When it comes to investing money, we have several choices at our disposal. But those looking for the best returns would be wise to consider the stock market. It's estimated that 54% of Americans have stocks in their portfolios, and if you're not part of that statistic, you're missing out on a key opportunity to accumulate wealth, whether it be for retirement or another long-term goal you might have.
Of course, investing in publicly traded companies carries some risk, and buying stocks can be a daunting prospect for beginners. That's why we've developed a comprehensive guide to investing in stocks for the first time. Here, we'll review the basics of how stocks work, how you can profit from them, and the pitfalls you'll want to avoid.
What are stocks?
You've probably heard of stocks in the context of investing, but how do they actually work? When you buy stocks, you're essentially buying a share of ownership in a given company. Stocks are sold as individual shares, and the more you own, the greater a stake in a company you'll get. Furthermore, when you buy stocks, you get certain rights as a shareholder, which could include the right to receive dividend payments and voting rights at shareholder meetings.
Why are voting rights important? Often, the matters you'll get to vote on will impact the value of your shares, either directly or indirectly. For example, if you're invested in a company proposing a stock split, the value of each share you own will be reduced as a result of that move (though you'll get double the number of shares) -- that's something you'll want a voice in. Similarly, you'll get to vote on things such as mergers and acquisitions and major structural changes within a company -- things that can impact cash flow and earnings, and therefore cause the value of your stocks to fluctuate.
Companies that issue stocks are considered public companies, because the general population has a chance to invest in those businesses. Private companies, by contrast, do not issue stocks that are available on a public exchange, which is an accessible, regulated marketplace where securities and other financial instruments are traded.
Companies that issue stocks do so to raise capital, which is money or assets that can be used for research and development, expansion, marketing, or other needs. Once companies issue stocks, however, they not only become accountable to shareholders, but are subject to strict reporting regulations and disclosures.
How to make money on stocks
There are two main ways you can make money on stocks. The first is to buy stocks at a certain price and sell them later at a higher price. Imagine you buy 20 shares of a stock at $100 a share, and the price later climbs to $150 per share. If you sell your 20 shares, you're up $1,000.
Now if you're wondering how many shares of a company you should aim to purchase, the answer is, it depends on the share price and the amount of money you have to work with. Technically speaking, you can invest in a company by buying just a single share of its stock. However, because you'll typically pay a fee or commission for each transaction you make, it's often preferable to buy multiple shares of a company at a time. Purchasing multiple shares also allows you to profit more when a company's stock price rises. If you buy a single share of a stock for $100 and it climbs to $150, you stand to make $50. That's not a whole lot. But if you own 20 shares, you'll be looking at $1,000.
The other way to make money on stocks is to hold your shares and collect dividends. A dividend is a portion of a company's earnings that's distributed to shareholders. Dividends are typically paid quarterly, though companies don't have to pay them. That said, if you buy stocks issued by a company with a long history of paying dividends, you can come to expect a pretty reliable income stream. For example, today, Verizon's (NYSE:VZ) dividend yields 5%, which means that for every $100 you have invested in shares, you'd get back $5.
Now keep in mind that there are other ways you might make money on stocks, such as shorting shares of a given company. But if you're new to stock investing, you're generally better off keeping things simple and sticking with the classic methods outlined above.
Where do you buy and sell stocks?
The good thing about stocks is that they trade on a public exchange, which means it's easy to get up-to-the-minute information on what various companies' shares are selling for. But how do you actually acquire those shares? Well, you need a broker -- either an actual person or an online brokerage firm. These days, many investors opt for the latter, but keep in mind that some accounts have a minimum funding balance you'll need to meet. For example, you might need $1,000 to open an account and start trading.
Our list of online stock brokerage accounts will help you compare your options, but as you review, think about how frequently you expect to be buying and selling stocks. You might get charged a fee or commission per transaction, which can eat away at your profits, so that's something to consider.
Types of stock
There are two types of stock you, as an investor, have the option to buy: common stock and preferred stock.
Common stock represents an ownership share in a given company. When you buy shares of common stock, you get voting rights with regard to that company. For example, if a new board of directors is proposed, you'd get a say in whether or not it's elected. And that's important, because the board will make decisions about the company's future, such as whether to expand operations, shut down certain revenue streams, or acquire other businesses, all of which can affect your stock price. As a holder of common stock, you're also entitled to dividends, provided the companies you've invested in are paying them. Assuming you hold shares of a company that is paying, you'll receive a certain amount of money for each share you own.
