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 is a little bit confusing. You’re buying and selling…what, exactly? 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, which means that as the company grows and expands, you stand to earn a return on your investment—though you also risk losing all or part of your investment if the company doesn’t prosper. (More on that in just a minute!)
Stocks are also known as “shares” of a company or “equity investments,” and are primarily bought and sold on publicly-traded stock exchanges. Which means that, yes, you can open up a brokerage account and become a partial owner of Coca-Cola right this second, all without spending even a single day at business school.
Stocks come in two varieties: common and preferred.
• Common stocks are the most, well, common, and what you’re most likely to invest in if you’re a stock market beginner. Along with proportional ownership of the company and growth potential, common stocks also confer voting rights to the stockholder, allowing you to speak your piece when it comes to things like management election 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 it a slightly less risky asset—if the company goes under, 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 Earning Money by Buying Stocks Possible?
So, now that you know what stocks are, let’s talk about how buying them has the potential to help meet financial goals. How does buying stocks earn money?
There are two possible ways.
• Over time, stocks have the propensity to appreciate in value as a company grows, expands, and prospers. Since each share represents proportional ownership, they’re 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 also might 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 high potential for returns in the long run.
On the other hand, the exact same dynamics that give stocks their exponential growth potential also adds considerable risk to the equation.
Buying Stocks—Risks and Rewards
Although buying stocks can turn even a few dollars into a sizeable nest egg 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 wider-reaching occurrences like economic recessions, war, or political changes.
Although diversifying your portfolio—that is, buying a variety of different stocks as well as other assets like bonds and cash equivalents—is one way to help mitigate the risk of investing, it’s important to understand that it is possible (and even likely) to 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 2018—a time frame that includes both the Great Depression and the 2008 housing fiasco.
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Should You Invest in Stocks?
Since stock market assets are intangible, purchasing them can feel a little bit like throwing your money into the wind.
Unlike buying real estate or a piece of art, you don’t get anything physically to hold onto—and the risk of losing it all can weigh heavily on investors, particularly those with a penchant for cable news.
But due to their exponential growth potential, stocks can offer investors one of the very best vehicles for building significant wealth over time, with 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 with the promise of having it returned, plus interest, within a set amount of time.
Because the bond promises certain repayment terms, or “face value,” ahead of time, they’re typically not considered as risky as stocks—although they are still vulnerable to interest rate fluctuations and company defaults.
Bonds do offer some growth potential at a relatively low risk level, 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 about 5-6% … which, you’ll recall, is only half of the annual growth rate actualized by stocks over the same time period.
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 only be worth $95 ten years from now due to inflation.
On the other hand, if you’d invested that Benjamin, it might have nearly doubled in the same amount of time. Of course, the new total would still be subject to inflation… but it could still be a whole lot more competitive than 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 are paid dividends only after other obligations, such as bond payments, are paid. Preferred stockholders don’t get voting rights, but are paid before those who hold common stock.
• 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, 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 for 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.
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 retirement accounts like 401(k)s and IRAs 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 undergo certain circumstances. Without getting too into the weeds, here are a few of the most common types of specialized investment accounts.
• The 401(k) might be the most familiar investment account, as it’s commonly offered to W-4 employees as part of their benefits package. It’s a retirement account whose contributions are taken directly from your paycheck, and in most cases, taxation is deferred until you take the funds out at retirement.
• IRAs might be better investment vehicles for the self-employed and others who don’t have access to an employer-sponsored retirement account. They come in Roth and traditional varieties, each of which offers unique benefits and limitations to savers.
• You can also open a plain olde 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 much higher—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 at no cost.
Once you have a brokerage account, you can typically choose which assets to invest in, including individual stocks as well as ETFs, which are pre-arranged “baskets” of stocks that can help build effortless diversification into your portfolio. 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—which is why it’s important to carefully vet stocks before you invest in them.
Researching the company’s financial history and learning more about its earnings patterns can help you make the most educated guess 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 the investment isn’t right for you. You might consider choosing an automated investing options (also known as “robo-advisor”) platforms offering pre-built investment portfolios based on your goals and timelines, which can help you get started with a minimal amount of research and effort.
These programs may charge a small fee in exchange for creating, maintaining, and rebalancing a well-thought-out portfolio for your needs. Some also may allow you to choose specific stocks or themed ETFs, which can help you support companies or industries that share your values and vision.
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Investing in established companies by purchasing stocks is one possible way to earn passive income, and thanks to compound interest, even modest investments have the potential to turn into nest eggs over time.
And while all investments do involve risk-taking, when it comes to the stock market, history is on your side—so 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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Tax Information: This article provides general background information only and is not intended to serve as legal or tax advice or as a substitute for legal counsel. You should consult your own attorney and/or tax advisor if you have a question requiring legal or tax advice.
Investment Risk: Diversification can help reduce some investment risk. It cannot guarantee profit, or fully protect in a down market.
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