How to invest in the stock market: a beginner's guide

We name the tests to pass before you start investing, the funds that fit the bill for beginners, and some golden rules to follow.

To a beginner, the stock market can appear rather daunting, but it has never been more important to top up your knowledge and take control of your financial future.

A key reason to learn more about investing is because most people today – particularly those under the age of 40 – have pensions that are linked to the stock market. In previous decades, the norm was a salary-related pension, in which the amount of income paid at retirement was based on how long the individual had been a member of the pension scheme and their earnings. Such pensions still exist but are in terminal decline and it is more common for individuals to save for retirement in an investment-based pension, known as a defined contribution pension.

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As a result, the onus has shifted to individuals to take control of their financial future. By becoming engaged with how your pension is invested, and saving in a stocks and shares ISA, for example, there is a greater chance of reaching your financial goals.

Below, we explain how to invest in the stock market, but first we outline three tests that anyone who wants to invest should pass before getting started.

Before you invest, pass these tests

First, everyone should have some “rainy day” money for emergencies, ideally three to six months’ salary held in cash. Then, if the unexpected happens, such as redundancy or a broken boiler, and you need to access cash in a hurry, you can do so easily and will not be forced to sell your investments during a potentially disadvantageous time.

Second, clear any debts, tackling the most expensive ones first. While it is important to have savings, it is not normally a good idea to prioritise additional savings over reducing debts, because debts usually cost more in interest than savings earn. Mortgage debt is not normally considered debt in this scenario.

The final test is a commitment to invest for at least five years, as over the short term the stock market can be unforgiving.

The basics

In the UK, the main stock market is the London Stock Exchange, where public limited companies and other financial instruments such as government bonds are bought and sold.

The stock market is split into different indices, with the most famous in the UK being the FTSE 100, comprising the largest 100 companies.

The most well-known indices come from the FTSE group: the FTSE 100, the FTSE 250 and FTSE All-Share. There is also the alternative investment market (Aim), which mainly lists small and venture capital-backed companies.

How to invest

In our 21st-century world of electronic trading, the ability to buy and sell shares is at the fingertips of anyone with an internet connection.

Investing in the stock market is always done through a third party, such as a stockbroker or investment platform. 

Online investment platforms, such as interactive investor, allow investors to buy and sell shares, funds, investment trusts and exchange-traded funds (ETFs). The onus is on the individual to select the investments – no financial advice is offered. At interactive investor, plenty of help is at hand for beginner investors in our Knowledge Centre.

Do-it-yourself (DIY) investors must set their own financial goals and carry out research ahead of making an investment. Understanding how a fund invests and what it is aiming to achieve puts investors in a good position to act if performance is not up to scratch.

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The investment options: funds, trusts, and ETFs

There are two ways to access the stock market: directly and indirectly. Although the term “directly” is a misnomer – as mentioned above, investing in the stock market is always done through a third party – direct investment means buying shares in a company and becoming a shareholder.

This route requires time and effort on the part of the DIY investor, who needs to get to grips with concerns including how the business makes money, current and future risks, and whether the share price valuation is viewed by the market as “cheap” or “expensive”. 

An indirect approach is a more common way of accessing shares, as it spreads risk by investing in several companies.

This can be achieved via an open-ended fund, which are structured as an Open-Ended Investment Company (OEIC) or unit trust. Funds are a type of pooled investment that invest in a “basket” of underlying assets such as equities, bonds or property. Funds typically hold between 50 and 100 companies to spread risk.

Funds tend to invest in a certain region (such as the UK) or sector (such as technology) and either invest for growth, income, or a combination of the two. Those with an income mandate generate a certain amount of income that is returned to investors over a specified period (such as quarterly or twice a year) in the form of dividend payments.

Money in funds is ring-fenced, so if the firm defaults £85,000 of your money is protected by the Financial Services Compensation Scheme. However, it does not protect your deposits in instances where your money has been invested and loses value.

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An investment trust is another pooled investment, but unlike funds trusts are listed on the London Stock Exchange.

There are two “layers” of activity: the performance of the underlying investments held in the investment trust, and its share price. The shares are traded on the stock market. The share price goes up and down according to investor demand and supply, but the fund manager’s investment plans are not affected.

Investment trusts have various structural advantages that benefit private investors, particularly those investing for income. You can find out more here.

While most investment funds and trusts are actively managed products, run by a fund manager who handpicks shares and has some direction over the performance of the fund, exchange-traded funds (ETFs) and index funds passively track the ups and downs of a stock market index.

Both ETFs and index funds offer investors a simple way to “buy the market” at a cheap price, with some ETFs and index funds costing less than 0.1% a year to track the performance of the US and UK markets, which works out at £10 on a £10,000 investment. Bear in mind that the performance will not be completely mirrored, owing to the fee levied among other factors.

ETFs and index funds will, in theory, be cheaper than funds or investment trusts, as there is no active manager to pay. But it is worth checking the annual charge, as some index funds launched decades ago are charging higher fees than competitors.

By selecting a passive fund, an investor will get exactly that – index-like performance minus fees. The investment will rise and fall with the index, so in the event of the index falling spectacularly, so will your investment.