Preferred stock, meanwhile, represents an ownership share in a company as well, only if you hold preferred shares, you're entitled to a predetermined dividend that's likely to be larger than what common stockholders receive. Furthermore, in the event of a liquidation (which is when a company shuts down operations and sells off all of its assets), preferred shareholders get paid before common stockholders, making preferred shares a less risky investment. On the other hand, preferred shareholders don't get voting rights on company matters.
Now that you understand how to buy stocks and the different share types available to you, the next question is: Which specific companies should you invest in? For this, you'll need to do your research to find the right stocks to add to your portfolio.
When you're first starting out, it helps to focus on businesses whose models and products you use or understand. If you're a tech fan, investing in a company that sells gadgets could be a good bet for you. But more than that, you'll want to find companies with a solid competitive advantage. This can come in a number of forms, whether it's an innovative product unlike any other or a fantastically streamlined manufacturing process.
Furthermore, it helps to find companies whose management teams are solid. This information is made public, so you can research the folks who run the big companies out there, check out their backgrounds, read or watch interviews with them, and see how they think.
Other key clues to look out for are how long the management team has been serving the company. Longevity is often a good sign that the folks in charge are doing something right. You'll also want a management team that's innovative and willing to take risks, but not too many risks. By reading up on a company and its history, you can get a sense of the sort of decisions its management team has made, and how those decisions have panned out.
Also, feel free to see how that management team is being compensated. That information is publicly available, and you can compare it to that of other companies to get a sense of what's fair. Keep in mind that higher compensation isn't necessarily a bad thing, as strong talent often begets more money.
Finally, think about how the companies you're researching are doing. For example, if you're looking at a pharmaceutical business, does the company have several promising drugs in its pipeline with the potential to lead to future growth and revenue? If so, that's a positive sign.
Of course, if you really want to get a sense of a company's value and growth potential, you'll need to look at some numbers. You can start by reviewing its balance sheet, which lists its various assets and liabilities. You can access public companies' balance sheets on the SEC's EDGAR website. Similarly, you can look at a company's cash flow statement to get a sense of how it manages its money, and its income statement to get a sense of its profits and losses.
Another key thing to look at is a company's earnings per share, which represents the portion of a company's profit allocated to each share of its common stock. Earnings can cause stock prices to rise, and when they do, investors make money. If a company has high earnings per share, it means it has more money available to either grow the business or distribute as dividends. That said, earnings should always be evaluated in the context of the industry you're dealing with. If you're looking at a company whose earnings per share is $2, but a competing company has earnings per share of $6, that's a potential red flag. That said, this is only one piece of the total puzzle.
You'll also want to look at a stock's P/E ratio, or price to earnings ratio, which is its market capitalization (the total value of its outstanding shares) divided by its earnings over the past year. Generally speaking, a high P/E ratio tells you that investors are placing a higher value on the company, which often means that company's stock will be more expensive than a company with a lower P/E ratio. But this doesn't always hold true.
Another key metric to look at is return on equity, which measures a company's ability to turn capital into profits. Return on equity is calculated by taking a year's worth of earnings and dividing that figure by the average shareholder equity for that year. If that number is 15%, for instance, then 15 cents worth of assets are generated for every dollar investors put in. Again, you'll want to compare that number to other companies in the industry to see how it stacks up.
Individual stocks versus mutual funds
Researching individual companies takes time, and sometimes, even if you perform your due diligence, you may come to find that a certain business has a bad year, gets nailed by a scandal, or experiences some other shakeup that causes its stock price to plummet. As an investor, that's clearly not good news. Therefore, when you think about buying stocks, it pays to load up on a wide range from a variety of industries in order to establish a diversified portfolio.And that's where investing in mutual funds can be advantageous.
Mutual funds are funds that pool investors' money and invest it under a specific strategy, which often includes stocks. Actively managed mutual funds employ fund managers who are in charge of making investment decisions. As an investor, you'll typically pay a notable fee in exchange for that professional, hands-on guidance.
