Chapter 5:

How to Invest in Stocks

The Rule #1 Guide To Investing In Stocks

In my opinion, stock market investing is a great way to earn passive income and is essential for any inflation-beating retirement plan. Learning how to invest in stocks is one of the best things you can do to set yourself up financially.

But here’s the catch:

You actually need to understand a few simple principles in order to make money. If you don’t approach market investing with a bit of knowledge, sound investment advice, and a decent investment strategy, then you might as well save your money for Vegas.

In the last chapter we reviewed a great guide to growing your wealth that went over the types of financial advisors and offline and online brokerage accounts and services, the account fees and trading commissions they charge, and much more – so let’s dive into this next part.

The stock market can be incredibly confusing to the uninitiated, and for many would-be investors, that confusion is enough to overwhelm them and scare them away from stock investing entirely. Those who choose to stay away typically figure out how to invest their money in other places, such. as in their retirement accounts, but they never give individual stocks a chance.

However, the benefits of investing in individual stocks and exchange traded funds ETFs far outweigh the time and effort it takes to learn. And, with the right information, the stock market isn’t really confusing at all.

If you’re ready to learn how to invest in the market, you better bookmark this page, because I’m about to explai everything you need to know about market investing, from opening an account, to how to find great companies to buy, to how to trade ownership of these companies.  All of this without needing any sort of robo advisor.

Consider this guide a crash course in investing that will provide you with a workable understanding of the stock market and investing in no time at all. While even the most knowledgeable investors never truly stop learning, the information outlined below will provide you with a great foundation to wade into the wonderful world of investing, including stock trading.

Now let’s get started!

How Does Investing In Stocks Work? 

Let’s get a few things straight… 

When a company makes the decision to go public, “shares” of that company become available for purchase allowing anyone to purchase an ownership stake in the company. The initial share price is determined by financial institutions, i.e., Charles Schwab and the like, that evaluate the company before most investors like you and me can start investing. Once a company is public, investors are able to buy and sell shares of the company at any time. Some of the larger companies also make up the S&P 500, which is essentially an index or barometer of the overall stock market.

Of course, as with any form of business, the goal is to buy a company’s stock when it’s “on-sale” or undervalued relative to its actual value and to sell that stock when it’s fully valued or overvalued in order to make a profit.

A simplified look at a successful investment is one where an investor buys a company for $10 (as an example), holds on to the company for an extended period of time until its value has grown to the point that they feel comfortable selling it, and then sells it for $20, $30, or even $100. If the company offers dividends, investors may also accumulate profits along the way without even having to sell any of their shares.

How Are Stock Prices Determined?

When a company decides to go public, an investment bank helps determine what the price of the individual shares should be at its Initial Public Offering (IPO). They determine the initial share prices based on the value of the company and early interest from investors before the stock is available to the public. 

But, what causes these prices to change after the company goes public? The stock price is based on supply and demand. When the demand for a certain stock goes up, its price goes up. 

The demand can increase if the company is doing extremely well and its value is increasing, or it can increase simply because of excitement from other stock traders, especially if active traders want to drive the share price higher. This is why Rule #1 investors do investment research and have patience – when a brand new company goes public, throwing all your money into it is just gambling. 

Remember… don’t get the “value of the company” confused with the “price of the shares of the company.”

The stock market can be incredibly emotional and price a great company way under its true value and vice versa. Ultimately, the price is determined by greed when the stock is going up and fear when the stock is going down; this is why we see market volatility.

How Does Investing In Shares of Company Stock Make You Money? 

For investors, the benefits of buying shares in a public company, or the ways to make money from stocks, are two-fold.

For one, investors hope that the value of the company they are buying will increase over time, allowing them to sell their ownership at a later date for a nice profit. In addition to this, any profits that the company makes along the way that are not reinvested back into the company are distributed to the shareholders in some form or another.

These profits may be distributed as dividends, which are quarterly payments made to the shareholders. They may be distributed in the form of share repurchases, which help drive up the price of the stock, making the shareholders money. They may also be set aside in order to be used at a later date to grow the company and increase the value of the shareholders’ stock.

Not all companies pay dividends to their shareholders, but this doesn’t mean they aren’t using their profit to make their shareholders money. Instead, it may simply mean that they are using their profit to buy back shares and/or grow the value of the company.

These ways to profit from investing don’t only apply to individual stocks; other investments, including stock funds, such as mutual funds, index funds, and exchange-traded funds, can give shareholders exposure to a large segment of the stock market that could also increase in value and distribute dividends.

One factor that is the key to investing success and how people are able to make immense returns on their investment over time is the principle of compounding interest.

When your stock or mutual fund brings in a profit from increasing in value or paying dividends, you can use those earnings to buy more stocks.

