If you're new to investing, buying and selling stocks may seem intimidating. How should you invest your money? Should you pick individual stocks or invest in index funds?
The truth is, you don't need to be the Wolf of Wall Street to find success in the stock market. We've put together a complete guide showing the ins and outs of how to invest in stocks (the right way). Let's get started.
What are Stocks?
Stocks represent ownership. A share of stock is simply a share of ownership in a company. When you own a share of stock, you own a share of all the company’s future profits and liabilities. It’s a small claim on a company’s future profits. When the company returns profits to the owners in the form of dividends, you are entitled to your share.
Not all companies pay dividends. Some aren't yet profitable enough to pay dividends, and some decide to reinvest profits into the company rather than send cash to stockholders so that they can grow faster.
If they’re successful at growing the company — or if the Market thinks they will be successful in the future — more people will want to invest more money in the stock, and they will bid share prices up.
For stock investors, profits come in two ways: Dividends and share price appreciation.
Are Stocks Risky?
Stocks tend to be very risky compared to other types of assets, like bonds, cash, and real estate.
First, any individual company can fail. If a company goes bankrupt and ceases operations, managers will sell off everything they can to pay off the company’s creditors and bondholders. If the company owes more than the assets are worth, the shareholder’s investment could get wiped out.
In contrast, if you own a company's bonds, and the company goes bankrupt, bondholders get paid first, before anything goes to stockholders. So your chances of recovering something in the event of a bankruptcy are much higher than they are for stockholders.
If you own real estate and your tenant goes bankrupt, you still have the property. The value of the land itself almost never goes to zero. But with stocks, the possibility that the investment can fall to zero is always there – as investors in Enron found in 2000-2001, when the company’s stock plummeted from a high of $91.75 down to just 26 cents per share on December 2nd, 2001, when the company declared bankruptcy.
At one time, Enron was the 7th biggest publicly-traded company in the world, measured by the total value of its stock. It became a grim laugh line. Like many others have, including Global Crossing, Lehman Brothers, Salomon Brothers, Bear Stearns, Washington Mutual, Countrywide, HyreCar, Pets.com, and MF Global.
For this reason, most personal finance experts recommend against individual investors investing large amounts of their personal worth into a single company's stock – or even stocks in a particular industry. That's because if the sector should experience hard times, all the stocks in that industry tend to take a tumble. Instead, it's better to diversify holdings across a wide range of stocks, spread across different types of different industries and regions.
That's where mutual funds come in. A mutual fund is a pool of money from many different investors, run by an investment company, which hires a professional money manager and a team of analysts and traders who buy and sell stocks, bonds, or other securities on investors' behalf. The investment company charges a fee — called an expense ratio — to keep the office lights on and to pay the manager and staff to run the fund.
The expense ratio can range from around 0.10% of assets in the fund each year to around 2%. However, the overall average these days is about 0.50%, according to the Investment Company Institute, an industry advocacy body that represents mutual fund companies.
Mutual funds make it easy for a retail investor, with only a few hundred, a few thousand, or a few tens of thousands to invest, to write one check and instantly diversify across dozens, hundreds, or even thousands of stocks.
Mutual funds come in many different varieties and investment styles: You can buy funds that specialize in stocks, bonds, shares of real estate investment trusts, or combinations of each of these.
Among stock funds, you can choose funds that specialize in many different types of assets, including:
- Large-cap stocks (these invest in big, established companies)
- Small-cap stocks (these invest in small publicly-traded companies)
- International stocks
- Industry-specific stocks
- Aggressive growth stocks
- Dividend-paying stocks
- Value stocks
- … and many others.
Very generally, stock funds that focus on larger, established companies are less volatile than funds that focus on small-cap stocks, though there's usually less growth potential over long periods of time.
Stocks that pay dividends tend to be less volatile than stocks that don't pay dividends. Value stocks tend to be less volatile than growth stocks. But again, these stocks may not offer as much potential for long-term growth as more aggressive growth stocks.
Index Funds vs. Actively-Managed Stock Funds
One problem the investment industry has been dealing with for decades is the underperformance of mutual fund managers. You would hope that investors get some value for the billions of dollars per year they pour into expense ratios and other management fees that go to these professional money managers and investment companies.
But study after study shows that once you account for their expense ratios and other costs, most mutual fund managers add no value at all.
For example, in 2020, 63% of large-cap mutual fund managers failed to keep up with the S&P 500, an index of the 500 largest publicly-traded stocks on the New York Stock Exchange, weighted by market cap. That was the 11th consecutive year that professional money managers fell short of their main industry benchmark.
Not only do most mutual fund managers FAIL to beat the S&P 500... they're also overcharging you.
Furthermore, numerous studies have shown that it’s not the same group of mutual fund managers who outperform the index every year. It’s a different group every year or two. And it’s next to impossible for the average retail investor to identify them in advance.
