You’ve decided it’s finally time to start investing in the stock market. Everyone keeps telling you you should — cable TV financial experts, those emails from your retirement plan at work, your parents, even your friends are talking about the stock market. But you’re the kind of person who wants to know what you’re getting into before buying.
Below, you’ll find everything you need to know about buying stocks, from how to value them to how to purchase them. By the end of this article, you’ll be ready to start investing in the stock market.
What Is a Stock?
A stock is an ownership investment in a business. It works like this: Shares of a company, called stock, are sold to investors, who then own a proportionate amount of that company’s equity (the difference between the company’s assets and liabilities — what it owns and what it owes).
For stock investors, positive returns can come from:
- Capital gains — the difference between what you paid for the shares and the price at which you sold them
- Dividends — a share of company net profits paid out to shareholders regularly (typically quarterly)
Investors purchase shares in a company because they expect that company’s value to grow, meaning they hope their stock price will increase over time. Companies sell stock to investors in order to raise capital to fund business operations, and sometimes offer current shareholders the option to sell their initial investment. The first time a company’s stock is sold to the general public is called an “initial public offering” (IPO).
After a company’s shares are sold to the public through an IPO, they trade in the securities markets, either on a stock exchange (like the NY Stock Exchange) or over the counter (like the NASDAQ). A trade matches a willing buyer and a willing seller at an agreed price. That means stock prices can go up — or go down — based on the behavior of buyers and sellers of the shares.
As a shareholder in common stock, one benefit is that you’ll have voting rights in the company. While you don’t get a voice in the day-to-day operations of the company, voting rights are important when a company is doing something like electing its board of directors.
The Difference Between Stocks and Bonds
The same company may issue both stocks and bonds. While a stock means you hold a small piece of ownership in a company, a bond means you’ve lent the company money for a set period of time, and they’re paying you interest in exchange for borrowing those funds. When the bond reaches the end of the borrowing period, called “maturity,” your principal is repaid.
Stocks increase (or decrease) in value through price appreciation (or depreciation), while bonds earn a set rate of return based on the interest that is paid. Bonds are primarily purchased by people who want steady income and portfolio stability, as the return amount is fixed. They’re a lower-risk, more reliable option and they get paid first in the event that something happens to a company, as all debts need to be paid before equity in a sale or liquidation of a business.
Common Stock vs. Preferred Stock
There are two primary types of stock issued: common stock and preferred stock. When you think of stocks, you’re likely thinking of common stock. Common stock gives owners voting rights in a company and is more likely to result in higher return over the long-term. Preferred stock, which pays higher dividends than common stock, is typically bought by investors seeking higher current income. Preferred stock is less risky than common stock, and dividends on preferred stock gets paid before dividends on common stock.
Preferred stock is ideal for those who want a steady source of income with some upside return on equity, while common stock is ideal for investors seeking higher returns.
How Risky Is the Stock Market?
The general guideline when investing in stocks is the risk of loss increases with the potential for gain (“return”). If you take on more risk, you’ll likely have more potential for higher returns — but you also have a higher risk of loss. The reason stock investing works this way is because people who are willing to take more risk and put more on the line must be rewarded for that risk.
Theoretically, the gains on stock investments are potentially unlimited. The risk of loss however, is whatever you paid for your initial investment. So, while you could gain 2x, 3x, or even 100x on an investment, you could also lose 100% of your investment.
What Types of Risks Exist When Investing in Stocks?
In stock investing, we’re primarily talking about two things that can affect the value of a stock:
- Systematic risks (market risk) are the risks that affect the economy as a whole. Examples of systematic risk are things like inflation, recession, high unemployment, and increases in interest rates. Systematic risk can be hedged, but it can’t be diversified away completely.
- Non-systematic risk are risks that affect either a small part of the economy or even a single company, such as a company’s earnings declining or a drop in a company’s operating performance. Non-systematic risk can be reduced through good diversification.
Mitigating as much risk as possible, particularly non-systematic risk, is critical for minimizing your chance of loss.
How Can Diversification Reduce Your Risk?
Diversification is key to reducing the risks of investing in stocks. A stock’s value can rise quickly, but it can also fall dramatically. If you’re invested in only one stock or many stocks within a single industry (such as just real estate or airline stocks), your portfolio will be hit particularly hard if something happens to that company or industry.
Instead, if you have a portfolio of many companies, industries, and regions, you’re spreading the risk that non-systematic risk will impact the majority of your portfolio.
In addition, it’s important to diversify when it comes to your asset allocation, or your overall mix of investments. Instead of just investing in stocks, for example, it’s wise to have a portfolio that includes stocks, bonds, real estate, cash, and other types of investments. Diversifying in this way can help ensure that even if some of your riskier investments are losing money, others will remain steady or make small gains that will help mitigate any loss.
How to Buy Stocks
Now that you’ve read about what stocks are and how to be a sage investor, you can get started. But where do you go to buy stocks?
