So you've decided to invest in the stock market. Congratulations! Historically, investing in stocks has handily outperformed investing in bonds, Treasury bills, gold or cash over the long term. In the short term, one or several other assets may outperform stocks, but overall, stocks have historically been the winning path.
But there are so many ways to invest in stocks. When choosing among individual stocks, mutual funds, index funds, ETFs, domestic or foreign, how can you decide what is right for you? This article will address several issues that you, as a new (or not-so-new) investor might want to consider, so that you can rest more easily while letting your money grow.
Risk Taker, Risk Averse or in the Middle?
You may be eager to get started so that you, too, can make those fabulous returns you hear so much about. But slow down and take a moment to contemplate some simple questions. The time spent now to consider the following will save you money down the road.
What kind of person are you? Are you a risk-taker, willing to throw money at a chance to make a lot of money, or would you prefer a more "sure" thing?
What would be your likely response to a 10% drop in a single stock in one day or a 35% drop over the course of a few weeks? Would you sell it all in a panic?
The answers to these and similar questions will lead you to consider different types of equity investments, such as mutual or index funds versus individual stocks. If you are naturally not someone who takes risks – and you feel uncomfortable doing so, but you still want to invest in stocks – the best bet for you might be mutual funds or index funds. This is because they are well-diversified and contain many different stocks. This reduces risk and doesn't require individual stock research.
How Much Time and Interest Do You Have for Investing?
Should you invest in funds, stocks or both? The answer depends on how much time you wish to devote to this endeavor. Careful selection of mutual or index funds would let you invest your money, leaving the hard work of picking stocks to the fund manager. Index funds are even simpler in that they move up or down according to the type of company, industry or market they are designed to track.
Individual stock investing is the most time-consuming as it requires you to make judgments about management, earnings and future prospects. As an investor, you are attempting to distinguish between money-making stocks and financial disaster. You need to know what they do, how they make their money, the risks, the future prospects and much more.
Therefore, ask yourself how much time you have to devote to investing. Are you willing to spend a couple of hours a week, or more, to read about different companies, or is your life just too busy to carve out that time? Investing in individual stocks is a skill that, like any other, takes time to develop.
Diversify Your Portfolio
It is best that you not be exposed to only one type of asset. For instance, don't put all of your money in small biotech companies. Yes, the potential gain can be quite high, but what will happen to your investment if the Food and Drug Administration (FDA) starts rejecting a higher percentage of new drugs? Your entire portfolio would be negatively impacted.
It is better to be diversified across several different sectors such as real estate (a real estate investment trust is one possibility), consumer goods, commodities, insurance, etc., rather than focus on one or two or three, as above. Consider diversifying across asset classes as well by keeping some money in bonds and cash, rather than being 100% invested in stocks. How much to have in these different sectors and classes is up to you, but being invested more broadly lessens the risk of losing it all at any one time.
A Portfolio for Beginners
If you are just starting out, think seriously about investing most of your money in a couple of index funds, such as one tracking the broad market (e.g. the S&P 500) and one that gives some international exposure. Maybe adding one that tracks small companies (e.g. the Russell 2000) would give your portfolio a boost.
A portfolio consisting of those three would give plenty of diversification, provide the steadier performance of large companies and be spiced up a bit with both international companies and small caps.
Building a Portfolio With Individual Stocks
If you are investing in individual stocks, a portfolio of 12 to 20 well-chosen ones will give you plenty of diversification and probably not be too many companies to follow regularly. However, you will need to ensure that you fully understand each company, from its businesses to its risks. If you plan to invest in only stocks, make sure to spread the funds across different sectors such as health care, technology, small cap and big cap.
If you don't have the time or desire to pick as well as follow that many stocks, consider investing in a mixture of index funds and individual stocks. Another consideration, especially if starting out with limited funds, is that investing in 12 to 20 stocks may not be feasible. Therefore, having the majority of your money in funds would provide the stabler returns they tend to generate. Adding in maybe a half dozen individual stocks could give your portfolio an extra kick.
Time to Invest
Once you've determined the shape of your portfolio, it is time to invest. Find a broker you are comfortable with, either an online broker or one with a local office or both. Call and talk with this person if necessary. Then fill out the paperwork, deposit some money and open an account.
After deciding what to buy, don't buy all at once – enter slowly. What if you invested all your money just before a market downturn? Being in the red that quickly wouldn't do much for your confidence. Plan to take several months to invest all of your money to minimize any market timing risk. Finally, remember to set aside time each week to review or catch up on the news for your investments.
Keep Adding to and Adjusting Your Portfolio
As your experience grows, your asset allocation decisions will probably change. You could adjust your portfolio on a regular basis, say every year or so, by selling some of one type of investment and buying more of another. You could also adjust your portfolio by adding additional funds to those areas in which you want to increase exposure.
These additional funds can be used to expand the number of securities you hold or can be added to existing holdings. Do this on a regular basis and before you realize it, you'll have a substantial portfolio that will help fund your retirement, pay for a second home or meet whatever financial goals you set when you started your investing journey.
The Bottom Line
Before you jump into the stock market, spend some time thinking about what you want to accomplish and how to do that while staying within your risk tolerance levels. Also consider how much time you have to devote to investing. Doing this before committing those first dollars will go a long way toward protecting you from the emotional roller coaster of investing first one way, then another, never really knowing why you are changing your mind.
Careful thought before and during your investing career will do more to help your results than trying to chase the latest hot stock. After all, it's your money, which means you should know what you are doing with it – and why.