and sold with the click of a button (unlike, say, land, real estate or physical gold)

Since a regulated capital market transaction has several conditions, numerous institutions ensure that transactions are carried out properly. These include the clearing house, but in many countries the national banks also provide various protections to ensure the ownership of securities. In addition, in most countries an investor protection fund compensates clients if, for example, the broker "steals" the securities, disappears, goes bankrupt, and so on. The stock exchange has existed in the USA for about 250 years, and shares for even longer. The first European stock exchange was opened in Amsterdam in 1602, so it cannot be said that it is a novelty.

So, in Western democracies, there is an established form of investing in securities, which has now become a very safe process. So much so that a significant part of American pension funds keep their savings in stocks, of course, along with other assets such as government securities or gold, reducing risk and diversifying investments. But of course, the above does not protect you from stock price losses, that will be your risk if you choose to invest in stocks.

Let's go back a little to the institutions above and what they do, so that you can better understand why buying a security is no more dangerous than, say, signing a home purchase contract.

What is a clearing house?

A clearing house is a key player in financial markets, whose main task is to make transactions on stock exchanges and other trading platforms safe and smooth.

The main tasks of the clearing house are:

• 🧾 Settlement of transactions: After the transaction is concluded, the clearing house matches the buyer's and seller's transactions and calculates who owes whom, how much, and what (e.g., the amount of money and securities).
• 🧱 Risk management: As a central player, it guarantees performance; if one party goes bankrupt, it bears the risk.
  • This is achieved by:
    • requests a deposit (margin) from participants
    • reassesses positions on a daily basis
    • creates safety reserves.
• 🔄 Central Counterparty (CCP) role
  • The clearing house stands between all transactions
    • as a buyer towards the seller,
    • and acts as a seller towards the buyer.
  • This reduces the direct risk between market participants.
• 🕒 Fulfillment of transactions
• The clearing house ensures that on the agreed date
  • securities are transferred from one party to another,
  • and the money arrives.
• 🏦 Examples of well-known clearing houses:
  • KELER: A central clearing house and securities depository operating in Hungary.
  • LCH, Eurex Clearing: European derivatives clearing houses.
  • DTCC: American securities clearing system.

So the clearing house does nothing more than stand between the two parties and supervise the transaction, only executing the transaction if everything is really in order.

🇭🇺 Good news for Hungarian stockholders is that the MNB requires brokers registered in Hungary to declare the securities held in their names, so it can be verified whether the broker actually executed the transactions or not.

What is the purpose of the reporting obligation?

Ownership register

• 🏛️The MNB requires investment service providers to maintain and report on their clients' securities holdings, broken down by name.
• 🔍This ensures that each security can be precisely identified, i.e. who owns it, in what quantity, with what ISIN code, and on what date it was registered.
• 💻In Hungary, With the ÉSZLA application Or the On the MNB website the contents of registered securities accounts can be requested.

Investor protection

• 🔒 This prevents investors' assets from being mixed up with the broker's own assets.
• 📉 If a brokerage firm goes bankrupt, the MNB sees exactly which client has which asset, and it is considered segregated property.

In almost every country, depositors are also provided with some kind of investor protection fund, which does not compensate for returns or exchange rate losses, but stands in for missing assets, for example in cases such as embezzlement or brokerage scandals. You should check the rules of this based on the laws of the given country. This primarily depends on the country in which the given broker from whom you buy the shares is registered. A very good example of this is that Interactive Brokers, which is the world's largest broker, serves American clients through its American subsidiary, while European clients are largely served through its Irish subsidiary.

Some thoughts before you start investing in stocks

Most studies and models are basically related to developed market stock exchanges, such as the USA, Western Europe and a few other markets, for which adequate data is available. There is the necessary financial culture and history, and it is not at all certain that the principles outlined here will be true for other stock exchanges or instruments. Of course, everyone knows their own market a little better, but this also causes a distortion in the approach, which is usually called “home bias”. I am not saying that there is not a hidden database somewhere for the papers listed on the Bangladeshi stock exchange, or that the country’s supervisory bodies are not of a very high standard, but checking them causes significant difficulties for most investors. There are also markets that you simply cannot access if you are not a citizen, such as Taiwan. Fortunately, Interactive Brokers has access to markets in most countries, so if you want to trade or invest cheaply, this is your best option for accessing instruments.

