To new investors, the stock market can seem mysterious and intimidating. Many people hear that buying stocks is risky, but they like the potentially high investment returns. Fortunately, there are some ways to make money investing in stocks that significantly limit your risk.
Just about every investor should own some amount of stocks, even during times of market volatility.
Just about every investor should own some amount of stocks, even during times of market volatility. I'll explain how to invest in stocks when you have little experience or money. You’ll learn the pros and cons of stocks and the best ways to own them to build wealth safely.
What are stocks?
Stocks are intangible assets that give you ownership in a company. That’s why they’re also known as equities or equity investments. Owning stock entitles you to part of a company’s earnings and assets.
Let's say a company needs to fund groundbreaking research, open a division in a foreign country, or hire a crew of talented engineers. Companies issue stock to raise money from investors for these types of ventures—it’s that simple.
Publicly traded stocks are bought and sold on exchanges such as the NASDAQ or the New York Stock Exchange (NYSE). However, you can trade them only through a broker or investment firm.
When a stock increases in value, it’s called "capital appreciation." That’s a fancy way of saying that the price goes up. As I'm writing this episode, Facebook and Apple stock are selling on the NASDAQ exchange for $266.12 and $469.51 per share. Visa and Walt Disney stock are selling on the New York Stock Exchange for $202.41 and $127.92.
If you buy Visa at $202.41 per share and the price goes up to $210, you can sell it for a gain of $7.59 ($210 – $202.41). You can easily find current stock price quotes on sites like Google Finance and Yahoo Finance.
In addition to capital appreciation, some stocks also pay a portion of company profits. If so, it’s called a dividend stock and distributes dividend payments to stockholders. For instance, right now, Discover pays a dividend of $0.44 a share. If you own 1,000 shares of Discover, you'd be paid $440 in dividends over a year.
Dividend stocks pay you even when the share price goes down, so owning them is smart to hedge against potential market losses. You can find a list of dividend stocks on a site like Morningstar.
The pros and cons of investing in stocks
There are many advantages to investing in stocks. One is that you don't need much money to buy them compared to other assets such as real estate. Buying just one stock share makes you an instant business owner without investing your life savings or taking on significant risk.
Buying just one stock share makes you an instant business owner without investing your life savings or taking on significant risk.
Another advantage of making stock investments is that they offer the most significant potential for growth. Although there's no guarantee that every stock will increase in value, since 1926, the average large stock has returned close to 10% a year.
If you're investing for a long-term goal, such as retirement or a child's education, stocks turbocharge your portfolio with enough growth to achieve it. Over the long term, no other type of common investment performs better than stocks.
The main disadvantage of investing in stocks is that prices can be volatile and spike up or plummet quickly as trading volume fluctuates from minute to minute. News, earnings forecasts, and quarterly financial statements are just a few triggers that cause investors to buy or sell shares, and that activity influences a stock's price throughout the day.
Price volatility is why stocks are one of the riskiest investments to own in the short term.
Price volatility is why stocks are one of the riskiest investments to own in the short term. Investing at the wrong time could wipe out your portfolio or cause you to lose money if you need to sell shares on a day when the price is below what you originally paid.
But as I mentioned, you can minimize this risk (but never eliminate it) by adopting a long-term investing strategy.
What is diversification in stock investing?
In addition to taking a long-term approach, another key strategy for making money investing in stocks is diversification. Having a diversified stock portfolio means you own many stocks.
People are often surprised to learn that it's better to own more investments than less. Diversification allows you to earn higher average returns while reducing risk because it's not likely that all your investments could drop in value at the same time.
Diversification allows you to earn higher average returns while reducing risk because it's not likely that all your investments could drop in value at the same time.
For instance, if you put your life’s savings into one technology stock that tanks, you’re in trouble. But if that stock only makes up a fraction of your portfolio, the loss is negligible. Having a mix of investments that responds to market conditions in different ways is the key to smoothing out risk.
Diversification isn’t a guarantee that you’ll make a killing with your investments, but the idea is that as some investments go up in value, others may decline and vice versa. It prevents you from “putting all your eggs in one basket,” financially speaking.
RELATED: How to Invest in the Perfect Portfolio
How to create a diversified stock portfolio
If you think creating a diversified stock portfolio sounds difficult or time-consuming, I want to put you at ease. Buying one or more stock funds is a simple and inexpensive way to achieve instant diversification.
Funds bundle investments of stocks, bonds, assets, and other securities into packages convenient for investors to buy. They’re made up of many underlying investments. Some funds may focus on one asset class only, such as international stocks, others may have a mix of asset types, such as stock and bonds.
Depending on the investment firm you use, you may see the following types of funds:
- Mutual funds are collections of assets that are managed by a fund professional. They give you a simple way to own a portfolio of many stocks. Shares can be bought or sold only at the end of the trading day when the fund’s net asset value gets calculated.
- Exchange-traded funds (ETFs) are similar to mutual funds because they’re baskets of assets. However, they trade like an individual stock on an exchange and experience price changes throughout the day.
- Index funds are a mutual fund that aims to match or outperform a particular index, such as the S&P 500. They typically come with low fees and may be comprised of thousands of underlying investments.
- Target date funds are a type of mutual fund that automatically resets the mix of stocks, bonds, and cash in its portfolio according to a selected time frame, such as your estimated retirement date.
How much stock should you own?
Stocks or stock funds should be an essential part of every investor's long-term portfolio. If you're young and have a long way to go before retirement, consider owning a large percentage of stocks. Though prices will go up and down in the short term, you're likely to see prices trend up and give you an impressive return over time.
But if you're nearing or already in retirement, take a more conservative approach to preserve your wealth. That doesn't mean eliminating stocks from your portfolio entirely but instead, owning a lower percentage.
There's a rough rule of thumb that says you should subtract your age from 100 or 110 to find the percentage of stocks to own.
There's a rough rule of thumb that says you should subtract your age from 100 or 110 to find the percentage of stocks to own. For instance, a 40-year-old should consider holding 60% to 70% of their investment portfolio in stocks. The remainder would be in other asset types such as bonds, real estate, and cash.
These investment allocation targets are not hard rules because everyone is different. To design your ideal allocation strategy, you can use an online resource, such as Bankrate's Asset Allocation Calculator.
What's important to remember about making money with stocks is that the amount you own should change over time. When you have decades to go before retirement, take advantage of as much growth as possible by investing mostly in stocks. As you get closer to retirement, devote more of your portfolio to bonds and cash, which preserve the wealth you worked hard to accumulate.