Before even considering putting money to work in the stock market, individuals should focus on making sure their personal finances are in order. This means that any high-interest debt, such as credit cards, is paid off. Additionally, it's best to have an emergency savings fund in place to cover major expenses you might have over the next several months (or more, depending on your specific situation).
After these important steps are completed, it's time to put your investing hat on. If I had $1,000 ready to invest today, here's how I'd start from scratch.
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Owning pieces of real businesses
That $1,000 would go into the stock market. And I would probably choose to invest it in an S&P 500 index fund, like the Vanguard S&P 500 ETF (VOO +0.56%), that gives broad exposure to the entire stock market, as represented by the largest 500 publicly traded companies in the U.S. The average annual return of about 10% over the long run is also appealing.
Legendary investor Warren Buffett, who many consider to be the greatest capital allocator we've ever seen, suggests that buying index funds is the best course of action for the majority of people.
In fact, he even put his money where his mouth is, betting that a group of hedge funds couldn't beat the S&P 500 over a 10-year stretch. Buffett won that bet, which indicates that even some of the smartest minds on Wall Street, who have an army of well-educated analysts and all the resources at their disposal, still couldn't beat the market over an extended period of time. This just proves how difficult it really is.
It's also important to note that it's a good idea to invest that $1,000 not in a single transaction but over many months in equal increments. This is called dollar-cost averaging. It benefits the investor by allowing them to take advantage of multiple entry prices, instead of trying to figure out exactly when the right time is to put everything in the market, which can lead to inaction.
The other aspect that will make this strategy work is to keep a long-term mentality. It's not a good idea to invest any money in the stock market that you might need within the next five years. That's because the stock market is a volatile beast, and the last thing you want to happen is that you find yourself being forced to sell stocks when they're down big because of the need for cash. You'll take a loss and miss out on a recovery.
Picking individual stocks
For some, owning index funds might be too passive of an approach, no matter how effective it has proven to be. Some investors might want to pick individual stocks because they not only have the time to do the proper research on specific companies, but they believe they have the analytical skills and emotional make-up to be successful at going this route.
If this sounds like you, then it's best to stick to businesses that are easy to understand, have competitive advantages, and are consistently profitable. Household names like Starbucks, Nike, and Apple immediately come to mind. I think these tickers are a good place to start doing research.
Ben Graham, Buffett's professor at Columbia University and early mentor, said, "In the short run, the market is a voting machine but in the long run it is a weighing machine." He meant that markets are exposed to the whims of investor sentiment in the near term, which is unpredictable. But over longer periods of time, markets will reward businesses that do well fundamentally.
Successfully managing a portfolio actively is hard. It's best to remain focused on how the underlying business is performing instead of fixating on the stock price and jumping into and out of positions frequently. Over time, your portfolio will thank you.
