You've paid off your credit cards. You've saved up an emergency fund. You've opened a brokerage account. You've done your research, compared notes with like-minded Fools, and found the stock of your dreams. Let the guns blaze!
Whoa there, cowboy!
Hey, we're just as excited as you are that you're ready to be a stock owner. But before you go knocking on Mr. Market's door, bearing cash and gusto, let's keep some perspective.
First, this is just one of many investments you'll end up owning. That's to say, you want to invest in sips, not gulps. Your first purchase should be as petite in size as it is bold in spirit. Second, don't forget that your first investment is also a learning experience. As any craftsman will tell you, there's no better way to learn than by doing.
A journey of a thousand miles begins with a single step. And that's what we recommend to you: Buy a single share of your favorite stock. Just one. This one share will teach you more about life as an investor than we could ever hope to teach you here. Follow it. Get to know it. Read the quarterly earnings releases, listen to the conference calls, and see how the stock's daily fluctuations affect you. For future stock purchases, you should keep trading costs and commissions to less than 2% of your total purchase amount, but we'll let that slide on your first buy.
But there's something else we want you to pick up while you're making a stop at your friendly broker: A stake in an index fund.
The passive investor's best friend
How many times have you heard someone ask, "How'd the market do today?" But what is "The Market?" And how do we know how it did? Usually, the answer reflects the performance of an index -- such as the Dow Jones Industrial Average or the Standard & Poor's 500 -- rather than the market as a whole.
What all indexes have in common is that the value of the index changes proportionally to the value of the stocks in the index. So when the index goes up, the aggregate value of the stocks in the index has grown by a proportional amount, and vice versa.
And you can invest in those indexes -- through index funds. These funds don't look to beat the market -- they look to match it as closely as possible. That might not sound enticing at first blush, but consider that index funds offer:
- Instant diversification: When you invest in an index fund, in one fell swoop you've spread your dollars across industries, markets, currencies, and countries, substantially lowering your risk in the process.
- Low costs: Index funds have much lower expenses than actively managed mutual funds. The average actively managed U.S. fund charges its investors 1.4% for the privilege of owning shares. The Vanguard 500 Index (VFINX) fund, meanwhile, carries an expense ratio of only 0.16%.
- Superior returns: According to the Fool’s own research, only 42% of actively managed funds beat the S&P 500 through the 15 years ending January 2009. And we're not alone; numerous studies show that you're likely to underperform by investing in a typical Wall Street fund. And as we just pointed out, you’ll pay a lot more for that privilege.
Little wonder that we think index funds should be the foundation of your portfolio (more on that in Step 8). But for now, we simply recommend that for every dollar you put into individual stocks, you roll the same amount into an index fund (the Vanguard fund we mentioned above is good choice).
But about that stock
Yes, we Fools love index funds, but we also believe everyone should own at least one stock (and ultimately, at least 15 to reduce your risk and increase your odds for success). Why? Well, it's fun (really!). By owning a stock, you have your own little piece of history, and you get to witness firsthand the power of capitalism and entrepreneurship at work.
But just as important, if you want to beat the market, you simply can't do that by investing only in index funds. In fact, your goal for every stock you buy should be to outperform the index. So get out there and start having some fun on your way to market-beating returns.
Action: Invest in an index fund, and buy your first stock!