Why Should You Invest in Stocks?
Its really simple. You should invest in stocks to create wealth and preserve the value of your dollars. For the every day person, it is going to be almost impossible to create wealth simply by saving money. Instead, you want to take the money that you have and turn it into more money.
For example, say that you make $60k per year and were able to save 15% of your income in a savings account for 40 years. You would end up with $360,000. However, say that you invested that same 15% in the stock market over 40 years and were able to capture an average return of 10% per year. You would have just over $3.9 million dollars thanks to
compound interest. Which option sounds better to you?
Also keep in mind that your dollars naturally lose value each year due to inflation. If you had saved $100 and the rate of inflation was 5%, the following year that same $100 would only be worth $5. So, not only do you want to create wealth, but you also want to preserve the value of your dollars.
Stocks can be a good way to do this. Over long periods of time, stocks tend to provide high returns. The average stock market return is around 10% per year. Keep in mind that stocks don't go up in value all the time. Prices can also go sideways, down and crash. Stocks are also easy to invest in, and you don't need that much money to get started.
A quick review on stocks and how they work
What are stocks?
Simply put, stocks are shares of ownership in a publicly traded company. Stocks are the easiest and most common way for the every day investor to invest in some of the best companies in the world. When you buy a stock, you now own a very small piece of that company.
How do stocks work?
Companies sell shares of ownership in their business to investors in order to raise capital. The money that companies raise from selling stock can be used for a variety of business purposes such as creating new products, acquiring other companies, expanding operations, and more.
A company goes through a process called an IPO when they first begin to issue shares of stock. An IPO is an initial public offering. It is the first time that the company offers shares of ownership to the general public. Once the IPO process has been completed by a company, the stock of that company can be bought and sold among investors.
You typically don't buy stock directly from the company that is issuing the stock. Instead, you buy it from another investor who wants to sell, or sell to another investor who wants to buy. This is where the stock exchange and stock brokers come in.
The stock exchange can be thought of as the marketplace where stocks can be bought and sold. A stock broker represents you and helps you execute trades within the market. Most investors buy stocks through an
online broker which connects them to the stock exchange.
How to Invest in Stocks in 4 Steps
Step 1. Decide how much help you want
Here is the good news about investing in stocks right now - you can have as little or as much help as you want buying stocks. You might be a highly analytical individual who enjoys researching the best stocks to buy. On the flipside, the idea of having to research and sift through the right stocks makes you sick to your stomach. There are typically three approaches you can take.
1. "I want to choose my stocks."
If you have lots of spare time to analyze companies or simply enjoy making your own investing decisions, there is nothing wrong with choosing your own stocks. However, choosing winning stocks is not easy, so having a deeper understanding of investing is generally recommended when choosing your own stocks.
2. "I want help choosing my stocks."On the flipside, you might be someone who has no idea how to choose their own stocks. Don't worry, you are not alone. The average, every day investor typically does not choose all of their individual stocks. If you want help choosing your stocks, you can work with a financial advisor.
3. "I want help choosing my stocks, but don't have enough to work with a financial advisor."Although human fincancial advisors are great, there is a downside. Most advisors typically require you to have a minimum amount of investable assets in order to work with them. The requirement can be around $50,000 or higher depending upon the advisor.
If you don't have that sort of money lying around, you could consider buying stocks through a
robo advisor. A robo advisor is a digital financial advisor that uses financial algorithms to build and manage an investment portfolio for you.
When you sign up for a robo advisor you will be asked a series of questions related to your investing goals. Based upon the information you provide, the robo advisor will pick investments that are best for you - including stocks.
Robo advisors are a great low cost option if you want help choosing your investments, but don't have the funds necessary to work with a traditional human financial advisor.
Step 2. Open an investing account
Once you have decided how much help you want, you need to open an investing account. An investing account will simply hold all of your stocks - the account is not an investment itself.
What are the best investing accounts to hold stocks in?
The short answer is that it depends, but we recommend looking at a couple to get started. (Don't get to bogged down on the exact account you should have. We will give you our recommendation for that later on.)
1) Work place 401k plan or IRA
Retirement is arguably the most common reason that people invest. Luckily, there are investing accounts designed for this purpose. Starting with your company's 401k plan (if one is offered) is a common way to invest in stocks. If you are lucky, your company offers both a
Roth and Traditional 401k plan.
When you contribute to a Roth 401k, you pay taxes on the dollars you contribute today, but then enjoy tax free withdrawals in retirement. When you contribute to a Traditional 401k, you get a tax break on the dollars you can contribute today, but then have to pay taxes when you withdraw the money in retirement.
The disadvantage to investing in a 401k is that you don't get to invest in individual stocks. Instead, you get to choose from a small selection of investment funds offered by your plan. This is where an IRA can come in handy.
