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.
However, there are so many ways to invest in stocks. When choosing among individual stocks, mutual funds, index funds, or ETFs—domestic or foreign, investors may feel overwhelmed by the many different choices.
- Stock investments have historically outperformed other types of investments, such as those in bonds, cash, gold, or treasury bills.
- It is important to assess your tolerance for risk before deciding how to invest in stocks.
- You should make sure that you have enough time to properly manage and monitor your stocks.
- Diversification can be an excellent way to reduce risk in your stock investments.
- If you need help with your investments, be sure to consult a broker either online or at a local office.
Being a Risk-Taker
You may be eager to get started so that you, too, can generate positive returns, but consider some simple questions: 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 can lead to considering different types of equity investments, such as mutual or index funds versus individual stocks. If you’re not up for taking risks, but still want to invest in stocks, the best bet might be mutual funds or index funds—both are well-diversified and contain a variety of stocks. This reduces risk and doesn't require individual stock research.
It is important to be aware of both your own personal predisposition toward risk and the different styles of stock investment before making any major stock investment decisions.
The Time Commitment
Should you invest in funds, stocks, or both? The answer depends on how much time you can devote. Careful selection of mutual or index funds would let you invest your money, leaving the hard work of picking stocks to fund managers. Index funds are even simpler in that they move up or down according to the type of index they are designed to track.
Individual stock investing is the most time-consuming because 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, future prospects, and 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’s best to own a variety of investments or assets, called diversification. For instance, don't put all of your money in small biotech companies. Yes, the potential gain can be high, but what happens if these stocks take a quick plunge when the Food and Drug Administration (FDA) starts rejecting a higher percentage of new drugs? Your entire portfolio would be negatively impacted.
It’s 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. Consider diversifying across asset classes as well by keeping some money in bonds and cash, rather than being 100% invested in stocks. How much you 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.
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, like the S&P 500, and one that gives some international exposure. Adding another index fund that tracks small companies, like the Russell 2000, would boost returns, but would increase risk.
Building a Stock Portfolio
If you are investing in individual stocks, a portfolio of 12 to 20 well-chosen ones will give you sufficient diversification while not overwhelming you with too many companies to follow and research. However, you will need to ensure that you fully understand each company, from its businesses to its risks. If you plan to invest in stocks alone, spread the funds across different sectors such as health care, technology, small-cap, and large-cap.
If you don't have the time or desire to pick a number of 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 stable returns that they tend to generate.
Find a Broker
Once you've determined the shape of your portfolio, it’s time to invest. Find a broker you’re comfortable with, either online or with a local office. 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 via dollar-cost averaging (DCA). 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.
Make Portfolio Adjustments Regularly
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 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.
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.