The vast majority of novice or retail stock investors (and even most experienced investors and institutions) would be better off avoiding these high-cost professional money managers, and instead investing through a low-cost index fund.
What’s an Index Fund?
An index fund is a mutual fund that doesn’t have a professional money manager deciding what securities to buy and sell and when to buy and sell them. They just buy the stocks that make up the index, and weight their own portfolios as close as possible to the market capitalization weightings in whatever theoretical index they’re benchmarking.
So they don’t have to pay a celebrity – or even a non-celebrity money manager. And they don’t have to pay teams of overpaid researchers to underperform the index. All they need is a couple of traders and a team of people to open envelopes and deposit checks from investors and send statements to them.
That saves a lot of money: In 2020, the average expense ratio charged by actively-managed funds was 0.71%. But it’s very easy to buy index funds from a variety of companies — including Vanguard, Fidelity, T.Rowe Price, USAA, and TIAA-CREF — that charge a fraction of that amount.
The simplest and easiest way for an individual investor to gain exposure to the entire U.S. stock market in a single transaction is via one of these S&P 500 funds (for large cap exposure). Alternatively, you can choose to diversify even more by buying shares in a total stock market index fund, such as Vanguard's Total Stock Market Index Fund, which tracks the Wilshire 5000 index of all the actively traded stocks in the United States – currently about 3,473 stocks.
This option not only gets you exposure to all 500 stocks in the S&P 500, but also to U.S. mid-cap and small-cap stocks, as well, all with a single transaction. The expense ratio for the mutual fund version of the Vanguard Total Stock Market Index fund is just 0.04% - a tiny fraction of what an actively managed fund would charge you to do your stock investing on your behalf.
For index funds, you can get an even lower expense ratio by buying shares of an ETF, or exchange-traded fund. These are index funds whose shares are traded on the open market. However, you may have to pay a commission to a brokerage company to buy them.
How to Buy Mutual Funds
For many mutual funds – called open-end funds, you can buy or sell shares directly from the fund company’s website. All you need is a bank account or somewhere to wire funds from, a Social Security or Tax ID number, and an internet connection.
Some funds only sell shares through financial advisors who charge sales commissions, which can run as high as 6.2%. These are called "broker-sold" funds – you have to buy them through a broker. The sales commission is usually paid up front, and is called a load. (Open-end funds that sell directly to the investor and don’t charge a sales commission are called no-load funds.)
Which is better?
It depends on how much value your financial advisor brings to the relationship. If you want to invest $10,000 in a load fund, it's up to your advisor to figure out a way to add enough overall value to your relationship to justify the $620 that their front-end load would likely cost.
If your relationship is just transactional – they aren’t giving you any value other than helping you pick an index fund to invest in – you might not need them. You can just go right to your favorite no-load fund company’s website and buy directly from them.
You can also buy funds through online brokers, such as Schwab, E*Trade, Interactive Brokers, Fidelity, or Robinhood. These brokerages will also let you buy shares in individual stocks.
Another option is to use a Robo-Advisor. These are online investment platforms that use artificial intelligence to recommend a set of investments for you. They'll have you fill out an online questionnaire detailing your financial situation, goals, and tolerance for risk, and then recommend a combination of mutual funds, ETFs, or other securities that, when put together in a portfolio, may help you attain your objectives with a reasonable amount of risk.
For more information on Robo-Advisors, see our article, Robo-Advisor vs. Traditional Advisor, Which is Best?
Use Your Retirement Plan
If you’re an employee, chances are good that you have an employer-sponsored retirement plan, such as a 401(k), 403(b), or SIMPLE IRA.
In this case, you can usually buy shares in a menu of several mutual funds through your employer's retirement plan. This is an excellent way to invest because many companies will match a portion of your investment. For example, it's common for employers to match your 401(k) contribution 50 cents on the dollar for every dollar you invest — up to 3% of your salary if you qualify.
This is free money, just waiting for you to pick it up: Effectively, if your employer offers this kind of match, you can buy $1.50 worth of stock for $1! It’s a no-brainer!
Additionally, money you contribute to your employer retirement plan receives favorable tax treatment: Contributions are generally pre-taxed, and everything in your retirement account grows tax-deferred until you take the money out in retirement.
If you're a novice to buying stocks, getting started by contributing to your company 401(k), SIMPLE IRA, or 403(b) plan may be a great way to get started.
How to Buy a Single Stock
Yes, it's true that most advisors recommend individual investors diversify their holdings across many stocks through mutual funds or ETFs.
But there are many people who just can't resist the thrill and challenge of buying single stocks, one at a time.
This section is for you.
Generally, if you want to buy shares in a single stock, you need to open a brokerage account. You can choose nearly any brokerage, but as a novice investor, you might want something easy to use, with either broker support or good research tools. You'll also want a lot of investor education materials.
Consider opening an account with a broker like TD Ameritrade, E*Trade, or Merrill Edge, each of which is known for ease of use. Each of these firms also has a lot of investor education materials.