First, you should consider what your investing needs are. Work through the five simple steps in How to Get Started Investing Confidently:
- Save some money
- Know your risk tolerance
- Identify your financial goals
- Figure out your investing style
- Put your investing strategy on auto-pilot
When you’re getting started with a smaller amount of money, consider investing in the stock market via stock mutual funds or stock exchange-traded funds to ensure you can invest in a diversified portfolio. The easiest type of account to start investing in stock mutual funds is your 401(k) plan at work.
If you’re a confident investor with a decent amount of experience, you can opt for a brokerage account in which you can trade individual securities. A brokerage account can be set up as a regular account or an IRA. It can either be opened online with a brokerage firm like Fidelity or Schwab, or at a bank that has brokerage operations, like J.P. Morgan or Bank of America. When searching for a brokerage account, take a look at fees, such as brokerage fees, trading commission fees, and inactivity fees.
If you’re new to stock investing and need guidance, you might want to opt for purchasing stocks through a financial advisor. An advisor can give you guidance and help you build your portfolio. However, keep in mind that buying stocks through a financial advisor will likely come with higher fees.
Value Strategy vs. Growth Strategy
When it comes to investing in stocks, most people either choose a value strategy or a growth strategy. Value investing is focused on trying to find hidden gems, or stocks that don’t match their intrinsic value and will likely go up in value. Growth investing, on the other hand, is centered on purchasing stocks that experts anticipate will grow quickly over time.
Growth investments are typically pricier and riskier, while value investments are typically cheaper and possibly less risky. Examples of growth investments are tech names like Facebook, Apple, and Google, while value investments might be stocks like J.P. Morgan and Johnson and Johnson.
Growth stocks and value stocks tend to do well at different points in the economic/business cycle. While some investors have a strong preference for one style of investing over the other, many others incorporate both growth and value investing into the stock portion of their portfolios to ensure diversification.
Ways to Avoid Losing Your Shirt in the Stock Market
Although it’s possible to make a significant amount of money by investing in the stock market, it’s also possible to lose a decent amount of money. In fact, one study found that the average investor underperformed the S&P 500 by 6% each year. That’s why an increasing number of investors don’t try and pick individual stocks or use actively managed mutual funds, and focus instead on index investing — a passive investment strategy in which the goal is to mimic the performance of a specific market index.
Below are a handful of principles for investing in the stock market:
Keep an Eye on Fees
Ultimately, reducing your risk through diversification and reducing the expenses you pay are the two most important ways to protect your investments and ensure they grow overtime.
The fees you pay while investing can add up. While average mutual fund expense ratios are 0.52%, the average for actively managed funds is 0.72% and can be as much as 1% to 1.5% depending on the investment type. Additionally, if you’re working with a financial advisor that charges assets under management, you could be paying an additional 1% to 2% of your asset value each year for them to manage your portfolio.
These fees can really add up over time. Paying just 1% in fees each year across these, as well as many other types of fees, can reduce your expected portfolio value by 25% over a 30-year period. Personal finance experts generally recommend focusing on lower cost ETFs and index funds, which typically have expense ratios under 0.15%, as well as working with fee-only and fiduciary financial advisors to ensure your costs don’t eat away at your gains over time.
Research shows investors who are more active don’t do as well as those who are “buy and hold.” Data from the S&P 500 shows that 89% of actively managed mutual funds underperform their benchmarks over a 15-year period. That means that even highly incentivized professional investors with significant resources and time cannot consistently beat the market. Instead, focus on a buy-and-hold strategy as opposed to a market timing strategy. A buy-and-hold strategy focuses on securing stocks and then keeping them long-term. A market timing strategy focuses on trying to time the market, and it’s typically difficult to succeed at.
Avoid Timing the Market
Some people will closely monitor market activity. Although it can be tempting to sell during a down market, doing so can cause a loss to be realized and affect your long-term portfolio performance. However, if the time until you need the money is far away (such as retirement) the best thing to do during a market downturn may be nothing. If your time until you need the money is less than five years, you probably shouldn’t be in stocks.
Just because a stock price went down due to market pull doesn’t necessarily mean the company is bad. For example, Walmart is still Walmart in a recession. And if people are still shopping there, it could be undervalued during a recession and a great time to buy.
Here’s an example to consider: If your $540,000 home dropped to only be worth $210,000 in 2009, would you sell it and lock in a $330,000 loss? No, because you still need somewhere to live and you don’t need your money urgently. The same goes for investing in the stock market:
What’s Right for Someone Else Isn’t Always Right for You
Just because other people are chasing returns on a certain stock doesn’t mean you should. Certain companies will gain attention in the media, but that doesn’t necessarily mean they’re a worthwhile investment. Look at the logical trajectory of the stock instead. After all, one of the world’s greatest investors, Warren Buffett, was right when he said, “Be fearful when others are greedy, and be greedy when others are fearful.”
All in a Day’s Work
If you’re planning on investing in the stock market, the most important thing is to be an educated, discerning investor. Be aware of best practices in investing, and don’t be tempted to take action that might seem right in the moment, but will lead to loss later on, like selling when the market is down or trying to time the market.