An IRA, or individual retirement account, is a type of account designed to help you save and invest for your retirement. Unlike a 401k, an IRA is held outside of work. Holding stocks in an IRA can be a good idea if you want more flexibility with your investments.
The two most common types of IRAs are the
Roth and Traditional IRA. A Roth IRA allows to contribute dollars that you have already paid tax on, and then enjoy tax free withdrawals in retirement A Traditional IRA allows you to contribute to the account with pre-tax dollars, and delay paying taxes until you take the money out in retirement.
2) Brokerage account
A brokerage account simply allows you to buy and sell a wide range of assets including stocks. Unlike the 401k and IRA, a brokerage account is not designed for a specific purpose. Instead, a brokerage account can be used for general wealth building and investing.
The downside to buying stocks through a brokerage account is that you won't get the tax benefits you will through a 401k or IRA. However, the advantage is that you have more flexibility with the account. Since the 401k and IRA have tax benefits, the IRS limits how much you can invest into these accounts and who can have them in certain circumstances.
This is not the case with a brokerage account. You can invest as much as you want into a brokerage account and there are no limitations on who can have one. However, since brokerage accounts don't provide the tax benefits of a 401k or IRA, you can incur capital gains tax.
A capital gains tax is the tax you have to pay on the profit you make from selling a stock. For example, say you bought a stock for $100 through a brokerage account and sold it for $125. That $25 profit is subject to capital gains tax.
There are short term and long term capital gains tax. If you hold a stock for less than a year and sell it for a profit within a brokerage account, you will be taxed at your ordinary income rate. This is known as a short term capital gains tax.
However, if you hold a stock for more than a year and sell it for a profit within a brokerage account, you will pay 0%, 15% or 20% tax depending upon your income and tax filing status. This is known as a long term capital gains tax. If you do decide to invest in stocks through a brokerage account, it is better to hold your stocks for over a year before selling to get a more favorable tax rate.
How do you open an investing account?If you want to buy stocks through a 401k, you will need to speak to your company's HR department as a 401k is an employer sponsored retirement plan. If you want to open up an
IRA or a brokerage account, you can fill out an application through an online broker or robo advisor - if you are using one to help buy your stocks.
The process is pretty straightforward. Go to the website of your chosen
broker or
robo advisor and select the option to open an account. From there, simply fill out the information. Expect to have to provide your contact information, social security number, government ID, address, and income.
3. Individual stocks vs investment funds - research your options
Once your investing account is approved, you are at the exciting point in which you can start to research the stocks that you want to buy. There are actually two ways that you can invest in stocks. You can either buy individual stocks or you can buy stocks through an investment fund.
An investment fund pools the resources of many investors and then uses that money to buy lots of stocks. When you buy shares of an investment fund, you are gaining access to all of the stocks that the fund holds. The most common investment funds are
mutual funds and index funds.
The case for investing in individual stocks
1. Control over your investments
The first advantage of buying individual stocks is that you have complete control over your investments. You can decide what companies you want to invest in and make changes at the drop of a hat when you want to switch things up.
2. Affordable
Almost all online brokers allow you to buy and sell individual stocks commission free, which can make individual stocks a very affordable investment. Additionally, most brokers allow you to buy fractional shares of stocks. A fractional share allows you to buy just a portion of a stock and not an entire share.
3. Potential for big returns
Finally, buying individual stocks does offer the potential for big returns. If you take the time to properly analyze a company and buy their stock at the right time, it is possible to see very high returns on individual stocks.
The case against investing in individual stocks1. Potential for large amounts of loss
Although you can see high returns from buying individual stocks, there is also the potential for large amounts of loss. The average investor does not have the skill required to consistently analzye and pick winning stocks.
2. Stressful and time consuming
Successfully picking a single stock could take hours upon hours to do. If you want to assemble a complete portfolio of individual stocks it could take days or weeks. The amount of effort, reasearch, and time it takes to choose individual stocks can often be very stressful.
Types of individual stocks you could invest in
1. Blue chip stocks
Blue chip stocks are the stocks of large, well established, and financially sound companies. These stocks typically have a market cap of over $10 billion. A market cap is simply the value of all the issued stock of the company. Think of companies like Apple, Microsoft, Disney, Coca-Cola and more.
2. Growth stocks
Growth stocks are the stocks of companies that are anticiapted to increase their earnings and profits faster than the typical company. Some investors like growth stocks due to their potential for higher returns than other types of stocks.
3. Value stocks
Value stocks are stocks that are priced less than what they are worth based upon the underyling financials of the companies. The idea is to find undervalued companies, buy the stocks cheap, and capture returns when the stock price aligns with the value of the company. Legendary investor Warren Buffet is famous for investing in value stocks.
