If you want your money to experience significant growth over time through the power of compound interest, you may want to consider investing in the stock market. When it comes to buying stocks, though, it’s important to understand what you’re doing. That’s why SmartAsset is bringing you this guide. Sit back, relax and prepare to get some clarity on what stocks are and what they can do.
Check out our retirement calculator.
Stocks: The Basics
Companies decide to issue stock because they want to raise money. Rather than issuing bonds, which are loans from bondholders to the company, a company might decide to “go public” by issuing stock. The money a company gets when an investor purchases shares doesn’t have to be paid back. The company can decide whether and when to issue dividends to shareholders. Plus, issuing shares spreads risk to investors rather than keeping it all on the shoulders of the company owners. When you buy stock, you become a partial owner of the company that issued the shares. You have what’s called shareholder’s equity. Like home equity, shareholder’s equity increases your net worth.
Related Article: How Does the Stock Market Work?
How to Buy Stock
To buy stocks, you can either go directly to the company whose stock you want to buy, or, and this is the more common approach, invest through a brokerage. If you buy through a company, you can buy a Dividend Reinvestment Plan (DRIP). This DRIP will take your initial investment and use it to buy company shares. As the shares pay dividends, those dividends will be put to work buying more shares.
If you buy through a brokerage, you have options. You can take the DIY approach and buy and sell shares in different companies of your choosing. Online brokerage firms make this easy, but you’ll have to pay a fee, often on a per-trade basis. For an extra fee, the brokerage may offer financial planning assistance, but you’ll still be responsible for making your own trades. When you buy your own shares, it’s important to make sure you’re diversifying your investments. That means investing in companies of different sizes and from different sectors of the economy as well as from the US and abroad.
If you’re considering this approach, it’s important to be aware that the average investor is very unlikely to “beat the market.” Obsessively reading about companies and spending your days trading stocks is probably not going to turn you into Warren Buffett. Even Warren Buffett advises investors to buy and hold index funds. Which brings us to the other option available to folks looking to buy stocks.
This other option lets you forego the time and trouble of researching individual companies and trading their stocks. With this option, you can invest in a fund that holds shares in many companies at once. These could be mutual funds, which hold a variety of stocks based on the fund managers’ decisions as to which companies are desirable investments. Or, they could be Exchange Traded Funds (ETFs) that are similar to mutual funds, but that trade on a stock exchange and offer competitive tax options. Finally, they could be index funds. Rather than trying to beat the market, index funds hold shares from a representative sample of companies and try to mirror the performance of the overall market. It’s called an index fund because it aims to mimic (or “index”) the market as closely as possible. They’ll be named for the exchange they index, for example the S&P 500. Index funds involve less management, so generally charge lower fees. Plus, research shows they consistently outperform actively managed funds.
Of course, for those who want minimal involvement with their money, there are full-service brokers and money managers who will sit down with you, learn about your financial goals and risk tolerance and then make investments on your behalf. This is a relatively costly option, since these folks charge a pretty penny for their expertise. If you go this route, it’s a good idea to shop around. Check stockbrokers’ credentials and make sure there isn’t a history of complaints against the broker. If possible, confirm that he or she is willing to sign a document declaring a fiduciary duty to you, the client. Having a “fiduciary duty” means your stockbroker won’t steer you into higher-fee options that won’t maximize the earning potential of your investments.
Related Article: 4 Key Investing Tips for Millennials
If you’re risk-averse, buying stock may be intimidating. But unless your salary is very high or you have a big inheritance coming your way, you’re unlikely to save enough for retirement without investing in stocks. Bonds may feel safer, but they don’t offer the same inflation-beating returns as stocks do. That’s why it’s important to find the balance between bonds and stocks that’s appropriate for your goals – and the time you have before retirement.
If you’re fortunate enough to have the option of investing pre-tax dollars in a 401(k) through work, look for low-fee places to put those dollars. Fees will eat into your investment gains over time, and who wants that? Ready to branch out from the 401(k)? Consider IRAs and Roth IRAs, which offer different tax advantages. Now that you’ve read our guide to understanding stocks, don’t ignore stocks’ potential to grow your money. Using your 401(k), IRA or Roth IRA to stash all your money in bond funds or money market funds will leave you with sluggish growth. Sluggish growth means more years of work and fewer rounds of golf in your golden years.
Photo Credit: © iStock/solarseven