This is Section/Lesson 2 covering Stocks. It's intended for someone who has had little if any investment experience. To start at the beginning, please go here. A glossary of investment terms is here.
We’re going to cover stocks first because, if held for the long term, they perform better than most other investments and, as we'll see, my recommendation for investment in stocks is super-easy to implement (that recommendation is highlighted in yellow below, if you want to jump right to it, but I stronly recommend that you read the entire section on stocks).
When you buy a stock, you’re buying ownership in a company. Granted, you will probably own a very tiny fraction of the company. Nevertheless, you’re an owner – and owners reap the benefits of a company’s growth and therefore an increase in the stock’s value. If you buy a stock of an established company, you’re buying it from an investor just like you, not from the company, so none of the money you paid goes to the company. Most of what you paid goes to the investor who sold you the stock, and a tiny piece, a commission, goes to the broker(s) who arranged the transaction.
Stocks are valued based on supply and demand. If a company is perceived to be on a roll, with outstanding performance and strong growth expectations, those who own the stock of that company will be reluctant to sell and demand higher prices, while those wanting to buy the stock will be offering ever higher prices. Therefore, prices can change frequently. You look at the price of a stock one day, and when you look a month or a year later it can be substantially higher – or lower! This fluctuation, referred to as volatility, is the reason why a stock investment is for the long term, desirably 10 years.
The gains from an investment in stocks comes not just from the increase in the value of the stocks but because many established companies pay dividends to shareholders. This is a distribution of part of their annual profits. (Newer/growing companies often don’t pay dividends or pay very little dividends, preferring to use the profits to grow the company.) So the gains you get from your investment in stocks may be in 2 parts: the appreciation in the value of the stock over the years, plus any dividends paid by the company to you.
Investors can buy shares of a company. You can buy 10 shares or 100 shares of Exxon or Microsoft. But most investors, instead, buy a stock mutual fund which pools the money from investors and buys the stock of many companies. In a stock mutual fund (there are other types, which invest in other securities), your money is spread among dozens to hundreds of companies, thereby reducing risk. This achieves one of the principal foundations of investing: diversification. If you have a limited amount of money, why would you buy one stock, or only several? It’s like putting all your eggs in one basket. If that company sputters, you might lose a lot of money.
The conventional or managed mutual fund today is like the very first ones started nearly 100 years ago. Their objective is to beat the market. If the stock market as a whole had a return of 5% in a given year (meaning that its value increased 5% that year), conventional mutual funds try to deliver 8% or 10% or more. To do that they hire a lot of very smart people who try to find companies that will excel, and they try to find them before other people do.
But some of these funds (like companies) may do well for a few years and then do worse than the market (which is the basis for an important investment fundamental, that past performance is not indicative of future results). The failure to beat the market occurs not only when wrong investment decisions are made, but also because a significant fraction of any market gain needs to be retained by the mutual fund in the form of high management fees to pay the many analysts, to pay the high commissions that result from the frequent buying and selling of stocks to try to beat the market, and to pay for the taxes that result when there are gains in the frequent sale of stocks.
So about 44 years ago someone came up with index mutual funds. These funds simply try to mirror the overall market, not beat it. They have no analysts, and stocks are not bought and sold regularly. Instead, the money from investors is spread among a fixed number of companies representative of the whole market. The absence of analysts, and the avoidance of commissions and taxes, means that nearly all the gains go to the investors, with only a vey tiny amount retained by the mutual fund. Such funds are referred to as passively managed, or simply passive funds.
The most common of these are the S&P 500 index funds, which invest in the 500 largest U.S. companies (details here). That index has had an average annual return of 6.2% over the past 20 years and 6.7% over the past 30 years, considerably higher returns than you get with savings like Certificates of Deposit. And don't underestimate these returns; because of compounding, where your investment is growing faster every year, like a snowball gaining size as it rolls down a mountain, your money grows quickly. My recommendation for someone starting with stocks is to invest in such an S&P 500 index fund, which is offered by all mainline investment organizations. I stand by this recommendation even though there are other ways of investing in stocks, including some which are relatively easy and have performed much better than the overall market in certain periods (details here).
Another important point is to add to your investment. If you suddenly get a nice chunk of money, perhaps a bonus, take a piece of that for the trip you've been dreaming of, and put the rest in the S&P 500 index fund. It's also a good idea to add a set amount to the fund at given intervals, like monthly or quarterly; that way you're buying when the market is low as well as when the market is high.
For those who would also like their stock investment to generate more income, my recommendation is that they put some in an S&P 500 index fund and some in what are called The Dogs of the Dow; for more on this, please go here.
I want to leave you with a few additional points about stocks.
First, stocks are also called equities. And, as we learned earlier, someone who has an investment in stocks or equities may not have bought the actual stocks but instead invested through a mutual fund, either a conventional (managed) fund, an index fund, or an Exchange Traded Fund (ETF, a form of mutual fund traded in a stock exchange).
Second, it’s not a good idea to try to time the market, to sell your stocks or mutual funds when adverse financial clouds appear in the horizon. So-called “experts” who forecast a downturn (or upturn) for the market are often wrong. An investment in equities is for the long term – desirably 10 years. Let the money sit there and you will be rewarded.
Third, stocks have tax advantages compared to some other investments. If a stock mutual fund that you bought 10 years ago has doubled in value, do you know what your tax obligation is? Zero. Nothing. You incur a tax obligation only when you sell it, not as it appreciates. And if held over a year, it’s taxed at a lower tax rate than interest or a salary.
Fourth, if you are in love with a company (e.g., Tesla or Apple or Amazon), put 10% of your money there and 90% in the S&P 500 index fund.
Finally, back in the day, the rule of thumb was that stocks make more sense for younger people, but older people, those at or nearing retirement, should instead own bonds (discussed in a moment) and little or no stocks. The reason is volatility, namely that the price can swing, sometimes drastically. So money you might need in 3 or 5 years should not go into stocks. This old rule is no longer true. Older folks who have a kitty of funds that they won’t need for 10 years and a reliable income stream should have some of their money in stocks.
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1 This was updated in Oct. 2019. The views expressed here are mine and at times may depart from the norm. In preparing this article I first read several articles, and ideas or phrases from those articles may have unintentionally crept into mine; I am happy to remove any plagiarism if alerted.