Ideally, those investments will end up making you even more money, which can then be invested back into the stock market again and again in an ongoing process. If you make good investments, the result will be that your money grows exponentially over time.

This is the principle that investors such as Warren Buffett have used to turn just a few thousand dollars into billions of dollars.

The Best Way To Trade Shares

Now that you understand the stock market basics and how investing in stocks can make you money, let’s get into my step-by-step guide for the best way to trade individual shares of a company to ensure a great return, regardless of your risk tolerance.

Before we jump in, It’s important to realize that buying stocks is not something that should be taken lightly. Selecting which companies to buy can make or break you as an investor. Before you buy shares in a company, it is essential to thoroughly investigate that company’s mission, management, goals, outlook, fundamentals, and more. 

Think of it this way: you would never buy 100% of a company without thorough due diligence, and, likewise, you shouldn’t buy a small percentage of a company without doing the same.

Here’s how to go about it the Rule #1 way. 

Step 1: Pick Companies You Understand

As a beginner investor, it’s easier to avoid investing mistakes by buying into companies you are already familiar with and that have meaning to you.

For example, if you work in the retail industry, it’s going to be much easier for you to understand the goals of a retail company as well as their potential to reach those goals than it is going to be for you to evaluate a company in the pharmaceutical industry.

Consider your personal passions, talents, and spending habits. Better yet, map them out using a three-way Venn diagram, placing passions in the first circle, talents in the second, and spending habits in the third.

The area where these three circles overlap is your “Circle of Competence“. This reflects the industries and sectors you have the most knowledge of and where you should start your search for companies to invest in. 

Over time, you can begin to research companies across various sectors and expand your knowledge base and comfort zone, but investing within your Circle of Competence is the best place to get started.


Step 2: Research and Build a Watchlist

Once you have a list of companies that fall into your Circle of Competence, it’s time to evaluate them to determine whether or not they’re worth investing in. This step is critical to knowing how to invest in individual stocks the right way and reduce your risk. 

how to invest in stocks

In Rule #1 Investing, we have a process of evaluating a company called the 4M’s. This process can be used for any company in any industry and is extremely helpful for finding companies that have a high probability of growing in value over time.

1. Meaning

One of the easiest parts of evaluating whether or not you should invest in a company is determining its meaning. Do you know what the company’s values are – and do they align with your own? If you don’t believe in the company’s mission, you shouldn’t invest in it. Do you use the product or service it provides and/or love what it stands for? Again, if the answer is no, you shouldn’t invest in the business.

A big part of Rule #1 Investing is ‘voting with our money’ – meaning, we are putting our time and money into businesses we think will improve the world.

Beyond that, you should have a very clear understanding of the meaning behind the actual business – what does it actually do and how does it operate? In order to be able to make an accurate assessment of the company’s value, opportunities, and possible obstacles, you need to understand it inside and out. 

If a company has a meaning you understand, you are going to be more motivated to research them, and thus more likely to make wise decisions about when it should be bought and sold.

In the end, meaning is often the factor that differentiates between truly investing in a company with confidence and simply gambling on whether or not it will grow in value.

2. Moat

In addition to having a meaning you believe in, any company you invest in needs to have a moat. That is, they need to have something that prevents their competition from coming in and stealing away the control they have over their market. 

For example, Coca-Cola is a company with a great moat. Anyone can make soft drinks, but Coca-Cola has entrenched itself in the market for decades with a powerful brand image. No new soft drink company is going to be stealing away their customers anytime soon. Other examples of moats can come from having patented technology, majority control over the stock market or a product or service customers would never switch from (like a utility company).

By investing in a company with a moat, you can ensure that you won’t lose your investment due to that company being watered down by competition.

3. Management

The third M is for Management. Like a fighter jet without a pilot, every company is only as good as the people who are leading it. Before you invest in a company, you need to make sure that the company is led by people with competence and integrity. Far too often, companies are sunk due to dishonest or poor management.

How do you know if a company has good management? Take your time to research the people who are leading a company and make sure they have a track record of integrity and success with their prior decisions. A good way to research your stock investments is by reading the shareholder reports, news reports, and annual letters from management.

4. Margin of Safety

Finally, you need to invest in a company at a price that gives you a good margin of safety. When you buy a business, there is no guarantee that it will increase in value over time or that it won’t experience problems along the way. This is why I stress buying companies “on sale”. 

When a company is on sale, its stock price is undervalued. If you buy a company’s stock at a low or undervalued price, you give yourself room to experience gains even if it’s not as great of a business as you originally thought it might be. That room is the Margin of Safety

To understand the margin of safety a bit better, let’s take a look at the example of buying a brand new car worth $10,000 for $2,000. Now, that car may end up having problems down the road that you couldn’t have foreseen, or its value may not be quite what you thought it was when you bought it, but because you got it for such a low price you are almost guaranteed to have made a good investment.

