The very idea is sublime: Having your money make you more money? Yes please!
If you’re reading this, you’ve likely heard about the opportunity to earn money by investing in the stock market, but maybe you don’t know where to start. Or maybe you’ve been turned off by that one friend or relative (we all have one) who speaks of “the market” with frustration.
By educating yourself on how the stock market works and proper practices for investing in stocks, you may be able to take advantage of the upside potential created in the stock market while minimizing risk (and feeling mentally prepared to deal with the inevitable volatility).
But for lots of people, this is easier said than done. There’s a lot of information out there for those who are interested in learning how to start investing in stocks. It can feel too easy to get swept up in the sea of information available to people who just want to get started.
The good news? Investing in the stock market is easier than ever with the prevalence of brokerage firms, financial services institutions and apps that have made investing accessible.
Let’s distill down some of the most important elements of stock investing, specifically for beginners. Here’s a step-by-step guide for those who want to start investing in stocks.
Learning stock market basics
It may sound obvious, but you might want to keep in mind what it is you are buying when you buy a stock. A stock represents a small percentage of ownership in a public company. Public simply means that anyone with the capital can invest, and therefore be an owner in that company.
There are two types of stocks: common stocks and preferred stocks. Common stocks are what you’re probably thinking of when you consider investing in the stock market. Preferred stocks, on the other hand, are considered first in line for dividend payouts, but they don’t come with voting rights, unlike the shareholders of common stocks.
Next, you could think of a big picture about investing: In general, the whole reason for investing is so that the investment earns money in the future. This is also known as a “rate of return.” When you buy a stock, you are also purchasing its potential future performance.
With stocks, that rate of return comes in two forms: price appreciation and dividends. Price appreciation is just as it sounds — that’s where the price (the value) of a stock increases over time. For example, if a stock’s value increases from $10 to $50, the price appreciated by $40.
Next are dividend payments. Dividends are cash payouts made by the company to stockholders — you can think of them as your share of the profits as an owner of the company.
Okay, so this is all pretty straightforward stuff. So, why is the stock market so volatile?
First, it helps to understand that volatility refers to the up-and-down movement in the prices of both individual stocks and the average of all stocks — the whole stock market.
And while we have many preconceived notions about what causes volatility — financial news, economic growth and geopolitical events, to name a few — volatility is also caused by the competing forces of supply and demand.
Another way to say this? Volatility in the prices of stocks is quite literally caused by the buying and selling of those same stocks, as well as world events and news that cause people to buy or sell.
Because the price of stocks is determined by the large, sweeping forces of supply and demand, it can be very hard to predict price movement in stocks, especially in the short term. In the short term, prices move on investor sentiment — how much investors want to buy or sell that stock.
Sometimes, price movements make perfect sense given the underlying fundamentals (company posts strong earnings, good economic growth, etc).
Sometimes, though, price changes in the market don’t make sense. Stock prices are not serially correlated, which is a fancy way to say that past performance doesn’t predict the future.
Because predicting short-term price moves in the stock market is so difficult, many investors may prefer to utilize a diversified, buy and hold strategy.
This way, they aren’t taking big bets on individual companies, but giving the overall stock market time to (hopefully) reflect the real wealth creation that happens at corporations across the country or even the entire world.
How to start investing in stocks: Know your options
For those wondering how to start investing in the stock market, it might help to understand that there is more than one method to do so: The first is to buy individual stocks.
Buying individual stocks
This method requires a fairly significant amount of research into the stocks themselves. If you go this route, you might want to do a deep dive into the business’s inner workings and compare that to the price the stock is currently trading at.
One of the most basic metrics for understanding a stock’s value as compared to company profits is its price-to-earnings ratio. You may also want to consider other ratios, such as price-to-sales and earnings per share.
Additionally, you might want to get comfortable reading a company’s balance sheet and other financial statements. All public companies are required to file this information with the Securities and Exchange Commission (SEC), so you won’t have trouble finding them.