Index funds, meanwhile, are passively managed, and they're designed to simply track existing indexes, such as the S&P 500. As such, their fees tend to be considerably lower than those charged by actively managed funds. And the lower your fess, the less money you lose along the way.
Investing in mutual funds is sort of like buying a big bucket of stocks, and that offers you a degree of protection. Remember, if you buy an individual stock and the issuing company has a bad year, you might lose quite a bit of money. But if you're invested in a mutual fund that owns 200 different stocks, and only one has a bad year, you won't feel the impact nearly as much. Buying shares of mutual funds also takes some of the legwork out of researching investments -- though you should still perform your due diligence regardless.
Why choose stocks?
Now that you know how to buy and research stocks, the question is: Why should you risk your money? After all, aren't bonds a much safer prospect? A bond is a debt instrument wherein you lend the issuer a certain amount of money in exchange for interest payments at a predefined rate and a return of your principal once the bond comes due. Though bond prices can fluctuate based on market conditions, as long as you hold your bonds until maturity and the issuer doesn't default, you get to collect the interest you're entitled to as well as get your full principal back.
The truth of the matter is that the stock market has always been more volatile than the bond market. It's also, however, historically delivered much stronger returns. Between 1928 and 2010, stocks averaged an 11.3% return, while bonds averaged just 5.28%. So let's say you have $10,000 to invest over a 30-year period, and you put it in bonds averaging 5.28%. After three decades, you'll have about $47,000. But if you were to put that same amount of money in stocks instead and score an average 11.3% return, you'd be sitting on $248,000 after 30 years.
Investing in stocks is a means of growing your wealth faster and more efficiently, and that's the primary reason to take on that added risk. Additionally, a good portfolio is one that's loaded with diverse investments, so even if you aren't particularly keen on risk, it helps to have at least some stocks in your portfolio.
Drawbacks of stock investing
The primary drawback of investing in stocks can be summed up in one word: volatility. The market can be up one day, down the next, and then back up again, and even the most sophisticated investors out there struggle to time the market just right.
But while the thought of losing money is what makes most people fear the stock market, one thing you ought to remember is that the market has historically spent more time up than down, and those who are in it for the long haul tend to come out ahead. Consider this: Between 1965 and 2015, the S&P 500 underwent 27 corrections where it lost 10% of its value or more, but it ultimately wound up recovering from each and every one. Therefore, if you're patient and willing to invest on a long-term basis, you really do stand to make money.
The smart way to invest in stocks
For starters, be long-term oriented. If your goal is to find a great stock, sell it quickly, and get out, you might easily get burned. But if you're willing to invest over a 10-year period or longer, you have plenty of time to ride out the market's downturns.
Speaking of which, don't react when the stock market takes a tumble. It may be disheartening to log on to your brokerage account and see that your portfolio value is lower one day than it was the week before, but remember this: Until you actually sell off your investments at a price that's less than what you paid for them, you're only looking at a loss on paper (or, in your case, a loss on screen). If you sit tight and wait for the value of your stocks to come back up, you won't lose a dime.
Another key strategy when investing in stocks is to diversify. This means investing in various market segments (say, energy, biotech, and retail) as opposed to putting all of your money into a single company or sector. And as we learned earlier, mutual funds are a great way to buy yourself some instant diversification.
Finally, stay away from penny stocks, which are those priced below $5 per share. Though they might seem appealing because they're so cheap, penny stocks aren't regulated the same way regular stocks are, so as an investor, you get much less information about the companies issuing them. As such, they're a riskier prospect despite their low cost.
The bottom line on stocks
With the right approach, stocks are an appropriate investment for people of almost all ages. Generally speaking, the younger you are, the more of your money you should put into stocks, since you have time to ride out the market's ups and downs. As you get older, it's usually a good idea to shift some investments out of stocks and into safer vehicles, like bonds. But even if you're retired or close to retirement, stocks still have a place in your portfolio.
That said, you shouldn't invest money in stocks if you expect to need that money within seven years. The reason? If the market takes a major hit during that time frame, its recovery period could be extensive, and if you need to access your money to cover an expense, you might have to sell investments at a loss. Therefore, your short-term emergency fund should be tucked away safely in the bank, and not in the stock market. But if you're talking about money you're investing for retirement, or another far-off goal, stocks are certainly a good way to generate some solid returns.