Stock investing means putting your money to work in publicly traded companies. Stock investing can allow you to own a piece of your favorite retailers, software providers, and much more. A share of stock represents a slice of ownership in a company and entitles the owner to benefit from its future profits.
When done the right way, investing in stocks is one of the most effective ways to build long-term wealth. But like most financial decisions, there are right ways and wrong ways to invest in the stock market. With that in mind, here's a step-by-step guide to investing money in the stock market correctly.
1. Determine your investing approach
The first thing to consider is how to start investing in stocks the right way for you. Some investors buy individual stocks, while others take a more passive approach with mutual funds and exchange-traded funds (ETFs, more on those in a bit). Both can be equally valid ways to put your money to work.
Try this. Which of the following statements describes you?
- I'm an analytical person who enjoys crunching numbers and doing research.
- I hate math and don't want to do a ton of "homework."
- I have several hours each week to dedicate to stock market investing.
- I like to read about the various companies I can invest in, but I don't have any desire to delve into anything math-related.
- I'm a busy professional and don't have the time to learn how to analyze stocks.
No matter which of these statements you agree with, you're probably a good candidate to become a stock market investor. The only thing that will change is how you do it.
The different ways to invest in the stock market
Individual stocks
You should 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.
On the other hand, maybe quarterly earnings reports and moderate mathematical calculations don't sound appealing. In that case, there's absolutely nothing wrong with taking a more passive approach.
Index funds
If you'd like to play a role in your investment decisions but don't necessarily want to choose individual stocks, you can invest in index funds. These track a benchmark index, such as the S&P 500. Index funds typically have low costs and are virtually guaranteed to match the long-term performance of their underlying indexes, minus some small investment fees.
Robo-advisors
Does putting your stock investing on autopilot sound like the best choice for you? One option that has exploded in popularity in recent years is the robo-advisor.
Robo Advisor
A robo-advisor, also known as an automated investing platform, is a brokerage that invests on your behalf in a portfolio of index funds appropriate for your age, risk tolerance, and investing goals. Not only can a robo-advisor select your investments, but many will also optimize your tax efficiency and make changes over time automatically.
2. Decide how much money you will invest in stocks
First, let's talk about the money you shouldn't invest in stocks. In simple terms, the stock market is no place for money you might need within the next five years, at a minimum. Money you need to pay your kids' tuition or pay day-to-day expenses in retirement should be kept in less-volatile investment vehicles.
The stock market will almost certainly rise over the long run. However, there's simply too much uncertainty in stock prices in the short term. In fact, a drawdown of 20% in any given year isn't unusual, and occasional drops of 40% or even more do happen. Stock market volatility is normal and should be expected.
So, here's what money you shouldn't be investing:
- Your emergency fund
- Money you'll need to make your child's next few tuition payments
- Next year's vacation fund
- Money you're saving for a down payment on a home
Asset allocation
How you distribute your investable money is a concept known as asset allocation. There are a few factors that come into play here. Your age is a major consideration, as are your particular risk tolerance and investment goals.
Let's start with your age. The general idea is that as you get older, stocks 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 stock market. This isn't the case if you're retired and rely on your investments for income.
Here's a quick guideline, known as the Rule of 110, to help you establish a ballpark asset allocation.
To use it, simply subtract your age from 110. This is the approximate percentage of your investable money that should be in stocks (including mutual funds and exchange-traded funds (ETFs) that are stock-based). The remainder should be in fixed-income investments, such as bonds or high-yield certificates of deposit (CDs).
Bonds
For example, some brokers offer customers a variety of educational tools. Some offer access to investment research and other features that are especially useful for newer investors. 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 to consider. Many will let you try a demo version before committing any money; if that's the case, it can be well worth the time.
4. Choose your stocks
We've answered the question of how you buy stocks. If you're looking for some great beginner-friendly investment ideas, here is a list of some of our top stocks to buy and hold to help get you started. Note that this isn't intended as personal advice -- just some well-run businesses to help get your search started.
Of course, in just a few paragraphs, we can't go over everything you should consider when selecting and analyzing stocks. However, here are the important concepts to master before you get started:
- Diversify your portfolio.
- Invest only in businesses you understand.
- Avoid high-volatility stocks until you get the hang of investing.
- Always avoid penny stocks.
- Learn the basic metrics and concepts for evaluating stocks.
It's a good idea to learn the concept of diversification, which means you should have a variety of different types of companies in your portfolio. That said, 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 up a relatively large segment of your portfolio.
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.
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.
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 the shares for as long as the businesses remain great (or until you need the money). If you do this, you'll experience some volatility along the way. But over time, you'll most likely enjoy excellent investment returns.
Types of stocks
There are literally hundreds of categories and subcategories of stocks. Here are some of the common categories investors should be familiar with:
- Common stocks: Stocks that allow you to own equity in a business
- Preferred stocks: Stocks that have a guaranteed rate of return and work like debt instruments, not equity investments
- Growth stocks: Companies that are growing sales faster than the overall stock market average
- Value stocks: Companies whose stocks are (theoretically) trading for a discount to the intrinsic value of the business
- Dividend stocks: Stocks that pay regular distributions of cash to investors
- Large-cap stocks: Generally used to refer to companies with a $10 billion market cap or higher
- Mid-cap stocks: A company with a market cap of between $2 billion and $10 billion
- Small-cap stocks: Companies with less than $2 billion in market cap
Potential benefits and risks of investing in stocks
As mentioned, stocks can be a great way to create wealth over time. Over periods of several decades, major stock market averages have produced returns of between 9% and 10% annually.
The main risks are related to how volatile stocks can be over short periods of time. Swings of 10% in the stock market are rather common, happening about once a year, and declines of 20% or greater (which define a bear market) happen occasionally.
Related investing topics
Stock investing mistakes to avoid
There are many potential mistakes new stock investors can make, and here are some of the most common. Avoiding these can save you a lot of money and aggravation as you build your investment portfolio:
- Don't make emotional investing decisions. Our instincts tell us to put our money into stocks when they're going up and we see everyone else making money and to sell "before things get any worse" when stocks go down. This is literally the opposite of "buy low, sell high," the central goal of investing.
- Don't day trade or try to buy stocks because you think prices are about to go up. Leave short-term trading to professionals.
- Don't invest on margin (borrowed money). Not only will you pay interest on the money you borrow, but if your stocks fall, this can also magnify your losses.
- Don't use options to invest. Options should be left to those with more experience, at least until you really know what you're doing.
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