The case for investing in stocks through investment funds
1. Instant diversification
When you invest in a fund, you are automatically investing in all of the assets held by the fund which means you get instant
diversification. Diversification can help hedge against the volatility of the market and provide stable returns over the long haul.
Think of it like this. If one of the stocks in an investment fund that you invest in does not perform well, the other stocks in the fund can make up for it. However, if you only invest in a few individual stocks, you incur more risk.
2. Less risk and less stress
Since funds offer instant diversification, they are less risky and cause less stress. This does not mean that funds don't ever lose value, but it does mean that you can be confident the fund will bounce back from the downturns and perform well over the long haul.
The case against investing in stocks through investment funds1. Less control over your investments
When you opt to buy individual stocks, you have complete control over what stocks you do or don't want. This is not the case when you buy a fund. You are simply purchasing the stocks held by the fund and don't get a say on what those stocks should be.
2. May underperform individual stocks
In a short time period, it is possible that holding individual stocks could outperform a fund. Individual stocks can skyrocket in value in the short term, where as funds tend to focus on the long term performance of all the assets held within the fund.
Potential investment funds to buyThe Fidelity 500 Index Fund (FXAIX). The Fidelity Zero Large Cap Index Fund (FNILX). The Schwad S&P 500 Index Fund (SWPPX). The T. Rowe Price US Equity Research Fund (PRCOX). The Massachusetts Investors Growth Stock Fund (MIGFX). The BlackRock Exchange Blackrock Fund (STSEX). The State Street US Core Equity Fund (SSAQX).
Important note: Keep in mind that these investment funds are only examples of what you could invest in and should not be taken as strict financial advice. The investment funds that are right for you could be different. We recommend speaking with a licensed financial advisor if you need help choosing investment funds.
Step 4. Buy your stocks or investment funds
The way that you buy your stocks or investment funds will vary based upon your preference in Step 1.
If you are choosing your own stocks
Go the the website, or app of your online broker that you opened your investing account with in Step 2. From there, you will need to transfer money from your bank account to your investing account. If you need help doing this, most brokers offer customer support to get assistance.
Once you have funds in your investing account, you can search for the stock or investment funds that you want to invest in. From there, simply enter the number of shares that you want to buy and click the button. Boom, you just invested in stocks.
If you are working with a financial advisor
Your financial advisor can walk you through how to buy your stocks or investment funds. Some advisors will take care of the whole process for you, where as other advisors will give you the steps you need to do.
If you are using a robo advisor
The first step is to transfer money from your bank account to your investing account that you opened with your robo advisor. Since a robo advisor picks investments for you, all you have to do is give the robo advisor your funds and the robo advisor will automatically invest that money for you.
Our recommendation on how to invest in stocks for beginners
The steps above can serve as a general guideline on buying stocks. However, we do have some additional recommendations that might be helpful.
1. Invest in stocks through a Roth 401k (if your company offers one)
If you want the easiest way to invest in stocks, you can contribute to your company's 401k plan. A 401k allows you to choose from a small selection of investment funds to hold within the account. This means that you get access to lots of quality stocks at the same time and don't have to sift through thousands of investment funds.
More speficially, we would recommend buying investment funds through a Roth 401k. Why is this exactly? In general, when you take money out of a Roth 401k in retirement, you will not have to pay taxes on the money you withdraw. No taxes in retirment sounds pretty good right? However, if you want to compare the Roth with the Traditional 401k you can click
here.
Additionally, we would recommend investing enough in your company 401k to get your employer's match. Most employer's will match contributions to your 401k up to a percentage of your total compensation. For example, lets say that your employer offered a 3% match to your 401k.
Say that you make $60,000 per year and contributed 3% of your total compensation ($1,800) to your Roth 401k. Your employer would match that contribution meaning that another $1,800 would go straight into your Roth 401k.
These extra contributions from your employer will allow you to buy more stocks through the investment funds within your 401k, meaning that you can grow your wealth faster.
2. Open a Roth IRA through a robo advisorAfter contributing enough to a Roth 401k to get your employer's match, it might make more sense to start buying stocks through a Roth IRA. The reason? Since a Roth IRA is held outside of work, you have more control over the account and you have a much larger investment selection - including a larger selection of stocks and investment funds.
Although you are more than free to open a Roth IRA through an
online broker if you are choosing your own stocks, we recommend opening a Roth IRA through a robo advisor if you are just getting started. Reason being is that a robo advisor will choose all of your investments for you. The majority of robo advisors build your investments using low cost investment funds, which is great.
You can compare our picks for the
top robo advisor here.