As Rule #1 investors, we like to buy companies with a margin of safety that can give us a 15% annual return over the next ten-year period so that your money invested could double every ten years.

I’ve developed a calculator to help you calculate the margin of safety for any company that you are considering, but you can also think of a price with a good margin of safety as 50% off the intrinsic value.

Go through the 4 Ms for each company you are considering owning. If a company passes the 4 Ms test, you can add it to your “watchlist.” Many online brokerage accounts have sections to save your watch list so you can easily track the companies you’re interested in investing in. Once you have your watch list, you’re ready to move on to the next step to build your investment portfolio.

how to pick stocks

Step 3: Evaluate Their Financial Metrics

After the 4 Ms, you need to evaluate each company’s financial metrics in order to understand its true value. There are 5 numbers that will help you determine the margin of safety price and whether or not a business can provide at least a 15% return on your investment each year.

The Big 5 Numbers of Rule #1 Investing are:

1. ROIC: Return on Invested Capital

The Return on Invested Capital is a good measure of how effectively a company’s management uses the money that it invests back into operations. If they do this well, it means they are invested in the investor’s interest.

The number should be equal to or greater than 10% per year, but the real key is seeing if the ROIC number is going up consistently over time. If it’s at the same level or going up, then it is a good indication that the business is running well.

Tip: If a business doesn’t have a healthy return on investing capital, move on to another business

2. SGR: Sales Growth Rate 

The Sales Growth Rate shows whether the total money a company earns is increasing or decreasing over time. When you look at the company’s last 10 years of sales growth rates, you will have a good idea of whether or not that company is performing and growing more each year. In general, we’re shooting for an SGR of 10% or higher each year.

3. EPS: Earnings Per Share Growth Rate

The EPS Growth Rate shows the trend of how much money the business is making for its shareholders over a given period of time. The EPS (earnings per share) is just the company’s net income divided by the number of outstanding shares it has. If the company is profitable, the EPS will be positive – if they lost money over the period you’re looking at, it will be negative.

4. Equity Growth Rate

Equity will vary from industry to industry, which is why we look at the equity growth rate. For example, businesses with a lot of real estate and machinery, like McDonald’s, can have a huge equity relative to their value. On the other hand, businesses that make use of intellectual property, like Google, might have a small equity relative to their value.

The Equity Growth Rate tells us if a business has enough surplus money to spend on tools to stimulate future sales from year to year.

If the equity growth rate isn’t increasing by at least 10% each year, you should be concerned that it doesn’t have the funds to spend on increasing its market share or developing new products.

5. Operating Cash Flow Growth Rate

The Operating Cash Flow Growth Rate shows if the company’s real cash is growing along with its profits. Real cash is key to a company’s ability to operate and its overall health. You want to look at the last 10 years of operating cash flow growth rates and see a rate of 10% or higher each year.

These numbers will reveal a company’s true value and help you determine the right price to buy stocks. To help you evaluate the Big 5 for the companies on your watchlist, I’ve created easy-to-use Investment Calculators. Once you have calculated the Big 5 for all the companies you are considering, you can remove the ones that didn’t meet the numbers we’re looking for.

How to Invest in Stocks

Step 4: Wait For An Event and Buy

Meeting the requirement of the 4 Ms and the Big 5 Numbers just proves that a company is worthy of being on your watchlist, but doesn’t give you the green light to buy just yet. 

As Rule #1 Investors, we want to buy wonderful companies ONLY when they are at the right price. That’s why the last step is to wait patiently to buy stocks when, and only when, they go on sale. Buying stocks on sale helps take the risk out of investing and makes it easier to get fantastic returns. The key to finding companies on sale is to wait for a Rule #1 event.

What’s a Rule #1 Event? It is when something happens that affects the entire stock market and makes the stock price of a good company drop far below its real value. This could be a recession, a pandemic, an election, you name it. 

Remember, the price doesn’t reflect the actual value of the company. We know that the company’s price will bounce back in time, and because we take a long-term approach to investing in the stock market, we aren’t worried. During an event, when others are panicking, we can take advantage of the downturn and buy wonderful companies at a tremendous discount.  

This is why it’s so important to have your watchlist of wonderful companies ready to go, now you can start by opening a brokerage account and can begin to track them there. When you do, you can just sit back and wait for a Rule #1 event to temporarily lower the price of the stocks on your watchlist, and then BUY. When the company recovers from the event and returns to its previous price, your stock investments could double.

Learn How To Invest in Stocks for Beginners 

Now, that’s really the nuts and bolts of investing in stocks using the key principles of Rule #1 Investing. You’ve completed your crash course in investing—congratulations! 

But if you may still have some questions, don’t worry.

