First of all, congratulations! Investing in the stock market is the most reliable way to create wealth over long time periods. It might surprise you to learn that a $10,000 investment in the S&P 500 index 50 years ago would be worth nearly $1.2 million today.
With that in mind, there's quite a bit you should know before you dive in. Here's a step-by-step guide to investing money in the stock market to help ensure you're doing it the right way.
Image source: The Motley Fool.
Investing checklist
- Determine your investing approach
- Decide how much you will invest in stocks
- Open an investment account
- Diversify your stocks
- Continue investing
1. Determine your investing approach
You can invest in individual stocks if -- and only if -- you have the time and desire to thoroughly research and evaluate stocks on an ongoing basis. If this is the case, we 100% encourage you to do so -- it is entirely possible for a smart and patient investor to beat the market over time.
In addition to buying individual stocks, you can choose to invest in index funds which will track a stock index like the S&P 500. Or, you can invest in actively managed funds that aim to beat an index.
On the other hand, if things like quarterly earnings reports and some moderate mathematical calculations don't sound appealing, there's absolutely nothing wrong with taking a more passive approach.
When it comes to actively managed mutual funds versus passive index funds, we generally prefer the latter (although there are certainly exceptions). Index funds typically have significantly lower costs and are virtually guaranteed to match the long-term performance of their underlying index. Over time, the S&P 500 has produced total returns of about 10% annualized, and performance like this can build substantial wealth over time.
2. Decide how much you will invest in stocks
First, let's talk about the money you shouldn't invest in stocks. The stock market is no place for money that you might need within the next five years, at a minimum. While the stock market will almost certainly rise over the long run, there's simply too much uncertainty in stock prices in the short term -- in fact, statistically speaking, a drop of 20% in any given year wouldn't even be considered an unusual occurrence.
Here are some examples of money that would be much better off in a high-yield savings account than the stock market:
- Your emergency fund
- Money you'll need to make your child's next tuition payment
- Next year's vacation fund
- Money you're socking away for a down payment, even if you will not be prepared to buy a home for several years
Asset Allocation
Now let's talk about what to do with your investable money -- that is, the money you won't likely need within the next five years. This is a concept known as asset allocation, and there are a few factors that come into play here. Your age is a major consideration, and so are your particular risk tolerance and investment objectives.
Let's start with your age. The general idea is that as you get older, stocks gradually become a less desirable place to keep your money. If you're young, you have decades ahead of you to ride out any ups and downs in the market, but this isn't the case if you're retired and reliant on your investment income.
Here's a quick rule of thumb that can help you establish a ballpark asset allocation. Take your age and subtract it from 110. This is the approximate percentage of your investable money that should be in stocks (this includes mutual funds and ETFs that are stock-based). The remainder should be in fixed-income investments like bonds or high-yield CDs. You can then adjust this ratio up or down depending on your particular risk tolerance.
For example, let's say that you are 40 years old. This rule implies that 70% of your investable money should be in stocks, with the other 30% in fixed income. If you're more of a risk-taker or are planning to work past a typical retirement age, you may want to shift this in favor of stocks. On the other hand, if you don't like big fluctuations in your portfolio, you might want to modify it in the other direction.
3. Open an investment account
To invest in stocks, you'll need a specialized type of account called a brokerage account.
These accounts are offered by companies such as TD Ameritrade, E*Trade, Schwab, and many others. And opening a brokerage account is typically a quick and painless process that you can do in a matter of minutes. You can easily fund your brokerage account via EFT transfer, by mailing a check, or by wiring money.
The brokerage account opening process is generally quick and painless, but there are a few things you should consider before choosing a particular broker:
Type of account
First, determine the type of brokerage account you need. For most people who are starting out in the stock , this means choosing between a standard brokerage account or an individual retirement account (IRA). The main considerations here are why you're investing in stocks and how easily you want to be able to access your money.
If you want easy access to your money, are just investing for a rainy day, or want to invest more than the annual IRA limit, you'll probably want a standard brokerage account. Both account types will allow you to buy stocks, mutual funds, and ETFs.
On the other hand, if your goal is to build up a retirement nest egg, an IRA is a great way to go. These accounts come in two varieties -- traditional or Roth. IRAs are very tax-advantaged places to buy stocks, but the downside is that it can be difficult to withdraw your money until you get older.
Compare costs and features
The majority of online stock brokers have eliminated trading commissions, so most (but not all) are on a level playing field as far as costs are concerned.
However, there are several other big differences. For example, some brokers offer customers a variety of educational tools, access to investment research, and other features that are especially useful for newer investors. Others offer the ability to trade on foreign stock exchanges. And some have physical branch networks, which can be nice if you want face-to-face investment guidance.
There's also the user-friendliness and functionality of the broker's trading platform. I've used quite a few of them and can tell you firsthand that some are far more "clunky" than others. Many will let you try a demo version before committing any money, and if that's the case, I highly recommend it.
4. Choose your stocks
First off, if you're looking for some great beginner-friendly investment ideas, here are five great stock ideas to help get you started.
Of course, we can't go over everything you should consider when selecting and analyzing stocks in a few paragraphs, but here are the important concepts to master before you get started.
- Diversify your portfolio
- Only invest in businesses you understand
- Avoid high-volatility stocks until you get the hang of investing and always avoid penny stocks
- Learn the basic metrics and concepts used to evaluate stocks
It's a good idea to learn the concept of diversification, meaning that you should have a variety of different types of companies in your portfolio. However, I'd caution against too much diversification. Stick with businesses you understand -- and if it turns out that you're good at (or comfortable with) evaluating a particular type of stock, there's nothing wrong with one industry making a relatively large proportion of your portfolio.
Flashy high-growth stocks may seem like great ways to build wealth (and they certainly can be), but I'd caution you to hold off on these until you're a little more experienced. It's wiser to create a "base" to your portfolio with rock-solid, established businesses.
If you want to invest in individual stocks, you should familiarize yourself with some of the basic ways to evaluate them. Our guide to value investing is a great place to start. There, we help you find stocks trading for attractive valuations. And if you want to add some exciting long-term growth prospects to your portfolio, our guide to growth investing is a great place to begin.
5. Continue investing
Here's one of the biggest secrets of investing, courtesy of the Oracle of Omaha himself, Warren Buffett. You do not need to do extraordinary things to get extraordinary results. (Note: Warren Buffett is not only the most successful long-term investor of all time, but he is also one of the best sources of wisdom that you can apply to your investment strategy.)
The most surefire way to make money in the stock market is to buy shares of great businesses at reasonable prices and hold on to them for as long as they remain great businesses (or until you need the money). If you do this, you'll experience some volatility along the way, but over time you'll produce excellent investment returns.
