As we recently wrote, investing in stocks is perhaps the best way to grow wealth over the years. But, to have the stock market money-making-machine work for you, you need know how to invest in stocks. As we noted in our investing in stocks article, you need to consider your goals, both short and long term. Basically, this is because you should invest differently to attain short term goals than you would to reach your long term goals. Then an investor will choose an active approach to managing their investments or one of the many passive investment options.
Also, a person may wish to use only conservative investments to avoid risking their investment capital on more risky investments in hopes of more spectacular gains. What we have put together is not a list of stock tips but rather a consideration of the wide range of choices and their pros and cons.
How to Invest in Stocks
There are successful and famous long term investors in the stock market and there are folks who have made money by skipping in and out of the market for short term profits. Some investors focus on a single investment while most choose to diversify their investment portfolios. Ultra-conservative investors choose ways to invest without losing any money while most investors realize that in order to make a profit over the years you need to tolerate the usual market volatility and accept a reasonable degree of risk. In fact, the trading off of risk versus profit potential is a recurring issue as you consider how to invest in stocks over the years.
Investing in Stocks for Beginners
Take Care of Loose Ends before Investing in Stocks
As you start your stock market investing journey, there are a couple of housekeeping chores to consider. One is that you should not be investing with the grocery or rent money. Thus, a beginning investor needs to simply put enough money in a bank account to cover the bills for the next three months. That way you will not end up taking money out of a promising investment in order to pay routine expenses. The other chore is paying off your credit card debt before starting to put money in the stock market. The interest rate charged on credit card debt is far and above what a beginning investor will make in the market and more than veteran investors expect over time.
How to Invest in Stocks Most Successfully Is to Start Early
Although there are times when a well-chosen stock investment will make a lot of money in a hurry, the vast majority of successful investors are in it for the long haul. They invest in such a way as to gain a high average return on their investment year after year. The important part here is the average return on investment. Many times the market goes into a slump and nobody’s stocks appreciate in value. And then a bull market takes hold and stocks go up a lot. The best investments are the ones that appreciate in value ten percent a year or more on the average.
Exponential Investment Growth
What investors get in the stock market is exponential growth of their investment capital. The S&P 500 is an index of 500 stocks meant to reflect the stock market as a whole. From the time this index started keeping track in 1926 until the present day, it has gone up 10% per year on the average. This is a better return, on the average, than any other investment vehicle available to investors. This rate of return, if delivered every year for seven years, with all appreciation and dividends reinvested, will double your investment during that time frame. Obviously, as the market moves through bull and bear cycles the rate will change but over the long term, the exponential growth of the market as reflected in the S&P 500 is what generates returns and builds wealth. The sooner you start, the more years you have to see your investments grow!
How to Invest in Stocks: Active Investing
The wealthiest long term investors pick their own stocks. They also invest in stocks as a full time occupation and when they are very successful they have lots of smart people helping them do research. The individual beginning investor does not start out with the knowledge, experience, and helpers that these folks have. But, the average investor has areas of expertise which the “experts” often do not. If you have insights that will help your investing, use them. And, stick to the areas where you expertise will make a difference.
The legendary manager of the Fidelity’s Magellan Fund, Peter Lynch, made this point. In the 1970’s one of the “in” investments for the wealthy was to buy railroad boxcars and lease them. Thus, many doctors followed this advice. These folks had money to invest but were pressed for time. They also had great insights in regard to pharmaceutical stocks, medical supply companies, and the like.
It turns out that the buy and lease boxcar investment strategy did not work out all that well as the folks who sold the boxcars did not help the good doctors with the leasing. And at the same time, the pharmaceutical giant, Smith Kline & French discovered cimetidine (Tagamet) which is a medicine that revolutionized medical treatment of ulcers, gastritis, and esophagitis, making ulcer surgery a thing of the past. Lynch said that all a physician needed to do was look at what was happening in the field of medicine and invest in Smith, Kline, & French as the stock soared. And, they needed to ignore the losing investments (like leasing railroad boxcars) that they knew nothing about!
The point of this little story is that there is definitely a place for active investing if you have unique insights and experience. Active investing takes work and time. And, it requires that the investor understand both the fundamentals that drive stock prices over the long term and market forces that cause shorter term volatility. Understanding and using important moving averages is a critical skill for active investing.
How to Invest in Stocks: Passive Investing
Letting someone else make investment decisions is the most common route for most beginning investors. In fact, today nearly half of all money investing in the U.S. stock market is directed by investment vehicles that track index funds. Although there are some concerns about too much passive investment being risky, this is still the most conservative and risk-free approach for beginners.
Investing in Mutual Funds
Mutual funds are a commonly used passive investment vehicle. Investopedia defines mutual fund.
A mutual fund is a type of financial vehicle made up of a pool of money collected from many investors for the purpose of investing in securities such as stocks, bonds, money market instruments, and other assets. Mutual funds are operated by professional money managers, who allocate the fund’s assets and attempt to produce capital gains and/or income for the fund’s investors. A mutual fund’s portfolio is structured and maintained to match the investment objectives stated in its prospectus.
The benefit if putting you money in a mutual fund is that someone who very likely knows more about stocks and bonds and spends their life making investments will invest your money for you. However, there are three drawbacks. First of all, these folks charge fees for making the investments. Second, if the fund buys and sells very frequently there are fees and commissions all the time and there are capital gains taxes to be paid on short term earnings. Third, in recent years many mutual funds have not done as well as ETFs (Exchange Traded Funds) that simply track the S&P 500!