3. Transfer your Roth IRA from a robo advisor to a financial advisorRemember in Step 1 how we said that most financial advisors require you to have a minimum amount of investable assets in order to work with them? This can be a big hurdle for people who would like to work with a financial advisor.
With that in mind, we would recommend growing the value of your Roth IRA at your robo advisor until you have enough money in the account to work with a financial advisor. Although robo advisors are great, they can't build a complete financial picture like a human financial advisor.
You can transfer your Roth IRA from your robo advisor to your financial advisor once you find one you want to work with. Once your Roth IRA is with your advisor, you can work together to create a complete financial plan, which would include buying the right stocks.
4. Buy stocks through a brokerage account if necessaryAs a last resort, you can buy stocks through a brokerage account. There is nothing wrong with buying stocks in a brokerage account, but it would not be our first recommendation since you won't get the same tax benefits of other accounts. However, if you want the flexibility to buy and sell stocks whenever you feel like it, opening a brokerage account in addition to a Roth 401k or Roth IRA can be beneficial.
Individual stocks vs investment funds - our recommendation
We recommend buying stocks through investment funds. As we have previously noted, there are benefits to investing in individual stocks. However, for most people, choosing the right individual stocks consistently over time is going to be almost impossible. Investment funds allow you to invest in lots of stocks all at once and tend to provide strong returns over long periods of time.
Important note: Keep in mind that the recommendations above are only an opinion and should not be taken as strict advice. The right way to invest in stocks can vary depending upon your individual needs. As always, we recommend consulting a licensed financial advisor.
Adopt a long term mindset as you invest in stocks
Investing in stocks is a long term game. Although there are short term strategies, such as day trading, that allow you to make quick dollars from stocks, the average investor will make money from stocks over long stretches of time - most commonly decades.
The reason? Over long periods of time, the stock market tends to go up in value. Since we don't recommend investing in individual stocks and instead investment funds, you need to hold on to good stocks for a long time and invest consistently to make money.
Lets dive into this further with a snapshot from the S&P 500, which tracks the performance of the top 500 companies in the US. The S&P 500 is commonly used to guage how the entire stock market is doing as a whole.
As you can see, the stock market tends to go up over long periods of time. However, in the short term there have been significant losses and crashes. It can be easy to panic during these times and want to sell all of your stocks to "stop the bleeding."
However, if you hold onto good companies, the stock market has always recovered from crashes up to this point in history when given enough time. Again, this is why we would recommend buying stocks through investment funds. When you do this, you can bet on the overall stock market doing well over time since you hold lots of stocks all at once when you buy shares of an investment fund.
FAQs
How much money do you need to invest in stocks?Not much. You can start with $10, $50, $100, and even a single dollar. There are some investments that do require you to have a larger minimum investment, but for the most part, buying stocks is very affordable thanks to the modern adoption of commission free investing from most online brokers.
How much should you invest?The short answer is that it depends. Most financial experts recommend investing at least 15% of your income. However, you might need to invest more than this if you got a late start to investing. Keep in mind that you don't have to invest all 15% into stocks. If you want to learn about other potential investments you can
learn more here.
Is it risky to invest in stocks?Yes, all investing carries some level of risk. The reality is that there is no way to completely eliminate all of the risk associated with investing in stocks. However, you can manage this risk through
diversification. Essentially, you want to spread your dollars across lots of stocks so that when one isn't doing well, the others you own can make up for it.
This is another great reason to buy stocks through investment funds - such as mutual funds and index funds. Don't misunderstand us. Even if you diversify, there is a good chance that your stocks will go down in value at some point. But, as we noted above, the stock market typically recovers so just hang on and keep investing.
Do you have to pay taxes when you sell a stock?It depends. If you buy your stocks through a Roth 401k or Roth IRA, you don't have to pay taxes when you sell the stock. However, since these are retirement accounts, you can't access the money within these accounts until you are retired and meet some other qualifications. If you want more information on these investing accounts you can
learn more here.
However, if you buy stocks through a brokerage account and sell them for a profit, you can incur capital gains tax. You will have to pay either short, or long term capital gains tax, which we already covered. (Click
here if you need a refresher.) However, you do not have to pay capital gains tax if you sell your stocks at a loss.
The bottom line
The bottom line is that stocks are a great investment for the every day investor. You can invest in them by deciding how much help you want, opening an investing account, researching individual stocks or investment funds, and then buying your chosen stocks. We would recommend buying stocks through tax advantaged account such as the Roth 401k and Roth IRA.
Keep in mind that it will be challenging to consistently buy winning individual stocks. Instead, you can buy stocks through investment funds and hold them for long periods of time. If you want to get the big picture on investing, you can see our guide on
how to invest for beginners.
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