I’ve answered a few common questions about investing in stocks below – plus, I’ll cover buying stocks extensively in Chapter 7.

But in the meantime, I hope these answers will help you feel even more confident as you start investing.  

How Do You Buy Ownership Shares Of A Company?

After you have found a company you would like to invest in, found it worthy, and found it on sale, the final step is to actually purchase the stock so you can start reaping the rewards. Buying shares in that company will require you to go through a brokerage firm. Brokers enable you to easily buy and sell shares in any public company, but they do charge a fee for their services.

Once you have an investment account with a broker, though, buying shares of a company is as simple as ordering something out of a catalog or making a purchase on Amazon. Simply choose the stock you want to buy, the number of shares you want to buy, and complete your purchase.

A great option that has come available in recent years is the use of online brokers. An online broker is a little more “self-serve” than a traditional broker, however, the fees they charge for brokerage services are also much lower.

For beginner investors with small amounts of money, online brokers are the best choice because the high brokerage fees of traditional brokers have the potential to eat up any profits. 

How Much Should I Be Investing in Stocks? 

The amount of money you should invest in stocks is entirely dependent on your own personal situation. However, the more you invest now, the greater your returns will be in the future.

Keep in mind that you shouldn’t invest more than you can afford to lose. Even the wisest investments sometimes turn sour, and if you won’t be able to afford your mortgage payment next month if you lose the money you invest then it’s probably a better idea to keep that money in a savings account.

Another thing to keep in mind is that your money won’t grow just sitting in a savings account. If you have an expendable amount of money, the stock market is a safer place for it than a savings account. 

Whether you have a lot or a little, don’t be afraid to start small, and invest more as you get more comfortable with your investing skills 

Can I Start Investing with Little Money?

Buying shares of ownership in a company doesn’t require you to start off with a fortune already. In fact, some of the most successful investors in the world started out incredibly small with just a few hundred or a few thousand dollars. You can start out with very little money and build long-term wealth.

When you’re starting small, though, it’s especially important to choose a company or two that you have thoroughly researched and that you deeply trust. Allow that company to make you money, and reinvest that money in the same company again, and again, and you’re off to the races.

Here are our favorite small investment ideas for investors with budgets between $500 and $10,000.

Should I invest in Stocks or Mutual Funds?

Mutual funds are big buckets of stocks, bonds, and other assets put together by a money manager and targeted at people with a low-risk tolerance.

While they have a reputation for being diversified and “safer” than individual stocks, when you invest in mutual funds you are giving up control of your money. Instead, you’ll pay mutual fund fees to someone else to manage it. 

The thing is most fund managers fail to beat the stock market.

You just learned everything you need to know to start investing and almost guarantee a 15% return year of year. So, why would you pay someone to do something that you could do better and for free? By investing in stocks over mutual funds, you can experience more control and better returns. 

When Should I Sell My Shares In A Company?

When you’re just starting out investing, you shouldn’t even think about selling stocks. The kind of investing you learned here today is long-term investing, not a short-term trading strategy; it is meant to give you great returns over 5, 10, or 20 years. Warren Buffett even says that the ideal investment is one that you can hold onto forever.

The power of compound interest is that your money grows exponentially the longer it is invested. If you sell too early, you could lose out on that exponential growth.

However, there are times when you should sell your stock and it’s important to know how to tell when those occur. 

For instance, if the fundamentals of the company have changed, which happens to every company, it’s important to reevaluate it and see if it’s still a great investment. Other times to consider selling are when the price of the company has reached its intrinsic value, or when you have a better opportunity and you need the cash.  

Whatever you do, don’t let your emotions get the best of you. If your reason for wanting to sell a wonderful company is driven mostly by fear, take a step back and determine whether or not selling the stock is really the best path forward. 

What Do You Do When You Buy a Stock and the Price Drops?

It’s natural to experience a bit of fear or regret when you see the price of your stock drop. You may even be tempted to sell. 

When the price of a stock starts going down, many investors become afraid and decide to cut their losses, but this is the worst reason to sell stocks, and market volatility is normal.

In fact, it’s important to take the exact opposite approach to a price drop. If you have invested in a wonderful company and bought it at half-off its true value, then a price drop means it just went on sale even further. 

So, what do you do

Buy more! 

As long as you understand the difference between value and price, you don’t have to worry, but instead can be excited when the price of your stock drops. This is an essential part of the tried and true value investing strategy.

But in the meantime, we’ll go deeper on the financial metrics in the next chapter you want to review so you understand exactly what they mean and how to find the information you need.

Hi, I’m Phil

I’m a full-time investor and 3x New York Times best-selling author. I want to help the little guys, people like you and me, gain financial freedom by using simple principles that Warren Buffett and Charlie Munger have been using for over 80 years.

I have a passion for investing and I can’t wait to share it with you.