You’ve likely heard about the opportunity to earn money by investing in the stock market, but maybe you don’t know where to start.
By educating yourself on how the stock market works, you may be able to take advantage of the potential upside in share prices, while minimizing risk. But it can be easy to get swept up in the sea of information available. The good news? Investing in the stock market is in many ways more accessible given the prevalence of brokerage firms, low trading costs, and mobile investing apps.
Let’s break down some of the most important elements of stock investing, specifically for beginners. Here’s a step-by-step guide for those who want to start stock investing.
1. Learn Stock Market Basics
A stock represents a small percentage of ownership in a public company. Public simply means shares of the company are available for anyone to invest in in the stock market.
There are two types of stocks: common stocks and preferred stocks. Common stocks are what you’re probably thinking of when you consider investing in the stock market. Preferred stocks are considered first in line for dividend payouts, but they don’t come with voting rights, unlike the shareholders of common stocks.
In general, the whole reason for investing is so that the investment earns money in the future. This is also known as a “rate of return.”
With stocks, that rate of return comes in two forms: price appreciation and dividends. Price appreciation is when the price (the value) of a stock increases over time. For example, if a stock’s value increases from $10 to $12, the price appreciated by $2 or 20%. Dividends can be cash payouts made by the company to stockholders—you can think of them as your share of the profits as an owner of the company.
3. Research Different Ways to Invest in Stocks
For those wondering how to start investing in the stock market, it might help to understand that there is more than one method to do so.
One way is by buying individual company stocks. Another is through purchasing funds, either mutual funds or exchange-traded funds (ETFs).
1. Buying Individual Stocks
This method requires a significant amount of research into individual stocks. You want to do a deep dive into the company’s inner workings and compare that with the price of the stock.
Additionally, you might want to get comfortable reading a company’s balance sheet and other financial statements. All public companies are required to file this information with the Securities and Exchange Commission (SEC), so you won’t have trouble finding them.
One of the most basic metrics for understanding a stock’s value as compared to company profits is its price-to-earnings (PE) ratio. Others include the price-to-sales (PS) ratio and the price/earnings-to-growth (PEG) ratio, which may be helpful for companies that have little to no profits but are expanding their businesses quickly.
If there’s a company whose share price is out of an investor’s reach, one possibility is to vest via fractional shares, or slices, if applicable of one whole company stock.
One advantage of owning individual stocks is getting direct exposure to a company an investor believes has the potential to grow revenue and earnings. The downside of course is that the investor needs to make sure themselves that their portfolio is well diversified.
2. Investing in Funds
A second way to start investing in stocks is by using funds, either mutual funds or exchange-traded funds (ETFs). A fund is a basket of individual investments, such as all stocks, bonds or a combination of both.
Two of the main differences between mutual funds and ETFs are fees and when investors can trade. In general, ETF fees tend to be lower than mutual fund fees. Most mutual fund buy-and-sell orders are executed once a day, during the market close at 4 p.m. Meanwhile, ETFs trade like stocks on an exchange so can be bought and sold during the market trading hours of 9:30 a.m. to 4 p.m.
Whether investors pick a mutual fund or ETF, they need to decide whether they want an active or passive (Index) fund. Active funds are typically managed by a human portfolio manager, who picks and chooses which stock they deem to be of best value. However, in the past dozen years or so, passive or index funds have become increasingly popular because of their low-cost structure and the easy diversification they offer.
For example, an S&P 500 index fund invests in all 500 companies that make up the benchmark stock gauge. With the purchase of just this one fund, the investor gains exposure to all these companies.
A benefit to stock funds is that you do not take on the risk of being invested in individual stocks that do not perform well. Additionally, index investing can be an affordable way to get broad exposure to the stock market. Some funds, such as thematic ETFs, may also hold a narrow slice of the market based on a specific niche or theme.
3. Investing Through Robo-Advisors
Another way people can get exposure to the stock market is through robo-advisors, computer algorithms that essentially generate financial planning for individuals. The services robo-advisors offer include building portfolios, rebalancing them, executing trades, and automated tax-loss harvesting.
Robo-advisors aim to make financial and retirement decisions more affordable for consumers. Many consumers have found robo-advisors worth it as they’ve been deterred by the higher costs of human financial planners. Here’s how they typically work: an individual fills out an online questionnaire about their financial goals, risk tolerance and investment horizon.
The robo-advisor will generate a portfolio for them, allocating more to riskier assets like stocks if the individual is investing for the long term, while allocating more to safer assets like bonds if the person is closer to retirement.
2. Set an Investing Budget
How much money should a person invest in the stock market? When it comes to a personal budget, essentials come first: housing and food costs, childcare costs, an emergency fund. Any money left over after important costs can be used as investment funds.
4. How to Invest for the Long-Term
People who put money into the stock market tend to benefit if they invest for a longer period of time. This is true from a tax perspective and due to the stock market’s tendency to experience shorter-term volatility.
Taxes on investment gains are called capital gains taxes, and profits from investment held for less than a year are taxed at a higher rate.
Plus, holding investments for longer may help investors ride out stock market volatility. For instance, after the Covid-19 pandemic triggered a selloff in share prices during March 2020, the market bounced back later in the year.
5. Open a Brokerage Account
Once you’ve made the decision to purchase stocks (or stock funds), it might be a good time to figure out where to do it. One of the easiest options is through a brokerage account.
A brokerage account gives you a platform on which to buy and sell securities (mostly stock, options and bonds) through an exchange or from their own supply. Additional services offered through a brokerage can include advice and management. Typically, full-service brokerages offer more services but at higher overall costs, while discount brokerages give scaled-down services with lower overall costs.
Some brokerage firms charge a commission, called a transaction charge or a trading fee, for securities bought and sold on an exchange including stocks and ETFs. This can make buying and selling individual stocks an expensive affair, especially if you are trying to build a diversified portfolio with many stock holdings. Therefore, ETFs or no-commission brokerages might be a more economical way for new investors.
6. Manage Your Investment Portfolio
As mentioned, it’s often better to invest for the long-term in stocks. While it’s important to monitor the stock market, worrying about the day-to-day price fluctuations isn’t necessary.
However, as a person gets older and closer to retirement, they may want to shift their investments to safer stocks. For instance, a person investing in their 20s may benefit from higher exposure to cyclical stocks, those more closely tied to economic growth, or international stocks, which are generally riskier than domestic blue-chip companies.
Meanwhile, an older person eyeing retirement may want to adjust their portfolio to have a bigger bond weighting.
Investing in the stock market has been an important way for individuals to build personal wealth. However, stocks are a risky asset class. While long-term they’ve generally climbed higher, the market is also prone to volatility and selloffs. It’s important for beginner investors to start investing by using the step-by-step guide above.
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