Stock investing has another big advantage: there is no need to sell, meaning you can hold the paper indefinitely. Bonds have an expiration date, while holding some assets over the long term simply makes no sense, here I am basically referring to formats designed for intraday trading. In addition, stocks represent ownership in companies, and according to stock exchange rules, these organizations must publish reports on their operations at certain intervals, so you will have a lot of data at your disposal to track the events surrounding the companies you own.

Stock investment: how and what to invest in

It is worth keeping a few rules of thumb in mind when investing in stocks:

• ☝️As a first line of defense, build up a 3-6 month reserve that is not invested in stocks. For example, if your monthly expenses are 1000 USD, then have 3000-6000 USD in some liquid form that you can access quickly and cover your unexpected expenses. Cash, foreign currency, short-term government securities are perfect for this.
• ☝️It's okay to have a second line of defense that covers a significant portion of your healthcare expenses. This could be some kind of health insurance, life insurance, or anything that provides coverage for the costs.
• ☝️The minimum investment horizon for stocks is 7-8 years, so only invest money that you won't need for a long time. If you have to sell your portfolio out of necessity, it will be a constant risk, and you may end up having to sell your positions at a loss.
• ☝️Everyone is concerned with returns, but in the long run, costs are also very important. The lower they are, the more you will have left, so low costs should be an important aspect of choosing a broker.
• ☝️Diversify among stocks: the more companies you own, the closer you will be to the market average. However, concentration also increases the expected price gain, so it's a two-sided scale: diversification reduces volatility and brings returns closer to the average, concentration increases volatility, but also the expected return/loss.
• ☝️Diversify between brokers: you have not only stock price risk, but also institutional risk. Don't keep your entire portfolio with a single broker.

Although this is not trivial, most investors invest in their own country's currency. Since more than 60% of the world's stock market capitalization is represented by US stock exchanges, investors' currency exposure is usually in USD. Of course, there are exceptions, if you invest in UK companies, the GBP will be the basis for the investment, while if you invest in German companies, the EUR will be the basis for the investment. Many countries support investing in their own stock markets, for example with tax breaks, so it is worth considering these as well.

Cost, cost, cost

In the list above, I mentioned low costs, which not only refer to how much it costs you to invest in stocks, such as trading fees or account management fees, but also the cost of foreign exchange, also known as FX, risk. In other words, if your national currency, in which you receive your salary, weakens compared to the currency in which most of the world's investments are denominated, i.e. the USD, then it is worth investing in stocks not denominated in your national currency due to the long-term exchange rate risk. In such a case, you can profit nominally from the exchange rate change.

I would like to present an example of exchange rate risk using the Hungarian forint. Do you know how much 1 USD was in HUF in January 1989? It was 1 USD=53 HUF. And in September 2019, 30 years later? It was 1 USD=303 HUF. The HUF/USD exchange rate peaked in October 2022 at around 435 HUF, which represents a more than eight-fold increase. In the 30 years between the first two dates, the value of the forint decreased by an average of 6.12% per year against the dollar, which is how much your investment would have lost in value if you had held it in HUF. So, for example, holding investment instruments in Hungarian forint is risky in the long term. Obviously, I could have also used the currencies of countless other countries, for example, the spread of the EUR against the USD over the past 5 years was 0.82-1.02. However, it is important not to overdo the switching of currencies back and forth, as this also incurs costs.

👆🏻What is liquidity and why is it important for stock investments?👆🏻

Liquidity is a financial concept that expresses how easily and quickly an asset can be converted into cash without suffering a significant loss in value. The liquidity of individual assets varies, it is not possible to say in general that, say, a stock is always liquid. In general, we can say that:

📌 Example: You can sell an Apple share on the stock exchange in seconds, while selling a vacation home can take months, so the former is more liquid.

So, you can only sell and buy something if there is someone willing to do so on the other side. So liquidity actually means how quickly a financial product or asset can be turned into cash. If you need to get out of an instrument, but you don't know who to sell it to, that instrument becomes illiquid and its price starts to fall.

When does a stock or stock market become illiquid?

• 😱 If there is panic and no one wants to buy. There are many sellers, few buyers, the price will fall. This is called oversupply.
• 📈 If there is no seller, but there are buyers, buyers still can't buy, which increases the price. This is called excess demand. For example, the American-listed counterpart of a European stock, called an ADR, is usually not very liquid.
• 🖼️ It is difficult to sell a given device because it is rare, not fashionable, and only purchased by a special group of customers, such as works of art.
• 🤏 The market is small, which is determined by the capitalization of the entire market.
• 🐳 If someone has a portfolio that is too large, in the billions of USD, and the amount of instruments circulating in the market is too small. This is a typical problem for large fund managers or, for example, Berkshire Hathaway.

