There’s a lot of good advice out there about investing in the stock market. Reduce taxes by investing through an IRA or 401(k). Don’t put all your money into the stock market. Invest for the long term. Invest in what you know. Avoid fees as much as possible. Buy low-cost index funds.
But first, why invest in the stock market at all? It’s riskier than CDs, which are insured by the US government, and bonds, which get paid first in case of bankruptcy. If you invest in a company and it goes bankrupt (or gets nationalized), you get nothing. If you buy a company’s bonds and it goes bankrupt, you might only get pennies on the dollar, but you’ll get something.
The fiscal reason is that the stock market has much higher historical returns than CDs or bonds. If you diversify (perhaps by buying index funds), you can mitigate your risk and get double the returns of just a CD. Over time, you can even make money in a volatile market.
In addition to the potential monetary upside, buying stock gives you an in at the company. You get in-depth information about the company, you can help elect board members, and you can address other shareholders about any concerns that you have. Even just holding onto a stock encourages long term thinking.
There are three main strategies for buying stocks, each with different benefits and drawbacks. The most prevalent for beginning investors is buying index funds. Index funds are collections of stocks tracking an “index” like the Dow Jones Industrial Average or the S&P 500. Since they don’t require much management, fees are very low (generally less than 0.5% per year). They also offer instant diversification, which makes them a good choice if you think the stock market will improve but don’t want to take risks with individual companies. Unfortunately, index funds are only as good as the underlying indices, generally including unsustainable or immoral companies like Exxon and Philip Morris (insert your own bias here if you think those two examples are okay). Most are also “market cap-adjusted,” which means that they own more stock the larger a company is, reducing diversification. Owning an index fund also means that you don’t get some of the benefits of stock ownership like voting rights and easy access to quarterly statements.
More sustainable are managed funds like the New Alternatives Fund (Maggie owns this, but this isn’t a recommendation, just an example). These funds pick a narrower field, like alternative energy, and trade actively in an attempt to beat the market. This makes it more likely that the underlying companies are good, sustainable ones but reduces diversification, making the investment riskier. Managed funds also have higher expense ratios (usually over 1%) so you have to earn more just to break even. You also have the same insulative problem as index funds where you are less active in the underlying companies.
Finally, there’s buying stocks individually. A lot of very smart people don’t think that most people should buy individual stocks. They’re probably right. If you don’t have a high tolerance for risk, a willingness to hold onto stocks despite short-term problems, and the time and inclination to spend some significant time researching companies, individual stocks aren’t for you. On the other hand, individual stocks are the cheapest way to invest in the market. Instead of paying a set percentage every year, you pay a flat fee up front (usually around $13). For a $1,000 investment, that’s only 1.3%, or about what you’d pay to keep an index fund for three years. For a long-term investor, that’s a deal! In addition, the increased risk brings with it an increased potential. Even in the poor market of the past year, there are stocks that have doubled in value.
More importantly, holding stock in an individual company gives you a piece of ownership. You have an obligation to pay attention to your company and you have a voice should it do anything inappropriate. There’s even a sense of satisfaction from being a small part of a company doing great things.
If you do decide to invest in individual stocks, make sure that you invest in companies that you understand. Without understanding, you won’t be able to reasonably evaluate the company, which makes it more likely that they’ll successfully hide any wrongdoing. You should also make sure to compare your picks against an appropriate yardstick. It’s great if your stock goes up 5%, but if the market went up 10% over that same period, you probably need to reevaluate your strategy.
Before buying a single share, start thinking about companies that you respect and admire as well as companies that you think just need a little nudge to approach greatness. Watch these companies for a while and find out all you can about them. It’s easy to find their financials online, which will help you decide if they’re in it for the long haul or if they’re having real trouble.
Even if you want to put your retirement savings in super-safe CDs, I recommend going through the process of picking and buying a stock. It gives real insight into our economic system, helps you understand a lot of hoopla that would otherwise be a mystery, and will help you decide if you have the temperament for further investment.