Take Brokerage Recommendations With a Grain of Salt
You can take advantage of the free research that brokerages provide. But understand that brokerages have a history of placing "buy" ratings on stocks for the general public while quietly advising favored clients to sell – leaving ordinary retail investors holding the bag when the stock eventually flops.
For this reason, it's great to develop other sources of information from independent sources that aren't connected to a broker-dealer firm.
Beware of very small or micro-cap stocks. Their prices are easily manipulated. Many investors have been duped by pushers on investing message boards excitedly posting about how a certain microcap stock is on the verge of a giant breakthrough, and now's the time to invest – only to lose money, because the anonymous pusher on an Internet Bulletin Board was quietly selling their stake the whole time at inflated prices to excited but gullible buyers — a scheme called the pump-and-dump.
How to Pick Stocks
This is a big subject, well beyond the scope of this article. But there are a few basic principles that may be useful for novice investors, and which may help you avoid getting clobbered too much while you learn the ropes of stock investing:
1. Look for stocks with a long history of consistent earnings in both bull and bear markets.
2. Look for stocks that are selling at a reasonable valuation. That means they have a reasonable price-to-earnings ratio relative to their growth rates. As of August 2021, the average P/E ratio of the S&P 500 is 34.5 times earnings. That means it costs you $34.50 to buy a dollar’s worth of current earnings at that company. That’s quite high compared to historical norms.
Historically, stocks have been priced around 15 times earnings. If you believe in buying low, the broad stock market is quite expensive, by historical measures. But with careful research, you may be able to find good companies that are selling at a much more reasonable P/E ratio. If you go much above the average S&P 500 P/E ratio, you should probably have a good, specific reason for doing so – such as the company's fast growth rate justifies the high share price.
To find the P/E ratio for any stock, look in your broker’s research tool for that stock and find the section on valuation or key ratios.
3. Avoid stocks in technologies you don’t understand. Tech stocks are usually very volatile. Many have gone to zero. But a few have made investors wealthy. So it may be worth the risk. But if you don’t understand the technology, be careful: You have no reliable way of assessing that risk. Many people do well buying basic consumer goods stocks, like Gillette, Coca Cola, and Johnson & Johnson. Everybody understands razor blades, soft drinks, and shampoo.
4. Look for stocks that have increased dividends each year for many years. Not all good stocks pay dividends. But dividend-paying stocks tend to be established companies with a proven record of profitability through multiple market cycles. Here’s a list of 65 publicly-traded companies that have increased their dividends every year for at least 25 years:
5. Buy stocks at a discount to their intrinsic value. Think of buying stocks as buying companies – which is exactly what it is. Companies fall out of favor with the stock market all the time, for many reasons – good and bad. Sometimes they are selling for less than they are really worth. If you can buy $1 worth of assets for 65 cents, you want to buy as much as you safely can.
To learn more about this approach to investing, see this classic speech from Warren Buffett, one of the most successful investors in history.
4. Invest with a margin of safety. Don’t invest assuming everything will go well for the company forever. Everything never does. When things go south, you don’t want your company or your investment wiped out.
5. Invest. Don’t speculate. Many people buy stocks just because other investors have been bidding up share prices, and so – like a shiny fishing lure in a lake full of trout – the price movement attracts their attention. But they may not be much smarter than a trout! If you’re buying because of upward momentum, and the people selling it to you bought it just because of upward momentum, you might be caught up in a speculative bubble.
Stay out of it.
Market sentiment is fleeting – and usually crazy. Instead, focus on what is true: The intrinsic value of the underlying assets, the earnings and dividend history and growth rate, the quality of earnings, the management track record, the balance sheet and income/cash flow statements, the price-to-book value, P/E ratio compared to other similar companies, and other important metrics.
6. Don’t trade too much. Trading generates costs – both overt and hidden. You pay commissions on trades, and you also take a hidden hit from bid-and-ask spreads you won’t even see. Every profitable trade outside of a retirement account also generates a capital gains tax liability. The tax is especially high for short-term capital gains, which are gains from stocks that you hold for less than one year.
Instead, it's better to buy stocks in well-run businesses with great underlying core operations in industries with staying power that you expect to hold for many years.
7. Diversify. Try to hold many stocks in many different industries. Also, don’t limit your investing to stocks. It’s usually a good idea to have some money in bonds, as well, and possibly in real estate. You can buy mutual funds in each of these broad asset classes.
- Most stock investors are better off skipping buying individual stocks and opting instead for mutual funds, which offer instant diversification.
- Actively-managed mutual funds add little or no value after their costs.
- Index funds tend to generate superior returns, on average, compared to actively-managed funds.
- Focus on value, earnings, and dividends, not market valuation.
- Buy companies you can understand, with a significant margin of safety and at a discount to their intrinsic value.
- Stay diversified.