To simplify the above, on well-known stock exchanges such as the American, European, and British, it is very difficult to encounter the above illiquidity phenomenon, but it does occur in rare cases.

How can you access the stock markets?

Based on my years of experience in the stock market, the biggest fear for new investors when it comes to investing in stocks is how they will access the stock markets and whether their money will be safe. The easiest way to do this is to find a reliable broker. The bigger the better, if they have a banking background, that's even better, but check to see if they serve your country. Many brokers only accept American or Western European clients. Some examples:

• 💼 Interactive Brokers: cheap, covers almost all markets, free access to special data like the EVA framework or Morningstar analyses. They have 2.2 million users and manage over 370 billion USD in investments. We also have several accounts here.
• 🎯 Tasty Works: It is mainly used for options trading, but it is also perfectly fine for buying stocks. It is not as cheap as Interactive Brokers, but it is big and well-known. 🏦 Charles Schwab: a large broker with a banking background.
• 🏛️ Erste, K&H Bank and other large banks: They are primarily good for European clients, expensive, cumbersome, and don't reach many markets, but they are very reliable and have a much higher chance of compensating clients than smaller institutions.
• 📱 LightYear and Revolut: I wouldn't keep a lot of money in fintech companies, but it's great for a second or third broker, for trying out investments.

You need brokers because you need an intermediary to connect you with listed companies. Another thing worth looking at is BrokerChooser. They also tend to have good ideas about choosing a broker. Theoretically, you can reach out to stock market companies directly and sign a contract with them if you want to buy shares above a certain amount, but you can expect an extremely cumbersome and expensive legal procedure, so you are much better off accessing the markets through a broker.

Another important thing to consider when dealing with brokers is the insurance that comes with the account, the amount of which varies from country to country. A given broker is always covered by the investor protection in the country in which the company is registered. So, if it is a broker registered in the USA, you will be covered by SIPC and will be compensated up to 500 thousand USD if the broker goes bankrupt, steals the papers, etc. Investor protection in some countries:

Always pay attention to the brokers' costs, as the cost practically means a negative return. Compare competitors where you have to pay less, that is usually a big advantage. Of course, not only the price is decisive, there are a thousand other aspects, but you will DEFINITELY lose the cost from your returns, so it can be a big pullback.

Costs can also be reduced by position sizing, let me give you an example. Let's say you want to build a portfolio worth 100000 USD from 20 stocks, which means positions of 5000 USD per company, which you can take in one or more steps. You choose Interactive Brokers as your broker. For costs, you need to visit the Interactive Brokers website (broker commissions), where you can see in the fixed column that:

• 🫰Buying and selling costs: 0.005 USD/share, but minimum 1 USD/transaction

Based on the above, if you buy all the shares of each company in a single purchase of 5000 USD and the share price is 50 USD, you will buy 100 shares, which would still be only 0.5 USD if there were no minimum limit of 1 USD. This means that your total cost will be 20×1 USD. This is 0.02% for the entire portfolio, which is much cheaper than buying a bank fund. However, if you buy the shares not in 1 step, but in 3 steps per company, for example in steps of 1000/2000/2000 USD, your cost increases to 3x20x1 USD, or 60 USD, which is still a very low cost. When does this make sense? For example, if the share price falls, your average price will be lower. The bottom line is that buying stocks is cheaper than almost any other form of investment.

This means that position sizing is a pretty important issue in terms of costs. How do you decide which stocks to buy? I will discuss this in a later article, in the meantime, read the fundamental stock analyses available on iO Charts (here).

Stock investment summary

Based on my experience, novice investors are unreasonably afraid of being scammed, that they do not know how to access the stock market or what stocks to invest in. Today, this is not a serious problem at all, it is much simpler than you think, you just need to follow a few rules of thumb, start with a small amount of money, try and learn. The costs are very low today, a broker charges much less for buying and selling shares than, say, your bank charges for buying an investment fund. So, I recommend that everyone feel free to start investing with a smaller amount to try out whether this form of investment is right for them or not.

🤑If you are interested in what brokers we use, read our articles below:
(I.e.Interactive Brokers broker account analysis – Professional for professionals
📈LightYear Broker Account Analysis - Simplicity and cheapness go hand in hand