Index Fund Investing
Index funds are a popular vehicle for passive investing and are becoming more popular all of the time. There are index funds that track the S&P 500 or the Dow Jones Industrial Average and there are funds that track sectors of the market. For those with insights into certain areas of the economy but not enough time to make individual investments, this can be a good mix of active investment choices but passive day by day investing.
Wealthy individuals and families often rely on professionals to invest and manage their money. This approach can be useful if the money manager is good at what he or she does. But the expense of paying someone with an exceptional skillset to buy and sell stocks should result in both better return on investment and fewer headaches than other approaches. Certainly, wealthy individuals need to pay attention because it can be all too easy to be bilked such as what happened with the Bernie Madoff Ponzi scheme.
It was great being in Bernie Madoff’s orbit, until it wasn’t. For decades, Madoff was a respected Wall Street financier, generous with employees and beloved by his family. But after his securities firm was exposed a decade ago as the biggest Ponzi scheme in U.S. history, thousands of investors lost their money, in many cases their life savings – $19 billion in principal, all told. Those closest to Madoff suffered in other ways, amid criminal convictions and giant payouts.
A simple answer to avoid a Madoff-type disaster for both the wealthy and for other normal investors is to diversify so that a disaster in one part of your portfolio does not take down rest.
How to Invest in Stocks: Diversify
The point of diversifying your investment portfolio and the stocks within that portfolio is to reduce risk and increase your chances of finding a spectacular investment. Fidelity writes about investment diversification.
Choosing a mix of different kinds of investments and maintaining that mix are among the most important ingredients in your long-term investment success. This means creating an investment mix based on your goals, risk tolerance, financial situation, and timeline; and being diversified both among and within different types of stocks, bonds, and other investments.
The usual advice that investment advisors give is to keep part of your money in stocks and part in bonds. The idea is that there is more room to grow your wealth with stocks and guaranteed preservation of your investment capital with investments like US Treasuries or AAA corporate bonds. Likewise, owning your own home should be part of that mix.
If you are an active investors picking individual stocks, you should diversify with stocks in different business sectors and a mix of growth stocks and value investments. However, if you are a passive investor who simply buys shares of an ETF that tracks the S&P 500 the stock sector of your investment portfolio is already diversified!
One smart way to diversify your stocks is to have a mix of dividend stocks and stocks whose whole value comes from the appreciation of their share price. This approach also works if you want to part of your money to work in socially responsible investing.
How to Invest in Stocks the Tax Deferred Way: IRA and 401k
Taxes become an issue with your stocks when you sell or when you collect dividends. When a long term investor sells a stock that he or she purchased more than a year before, they are liable for long term capital gains taxes on any appreciation. If they sell within a year, they are liable for taxes at the higher short term capital gains rate. Either way, paying taxes when you sell on stock and buy the next reduces how fast you can grow your wealth. And, when you receive a dividend payment you need to pay taxes on that even if you routinely reinvest dividends.
Fortunately, there are vehicles that an investor can use to defer paying taxes on capital gains and reinvested dividends. These are IRAs and 401k plans from work. In each case, money invested in stocks typically remains in the account until you retire at which time any profits are taxed at your current tax rate. And, of course, if you are retired you will be in a lower tax bracket! But, perhaps more importantly, your wealth multiplies more rapidly because the IRS is not taking their share every year and reducing your rate of appreciation!
Every investor should take advantage of every tax-deferred way investment vehicle that they can.
How to Invest in Stocks by Yourself
There are investors who want to manage their own money, pick their own stocks, and not rely on or pay someone else to do the work. Choosing stocks to own and to hold is not an impossible task but it does require that the investor learn how to assess intrinsic stock value. This is the “real value” of the stock based on the projected ability of the company to make money and to continue to do so for many years to come. Whether an investor works from a stock “tip” or decides on a stock for some other reason, it is important to know what the company does to make money and how their business plan is likely to remain viable for years to come. And, it is important to use the intrinsic value calculation to come up with a reasonable valuation of the stock based on fundamentals as opposed to its market value.
Successful long term investors will often evaluate many stocks before choosing one with good earnings potential for years to come and a current market price that is less than the price based on intrinsic value assessment. However, when an investor finds such a stock, it can typically be held in their portfolio for years if not decades as it steadily appreciates in value and pays dividends (hopefully reinvested). An excellent choice for average investors in this era is the FAANG group of stocks. What does FAANG mean? These are the leading tech stocks, Facebook, Amazon, Apple, Netflix, and Google.
Invest in Stocks Early and Routinely: Dollar Cost Averaging
The “secret” to successful long term investing in stocks is to start early and let exponential growth take care of creating wealth. Picking good stocks and paying attention are important as not all stocks that have been strong for years remain strong forever. So, re-balancing a stock portfolio from time to time is advisable. But, many investors worry about waiting for the right time to invest. A simple and advisable way to avoid this worry is called dollar cost averaging.
DOLLAR-COST AVERAGING is a disciplined way for investors to build wealth in their portfolio over time while helping them avoid emotional-driven decisions.
Many people mistakenly believe that they need thousands of dollars to start investing for their retirement, causing them to be risk-adverse in opening a traditional investment retirement account or Roth IRA. But nearly anyone can get started with the strategy. For instance, this style of investing can help novice investors who have recently opened a retirement portfolio, and don’t have a large sum of money for an initial investment.
With dollar cost averaging an investor invests a set amount each month, such as $100. When stocks are expensive, they are not overspending on their investing and when stocks are cheap they are buying at bargain prices and getting more for their money. Perhaps more importantly, with dollar cost averaging an investor sets up a system by which they invest routinely for years and years. That is really how to invest in stocks to grow wealth.
(U.S. News & World Report)