When done correctly, investing in stocks is one of the most effective ways to build long-term wealth.
Here’s a step-by-step guide to ensure you get your stock market investments right.
- Determine your investment approach
The first thing you need to consider is how to start investing in stocks. Some investors choose to buy individual stocks, while others are less active.
Try this. Which of the following statements best describes you?
- I’m an analytical person and enjoy working with numbers and researching.
- I hate math and don’t want to do “homework” too much.
- I spend several hours each week investing in the stock market.
- I enjoy reading about the different companies you can invest in, but I don’t feel like doing the math.
- I’m so busy with work that I don’t have time to learn how to analyze stocks.
The good news is that no matter which of these opinions you agree with, you are still a good candidate for a career as a stock market investor.
The only thing that changes is the “method”
Different Ways to Invest in the Stock Market
Individual Stocks
Investing in individual stocks is only possible if you have the time and desire to thoroughly research and evaluate stocks on an ongoing basis. If so, this is definitely for you. If you’re a smart and patient investor, it’s entirely possible to beat the market over time. On the other hand, if quarterly financial statements and modest calculations don’t sound appealing, it’s perfectly fine to take a more passive approach.
Index Funds
In addition to purchasing individual stocks, you can also invest in index funds that track stock indexes such as the S&P 500. When it comes to actively managed funds and passively managed funds, I usually prefer the latter. Index funds typically have significantly lower costs and are almost guaranteed to match the long-term performance of the underlying index.
Over time, the S&P 500 has achieved a total return of approximately 10% per year, and such performance can lead to significant wealth accumulation over time.
Robo-advisors
Finally, robo-advisors are another option that has grown significantly in popularity in recent years. A robo-advisor is essentially a brokerage firm that invests your money in a portfolio of index funds that suit your age, risk tolerance, and investment goals.
- Determine the amount to invest in stocks.
First, let’s talk about money that you shouldn’t invest in stocks. The stock market is not a place where you can raise the money you might need for at least the next five years. The stock market is almost certain to rise in the long run, but there is too much uncertainty in stock prices in the short run.
In fact, it’s not uncommon for stocks to fall 20% in a given year, and even 40% in some cases. Stock market volatility is normal and to be expected. Such sharp declines have occurred several times in recent history.
During the 2007-2009 bear market triggered by the financial crisis, the S&P 500 fell more than 50% from its all-time high. In 2020, at the beginning of the COVID-19 pandemic, the market plunged more than 40% before beginning to recover.
So, here’s what you shouldn’t invest with:
- Emergency fund
- Money needed to pay your child’s next college tuition
- Vacation fund for next year
- Money set up for a down payment, even if you won’t be ready to buy for a few years
Asset Allocation
Now let’s talk about what to do with investable money, money that you probably won’t need in the next five years. This is a concept known as asset allocation, and several factors come into play.
Age is an important factor, as is your specific risk tolerance and investment goals. Let’s start with your age. The general idea is that as stocks get older, they become less attractive as a place to store your money.
When you’re young, you still have decades to overcome the ups and downs of the market. However, this is not the case if you are retired and relying on investment income.
Here are some simple rules of thumb to help you determine a consistent asset allocation. Subtract your age from 110. This is the approximate percentage of your investable funds that should be invested in stocks (including stock-based mutual funds and exchange-traded funds (ETFs)).
The rest should go to fixed-income investments, such as bonds or high-yield certificates of deposit. You can then adjust this ratio up or down depending on your personal risk tolerance.
For example, let’s say you and your girlfriend are 40 years old. This rule states that 70% of his investable funds must be invested in stocks and the remaining 30% in fixed income investments such as bonds and high-yield CDs.
If you tend to take risks or plan to work beyond typical retirement age, you may want to change that ratio in favor of stocks. On the other hand, if you do not like large fluctuations in your portfolio, we recommend changing your portfolio in a different direction.
- Open an Investment Account
Advice on stock investing for beginners is of little use unless you have the opportunity to actually buy stocks. To do this, you need a special type of account called “The Brokerage Account.”
These accounts are offered by E*Trade, Charles Schwab, and many others. Opening a brokerage account is a quick and hassle-free process that typically takes only a few minutes. Easily deposit funds into your brokerage account via electronic funds transfer, check, or wire transfer. If you have an existing brokerage account or a 401(k) or similar retirement account from a previous employer, you may be able to transfer them to your new brokerage account.
- Picking Stocks
Of course, we can’t cover everything you need to consider when choosing and analyzing stocks in just a few paragraphs, but here are some important concepts to master before you get started.
- Diversify your portfolio.
- Invest only in companies you understand.
- Avoid stocks with high volatility until you get the hang of it.
- Always avoid penny stocks.
- Learn basic metrics and concepts for evaluating stocks.
We recommend that you understand the concept of diversification. This means your portfolio should include a wide variety of companies. However, we strongly advise against over-diversification. Stick to companies you understand. And if you find that you’re good (or even better) at valuing a particular type of stock, it’s okay to have one industry make up a relatively large portion of your portfolio.
Buying flashy high-growth stocks sounds like a great way to build wealth (and it certainly is), but I think it’s best to wait until you have a little more experience. It’s better to create the “base” of your portfolio with stable, established companies, or mutual funds or ETFs. If you want to invest in individual stocks, you need to understand some basic methods for valuing those stocks.
- Don’t Stop Investing
The surest way to make money in the stock market is to buy stock in great companies at a reasonable price, as long as the company remains great (or buy as many shares as you need). If you do this, you will incur some volatility over time, but you will enjoy superior investment returns over time.