How to buy stocks: A step-by-step guide for beginners

If you've never bought a stock, this practical guide will set you on your way. With the rise of online brokers, investing has never been simpler and you can get started with as little as a few hundred dollars.

1. Preparation

The best way to start out is to take it slow. Investing can be highly rewarding – both financially and intellectually – but it also carries risks. Before putting your money to work it's important to do a little reading first.

What causes most investors to fail is psychology so you need to be prepared for biases like anchoring, commitment bias, a fear of missing out and confirmation bias, as well as your emotional response when a stock moves against you (as will inevitably be the case from time to time). We recommend buying or borrowing 'The Intelligent Investor' by Benjamin Graham, and heading straight to chapters 8 and 20. These are possibly the two most important pieces on investing ever written – the Mr Market and Margin of Safety concepts – even though they are now some 60 years old. The education section of our website is loaded with useful information.

2. Consider alternatives

Before you dive into stocks, be sure you have enough cash put aside as an emergency fund in case you lose your job or any large expenses, such as medical bills, suddenly appear. Aim for six months' worth of living expenses as a minimum. You should also pay off any costly debt, such as credit cards and personal loans, before you buy stocks. The interest savings are likely to exceed your investment returns.

Funds allocated to the sharemarket must stay invested for long periods to ride out the volatility. If you'll need access to your funds within the next 5 years, stick with cash in a high interest savings account. I love Ubank, but I've also heard good reviews for ING Direct, ME Bank and Rams. If you have a mortgage with an offset account, though, this will probably be the better place to park your cash.

Once you've paid off your credit card and put enough cash away for emergencies and large future expenses, you're ready to start investing. Almost no amount is too small. I'm all for starting young with, say, $500, rather than saving for a larger amount. You'll lose a chunk of your return to fees, but think of it as an education expense. No amount of reading will teach you what it's like to invest until you have real money on the line. 

3. Open an online brokerage account

A brokerage account is the vehicle through which you'll make your stock purchases and sales. It looks a little like a bank account, but instead of seeing a cash balance on your screen, you'll see the different stocks you own and what they are currently worth.

Brokers charge a commission to buy and sell stocks on your behalf, usually $10-20 or a fixed percentage for large sums. Fees are can be a big drag on your returns, which it is why you should keep trading to a minimum and take the time to seek out a low cost broker. You can open a brokerage account through any of the big banks and they all have similar pricing (the Commonwealth Bank's CommSec is Money Magazine's pick, and mine too). We've also heard good things about budget options, such as Interactive Brokers. 

4. Choose what to buy

Once you have an account set up and have loaded it with funds, you're ready to make your first stock purchase.

Ultimately, you want to own high-quality companies for the long term and buy them when they are trading at a discount to their intrinsic value (that is, you want a margin of safety).

Stick to what you know. Before you invest, ask yourself if you could explain to a 10 year old what the company's product or service is and how it makes money.

Another rule of thumb is if you aren't willing to own the stock for 10 years, don't own it for 10 minutes. Before I make a stock purchase, I ask myself if I would be willing to buy it if I knew I could never sell it. If you were going to buy a farm, you wouldn't be thinking about how much you could sell it for the next day, you'd want to know how much wheat it produces and its earnings potential over many years. The same should go for stocks. The closer you can get your thinking to that of a business owner, the better. 

When you're just starting out, it's best to stick to large high-quality companies (the 'blue chips'). Leave the speculative miners, less established companies ('small caps') and biotechs for when you're more experienced (see Good things happen to great businesses). 

Finally, steer clear of hype. If you're reading about how good a stock or industry is in the news day after day (we're looking at you A2 and Blackmores), then there's a good chance you'll be caught overpaying.

For a list of the stocks we believe are trading below their intrinsic value and offer the best potential for good returns, check out our current Buy list (subscription).

5. Dollar cost average and use limit orders

Once you have decided what to buy, it's time to ask your broker to make the purchase on your behalf. This is easy using an online broker – look out for the 'Trading' menu option on their website. You'll need to enter the stock's code/company name as well as how many shares you want to buy.

You'll also be given the option to choose between a 'limit' or an 'at market' order. Always choose the 'limit' option and enter the maximum price you are willing to pay per share. The 'at market' option is essentially saying to your broker that you want to buy the stock at the best available price – whether its $1 or $100 – so you're more likely to be caught overpaying.

If you're investing amounts under $5,000, it's probably better to buy the stock in one hit. If, however, you have more to invest, consider 'dollar cost averaging' by buying some today and then adding to your position gradually over time.

6. Diversify

As they say, 'don't put all your eggs in one basket'. With small amounts, however, it's impossible to diversify adequately without investing your money in an index or mutual fund. If you don't want to actively manage your money, a fund may be the better option. You can find out about investing directly in Intelligent Investor portfolios by clicking here. These portfolios will spread your money across more than a dozen stocks, and so reduce risk, and are low cost with fees less than 1% (ideal if you have only $1,000 or so to invest).

If you would rather invest directly, you should aim to eventually own 10-20 stocks but, again, there's no rush. Remember it's the safest stocks with the least downside that should form the core of your portfolio. To learn more about how to manage your portfolio, see Your $10,000 starter portfolio and Building and managing an income portfolio Part 1, Part 2 and Part 3.

7. Be patient

As Warren Buffett likes to say, investing is a no-called-strike game. There's no penalty for sitting on the sidelines other than opportunity cost, so it's better to patiently wait for the fat pitch – an undervalued, high-quality company that you understand and are happy to own for the long term.

And patience is just as important for holders as it is buyers. Ideas can take several years to play out and the volatility – or lack thereof – in the interim can be gut-wrenching. However, research at the University of California found that those who trade the most lagged the overall market's performance by 6.5% (see Why patience pays off).

When you see your stocks in free fall, don't sell into the panic. Focus on the fact that over the past 90 years, Australian shares have returned 11.5% a year, more than any other asset class – and despite a fleet of wars, recessions and financial crises. Ignore the short term fluctuations. As Baron Rothschild put it, 'the time to buy is when there's blood in the streets'.

The time to sell a stock is when: (1) it has become too large a chunk of your portfolio, or (2) you're no longer confident to make assessments of the business and its future, or (3) when you've found an even more undervalued stock to replace it (see How to decide when to sell).

The road ahead will be exciting for you, have fun and good luck!

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