Chances are you’ve heard it before—investing is one possible way to grow your nest egg, achieve a secure and comfortable retirement, or even accomplish shorter-term financial goals like buying a house.
But even for the savviest saver, the stock market can be a bit confusing. You’re buying and selling… what, exactly? Just what are stocks, and how can they help you build the future you’re aiming for?
A stock is, put simply, a portion of ownership of a company. Stockowners are entitled to a proportional cut of the company’s assets and earnings. That means that, if you own stock in a company, as the company grows and expands, you stand to earn a return on your investment. But you also risk losing all or part of your investment if the company doesn’t prosper. (More on that shortly.)
Stocks are also known as “shares” of a company or “equity investments.” Whatever you call them, stocks are primarily bought and sold on publicly-traded stock exchanges. That means that, yes, you can open up a brokerage account and become a partial owner of many major name-brand corporations right now, all without spending even a single day in business school.
Stocks come in two varieties: common and preferred.
• Common stocks are, as you might guess, the most common. Along with proportional ownership of the company, common stocks also confer voting rights to the stockholder, allowing a voice when it comes to things like management elections or structural business changes.
• Preferred stocks don’t come with voting rights but they are given “preferred” status in that earnings are paid to preferred stockholders first. That makes this kind of stock a slightly less risky asset. If the company goes under and its assets are liquidated to repay investors, the preferred stockholders are less likely to lose everything, since they’ll be paid their share before common stockholders.
For the purposes of this guide, we’ll focus primarily on common stocks, since those are the ones you’re most likely to purchase.
Is It Possible to Earn Money by Buying Stocks?
Now that you know what stocks are, let’s look at whether buying them has the potential to help you meet your financial goals. How does buying stocks earn you money?
There are two possible ways.
• Over time, stocks may tend to increase in value if the company grows, expands, and prospers. Since each share represents proportional ownership, stock is worth more when the business’s overall value increases—and may also command higher market prices due to demand. That means you can earn money by selling your stocks at a profit later on down the line.
• Stockholders may also earn dividends of a company’s profit, which may be paid in cash or as additional stock. Dividends are typically paid on a regular basis, such as quarterly or annually, though executives may also decide to cut dividend payments if the company is faltering. That means owning stock can create a form of passive income, since you could earn dividends just by holding onto your shares.
Stocks make up the foundation of many investment portfolios because of their potential for returns in the long run. On the other hand, the same dynamic that gives stocks their exponential growth potential also adds considerable risk to owning stock.
Buying Stocks—Risks and Rewards
Although buying stocks can sometimes result in a nice profit, thanks to compound interest, it’s also possible to see significant losses—or even to lose it all.
Stocks might lose value under the following circumstances:
• The issuing company falters or goes under, in which case individual shares can drop in price and the company may forego paying dividends. This is also known as “specific” or “unsystematic risk,” and may be slightly mitigated by having a diversified portfolio.
• The market as a whole experiences losses, due to wide-reaching occurrences like economic recessions, war, or political changes.
Diversifying your portfolio—buying a variety of different stocks as well as other assets like bonds and cash equivalents—is one way to help mitigate the risks of investing. But it’s important to understand that it is possible (and even likely) that you may lose money by investing.
That said, scary news headlines can blow things out of proportion. A certain amount of market fluctuation is absolutely normal—and, in fact, an indicator that the market is healthy and functioning.
Furthermore, the market’s overall value has increased on average over the last century, even taking into account major collapses. In fact, the S&P 500, an index tracking the performance of America’s largest publicly-traded companies, saw an annual return of approximately 10% between 1926 and 2020—a time frame that includes both the Great Depression and the 2008 housing fiasco.
Should You Invest in Stocks?
Since stock market assets are intangible, purchasing them can feel a little like throwing your money into the wind. Unlike buying real estate or a piece of art, you don’t get anything tangible to hold onto, and the risk of losing it all can weigh heavily on some investors.
But due to their growth potential, stocks may offer investors a possible way to build wealth over time, given that they tend to have higher average return rates than many other kinds of assets.
Take bonds, for instance. Bonds are a type of investment asset wherein you lend your money to a company or government and get a promise that it will be returned, plus interest, within a set amount of time.
Because bonds promise certain repayment terms, or “face value,” ahead of time, they’re typically not considered as risky as stocks. However, they’re still vulnerable to company defaults.
Bonds do offer some growth potential, sometimes with relatively low levels of risk,, and you may wish to consider keeping a portion of your investment portfolio invested in them. But over the past century, bonds have seen an average return of about 5-6% . As you’ll recall, that’s only half of the annual growth rate actualized by stocks over the same time period. Remember, past performance doesn’t guarantee that the future will be the same.