You may also want to consider factors such as the business’s relative industry strength, operating margins, leadership, product pipeline and capital structure, among other things. While “buying what you know” may be fine advice to get started, investors who are serious about buying individual stocks have their work cut out for them.
One advantage of owning individual stocks is that you have control over the investments. Many folks who choose to invest in individual stocks do so because they want the chance to “do better” than the market average. Others may do so because they have an interest in the individual stocks or like buying stocks as a hobby.
The flipside to the possibility of outperformance is the corresponding possibility to do worse. And each individual must decide for themselves whether this is the route they want to take, given their personal risk tolerance and preference for investing methodology.
Investing in funds
A second way to start investing in stocks is by using funds, either mutual funds or exchange-traded funds (ETFs). A fund is a basket of some other investment type, like stocks or bonds.
While there are some structural differences, mutual funds and ETFs serve a similar purpose — to help investors achieve diversified exposure to a particular market.
Index funds, in particular, have become increasingly popular because of their low-cost structure and for consistently outperforming their managed counterparts. An index fund — whether an index mutual fund or an index ETF (most ETFs are index funds) — is designed to invest in the whole market or a representative sample of the market.
For example, an S&P 500 index fund invests in 500 of the largest companies in the United States. With the purchase of just this one fund, the investor hopes to return the average of the U.S. market.
A benefit to investing in stocks via funds is that you do not take on the risk of being invested in individual stocks that do not perform well. Additionally, index funds may be a more affordable way to invest in the stock market.
While most index funds do carry an annual management fee (called an expense ratio), it is quite low compared to managed mutual funds. And at most brokerage firms, there is a transaction cost to buy and sell individual stocks (and sometimes ETFs), but sometimes, there is no such fee to buy a firm’s proprietary index mutual funds.
Whether investing in individual stocks or funds, you may want to think about the level of diversification that feels right for you. There is no one universally accepted consensus about the right way to diversify. For one person, proper diversification could mean owning 20 stocks. For another, it could mean owning the “whole” market via a handful of funds.
Just remember that anytime your investments are focused on narrower areas of the market, such as owning only a handful of individual stocks or only investing in certain industries, you may be taking on additional risk. But with that risk does come the potential for added reward.
Where to start investing in stocks
Once you’ve made the decision to purchase stocks (or stock funds), it might be a good time to figure out where to do it. The good news is, you have lots of options to choose from.
The first option is through a brokerage account. A brokerage account gives you a platform on which to buy and sell securities (mostly stock and bonds) through an exchange or from their own supply. Brokerage firms will typically charge a fee for the service either in the form of a per-trade fee or per-security commission.
Additional services offered through a brokerage can include advice and management as well as banking. Typically, full-service brokerages offer more services but higher overall costs, while discount brokerages give scaled-down services with lower overall costs.
As mentioned before, most brokerage firms charge a commission — called a transaction charge or a trading fee — for securities bought and sold on an exchange including stocks and ETFs.
This can make buying and selling individual stocks an expensive affair, especially if you are trying to build a diversified portfolio with many stock holdings. Therefore, ETFs or no-commission mutual funds might be a more economical way for new investors to get into the stock investing game.
If you choose to invest in individual stocks, and they pay a dividend, you will want to decide how you would like to handle the dividend.
One option is to simply accumulate the dividend in cash and use it to supplement income. This strategy is generally used for older investors rather than younger ones.
You could also use the dividends to purchase either a different security or additional shares of the security that generated it.
If you choose the latter, you may want to utilize a Dividend Reinvestment Program (DRIP). DRIP allows you to repurchase shares (including fractions of shares) as dividends are generated. Utilizing DRIP is typically commission-free and ensures that you are fully invested in the stock.
Most brokerages offer DRIP services. Another way to invest in stock is by purchasing directly through the company itself or through its designated transfer agent.
This will allow you to hold the shares in your name (rather than street name) but you can expect higher costs and less convenience. Most publicly traded companies list their transfer agent on the “investor relations” section of their website.
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