The temptation of getting into the stock market to try and build wealth can be great. But some people start investing before they are ready. That can lead to them losing money, not making it.
Here is a handful of questions I think can be helpful for someone to ask themselves before they start investing.
Can you spare the money?
It does not take a lot of money to start investing. But it does mean prioritising. Investing can make sense once life’s essentials are paid for. But if there is not enough spare cash to invest without eating into vital expenditure, it might be best to wait.
Do you know how to assess a business?
Investing in shares is basically buying stakes (albeit small ones) in businesses. It is therefore helpful to understand how businesses work. Not all of them, just the ones in which you may invest.
Getting to grips with things like how much debt is on a firm’s balance sheet and what its competitive advantages are important when trying to judge a company’s prospects.
How are you valuing shares?
Even a great business may not necessarily make for a great investment. It depends how much an investor pays for the shares.
Therefore, getting to grips with how to value shares is an important move before you start investing. Different investors use a variety of valuation techniques, but it is important at least to have a sense of how you will try to value shares.
Do you understand how to build a portfolio?
One of the basic risk management principles of investing – even on a small scale – is not to put all your eggs in one basket. So it is important to understand some basic principles of constructing a share portfolio before you start investing.
That can involve not putting all of the portfolio into one share, for example. But it can also be important to diversify between different business sectors, as well as different individual shares.
Can you explain an investment case for a given share?
I mentioned above that a good business does not necessarily make for a good investment. When buying shares, I look to buy into a great business at an attractive valuation. So I ask myself what the investment case is for a particular share at a given price?
As an example, I could use a share I have decided not to own: National Grid (LSE: NG).
The investment case looks quite strong in some regards. The long-term demand for power generation and transportation is high and fairly resilient. National Grid has unique assets that it would be hard or impossible for a competitor to replicate cost effectively.
That gives the FTSE 100 firm pricing power, albeit that some of its operations are heavily regulated, limiting how much profit it may make.
So far, so good. But why do I not own the shares? Maintaining a power distribution network is expensive. On top of that, although power demand is resilient, where it is generated and where it is used has been changing in recent years. That could mean even more costly expenditure to change the network. National Grid, perhaps unsurprisingly in its case, is heavily indebted.
So even before considering valuation, I do not see a compelling investment case for the business.