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Why collective investment funds suit beginners

Beginner investors are best suited to using collective investment funds to access the stock market, as it enables them to use the collective buying power of a fund to reduce charges on a small starter portfolio.

It also means the professional fund manager buys and sells the individual shares, so the individual investor does not have to make their own investment decisions.

Other reasons why people use funds or trusts

Diversification: you can pool money with other investors and spread your risk among a large portfolio of stocks that you could not access with smaller amounts of money

Time: monitoring large portfolios is a time-consuming process

Access: some overseas and emerging markets are difficult to access as a DIY investor

Cost: some funds, particularly index funds and ETFs, and some investment trusts, offer very cheap ways to buy a portfolio. Several passive funds cost less than 0.1%

Asset allocation: some investors may have a direct portfolio of UK shares but need to spread risk among other assets, such as commercial property and corporate bonds, using funds or investment trusts.

Funds for starter investors

Building your own portfolio takes time and effort. There are, however, short-cut options for those who prefer a more hands-off approach and investors can outsource the decision-making over what to hold. Broadly speaking, there are two types of strategy. Some multi-asset funds directly invest in shares and bonds, while others, known as “multi-manager” or “funds of funds”, buy other funds.

Such funds split your money across a mix of different assets, which tend to perform differently in different market conditions, to avoid large fluctuations in overall value.

Be aware that the amount you pay to buy a multi-manager fund is significantly higher than other funds. Yearly charge figures are usually north of 1.5%, versus 0.85% to 1% for most other funds.

Interactive investor has a Quick-start funds range to help make investing easy. They are like ready-made portfolios that give you access to the world’s markets. We offer a choice of three passively managed funds from Vanguard – these track the various asset classes with little intervention from a fund manager – and three actively managed funds from Columbia Threadneedle, where a fund manager will make decisions on what to invest in and when. 

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Well-diversified global funds and investment trusts are also potential good fits for beginner investors. One option is F&C Investment Trust, one of interactive investor’s Super 60 investment ideas. The trust invests in more than 350 companies.

Interactive investor also has five Model Portfolios, which can be used as reference tools for selecting individual funds.

How risky is investing?

The reality is every investment has an element of risk and there are no guarantees a return will be achieved. Cash is safer, yes, but it would be a mistake to think cash is completely ‘risk free’. While your £100 will always be £100, the effects of inflation will have a significant impact on that £100 in real terms.

While most people think about risk as losing money, academic finance defines risk as volatility. In the simplest terms, this means how much the price of an investment fluctuates over a given period.

The good news is that investors can manage risk by following the three golden rules of diversification, investing regularly rather than all at once, and reviewing a portfolio twice a year.

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Diversification

Diversification is achieved by investing in different assets – mainly shares, bonds and property; as well as different regions and different investment styles, such as value and growth. You could also include some commodities, such as gold.

It is also important to consider the investment style of a fund, and to have a mix of approaches.

Invest regularly rather than all at once

One of the key benefits of regular investing is what’s called pound-cost averaging. By investing each month, you benefit from times when stock markets are falling because you can buy more units in a fund or shares in a company.

This removes the risk that you put all your cash into the market just before a nasty dip.

Reviewing a portfolio twice a year

Rebalancing maintains the level of investment risk the portfolio aimed to achieve when it was first put together.

Failure to rebalance could result in an investor taking on more risk than they desired and possibly not achieving their financial objectives.

In a nutshell, rebalancing involves looking at your winners and converting some of those paper gains into real profits. Some of the proceeds could then be reinvested into areas of the portfolio that have been underperforming, but which may soon recover their poise.

For example, let’s consider the two major asset classes – equities and bonds. Over the long run, equities tend to outperform bonds. If the portfolio is not rebalanced for several years, the equities weighting is likely to rise, potentially to a level an investor is not comfortable with. It could turn a low-risk portfolio into a medium-risk or higher-risk portfolio. 

What else to be aware of

Before committing money to the stock market, decide what you want to achieve, how long you are planning to invest for, and how much risk you are prepared to take. You must also understand your tolerance to risk rather than appetite for reward. Every investor must consider the potential downsides before getting started.

Tales of other people’s huge gains can be tempting, but the market won’t always move in your favour, and you must be prepared to see your investment fall as well as rise.

Second, investors ought to understand what they are investing in. To do that, always read the fund factsheet and other literature.

The costs involved in buying funds, trusts, shares, or ETFs can vary hugely, and higher fees can easily eat away at future returns. To ensure value for money, compare charges on different products. As an investor, the only thing that you can control is costs.

Without the help of a crystal ball, timing the market is impossible. Instead, look to invest regularly each month, rather than investing a lump sum in a fund. By drip-feeding money, it is possible to negate the risk of market timing. So, when the market falls, your regular investment will buy shares or fund units at a cheaper price the following month.

The final point to stress is that investments should be held for at least five years to smooth out any bumps in the market, but that doesn’t mean that investments can be left unchecked. Review investments regularly, perhaps every six months, to ensure that they are performing in line with expectations. If they aren’t, try and understand why and then look to make changes if appropriate.