Along with helping you build wealth to achieve financial goals like retirement or homeownership, investing in stocks is also a possible way to keep up with inflation. As tempting as it may be to stash your cash under your mattress, the value of those paper dollars decreases over time, which means the $100 you squirrel away today might be worth only $95 ten years from now, due to inflation.
On the other hand, if you’d invested that money, it might have nearly doubled in the same amount of time. Of course, that new total would still be subject to inflation, but it could still be a lot more competitive than the dusty paper bills
• Stocks, also known as “shares” or “equity investments,” are small pieces of ownership of a larger company. Stocks come in both common and preferred varieties, which offer stockholders different benefits and risks.
• Common stockholders receive voting rights as stakeholders in the business, but receive dividends only after other company obligations, such as bond payments, are paid. They are last in line when company assets are paid out. Preferred stockholders don’t get voting rights, but receive dividentds before those who hold common stock. If the company’s assets are sold, preferred stockholders are paid before common stockholders.
• Stocks, although relatively risky, tend to offer better earning potential than other asset classes like bonds or long-term savings accounts.
• Even taking major financial crises into consideration, the market’s overall trend over the last 100 years has been toward growth.
So, if you’re ready to take matters into your own hands and become an investor, here’s what to know.
Getting Started Investing in Stocks
If you decide that investing in the stock market is the right move to help you reach your financial goals, you’ve got a variety of ways to get started. Before you even sit down to choose your first stock (or learn to evaluate stocks in general), you’ll need to decide what kind of investment account you’ll use.
Recommended: How to Buy Fractional Shares
Types of Investment Accounts
There are a wide variety of different investment account options, some of which carry certain benefits and incentives for specific purposes. For example, the money you put into a 401(k) may be tax-deductible.
On the other hand, these specially-designed investment accounts do come with strict regulations which could keep you from accessing your funds until you reach a certain age or find yourself in special circumstances. . Here are a few of the most common types of specialized investment accounts.
• The 401(k) might be the most familiar investment account. It’s commonly offered to W-2 employees as part of their benefits package. Contributions are taken directly from your paycheck for this retirement account, and in most cases, taxation is deferred until you take the funds out at retirement.
• IRAs may be useful investment vehicles for the self-employed and others who don’t have access to an employer-sponsored retirement account. There are a number of different types of IRA–two of the most common are the Roth and the traditional IRA–, and each type offers unique benefits and limitations to savers.
• You can also open a plain old brokerage account, which allows you to buy and sell assets pretty much at will. However, the interest and dividends you earn are subject to taxes in the year you earn them, and you may incur taxes when you sell an investment. Tax rates are usually lower for “long-term” assets, or those held for a year or longer; taxes on “short-term” capital gains tend to be higher. That’s just one more reason you might consider playing the long game when it comes to the stock market.
Choosing Your Investments
Different brokers assess different maintenance and trade fees, so it’s important to shop around for the most cost-effective option. Some places, like SoFi, offer active investing accounts that allow you to buy and sell stocks commission-free.
Once you have a brokerage account, you can typically choose which assets to invest in, including individual stocks as well as Exchange-Traded Funds (ETFs), which are pre-arranged “baskets” of stocks that can help build diversification effortlessly into your portfolio. Typically, ETFs are subject to management fees, but many brokers even offer a certain number of commission-free ETFs, which can help you start investing at the lowest cost possible.
Of course, no matter what type of account you open or who your broker is, you’re ultimately responsible for the risk you take in buying stocks. That’s why it’s important to carefully vet stocks before you invest in them.
If you’re considering investing in a company, researching its financial history and learning more about its earnings patterns can help you make the most educated choice possible. It’s also important to keep your own goals and values in mind when learning what to look for in a stock.
If all that footwork sounds exhausting, that doesn’t necessarily mean investment isn’t right for you. You might consider choosing an automated investing options (also known as “robo-advisor”) platform offering pre-built investment portfolios based on your goals and timelines. These can help you get started with a minimal amount of research and effort.
The programs may charge a small fee in exchange for creating, maintaining, and rebalancing a well-thought-out portfolio for your needs. Some may also allow you to choose specific stocks or themed ETFs, which can help you support companies or industries that share your values and vision.
Ready to Start Investing?
Investing in established companies by purchasing stocks is one possible way to earn passive income — through the dividends you receive.
And while all investments do involve risk-taking, when it comes to the stock market, history is on your side. If you diversify your portfolio and play the long game, you may be thanking yourself for your bravery in a decade or more.
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