This is Chapter/Lesson 2 covering Stocks. It's intended for someone who has had little if any investment experience. Each chapter is only a few minutes long. When you've read the 5 chapters, you'll be ready to invest. 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 this entire chapter on stocks).
When you buy a stock, you’re buying ownership in a company. You'll 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 another investor, not from the company, so none of the money you paid goes to the company. Most goes to the investor who sold you the stock, and a tiny piece, a commission, goes to the broker(s) who arranged the transaction.
The price of a stock, by itself, means absolutely nothing. A cheap stock, say $5 - 14 a share, does not mean it's poised to climb or that the company is in trouble. It's the same with an expensive stock, say $1,000 per share, the price alone tells you nothing. Instead, the price of a stock depends in part on how many shares are owned by investors and, more importantly, 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 (speaking of Microsoft, the cartoon on the right is my attempt to add some levity to this page). 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). In fact, a study reported in this article found that only 8% of managed funds were able to beat the market over the 10-year period ending in June 2019. 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 a new concept, a new kind of mutual fund: index 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, and today there is more money invested in index/passive funds than in managed funds.
The most common of these are the S&P 500 index funds, which invest in the 500 largest U.S. companies (details here). With dividends reinvested, that index has had an average annual return of 6.1% over the past 20 years and 9.7% over the past 30 years, considerably higher returns than you get with savings like Certificates of Deposit (CDs). 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. This is offered by all mainline investment firms, so, when you're ready, go to one of these firms and get started (I like Fidelity because it has the S&P 500 index fund with the lowest management fee, offices in most cities, and they don't hassle you to try to push you to one of their managed funds with higher fees).
Aside from performance, investing in an S&P 500 index fund is super easy. Invest once and leave it there, or add to it over time or when you suddenly get a nice chunk of money. As a final argument for this, it's what Warren Buffett now recommends. Buffett, the 90-year-old Chairman and CEO of Berkshire Hathaway, is considered to be the most successful investor in history. And he puts his money where his mouth is, directing the trustee of his Will to invest 90% of his money into an S&P 500 index fund for his widow, as you can see in this article. Buffett's comments on the S&P 500 brought up another important point: because the S&P 500 frequently adjusts the companies in it, you're always investing in the top companies. This point was powerfully made when he showed a chart of the top 20 companies 20 years ago and none of them were in the top-20 list now.
There are other ways of investing in a diversified group of stocks. One turned an $11,000 investment into more than $1 million over a 17 year period ending in 2004, but has done poorly since then and its author now recommends that you invest in an S&P 500 index fund. Another divides your investment equally into four index funds that invest in different size companies. Both are described here if you wish to explore them.
The fact that an S&P 500 index fund invests in 500 companies reduces risk and volatility, but does not eliminate them. Some years have been spectacular, but there have been losses in other years -- read more 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.
2021 ADDITION: During the Covid-19 pandemic the S&P500, which had initially tumbled, recovered and showed extraordinary growth. To the point where the component stocks -- all large firms like Apple and Amazon -- became very expensive. Put differently, the prices of these stocks were SO high that they were hard to justify based on the anticipated long-term profits of these firms. Perhaps part of the reason is that the popularity and demand for S&P 500 index funds has driven the price of the underlying stocks to excessive highs. There are those in the spring of 2021 who believe it's a bubble ready to burst; other experts disagree, as you can see in this article. Still, in the interest of diversification, given that an ininvestment in an S&P 500 index fund is invested entirely in large companies ("large-cap" in industry jargon), I now recommend that part of your investment in stocks go to an index fund that invests in medium and smaller companies ("mid-cap" and "small-cap" firms). The Russell 2000 is an index that tracks the 2000 companies just below the 500 firms in the S&P 500 index. A number of index funds mirror the Russell 2000, with tiny management fees. Aside from diversification, at least one expert believes that the returns from the Russell 2000 will "dwarf" that of the S&P 500, as you can see in this article. Of your planned investment in index funds, you might consider putting 70 - 80% in an S&P 500 index fund and 20 - 30% in an index fund that mirrors the Russell 2000 (I like the Fidelity Small Cap Index Fund for the same reasons cited earlier regarding their S&P 500 index fund, but there are many other similar funds).
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 stock mutual fund, either a conventional (managed) fund or an index (passive) fund. Another mutual fund term you may hear is an Exchange Traded Fund or ETF, which is any type of mutual fund that can be traded any time the stock exchange is open, rather that at the end of a trading day.
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. The previously cited article found that few people would have invested in this decade (when the S&P 500 grew at a whopping annual rate of 13.2%) had they followed the multitude of negative news and advice that was prevalent in 2009 - 2010. An investment in equities is for the long term – desirably 10 years. Let the money sit there -- ignoring the "experts" -- and you will be rewarded.
Third, don't go buying stocks just yet. Read the remaining chapters covering other investments, because diversification also means having other types of investments, so when stocks fall your other investments can keep growing. This reduces the volatility of your portfolio and let's you sleep well at night.
Fourth, 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.
Fifth, if you are in love with a company (e.g., Tesla or Apple or Walmart), put 10% of your money there and 90% in the S&P 500 index fund.
Sixth, a term you might hear often is Price-to-Earnings Ratio, or simply PE. It's one of the key points when valuing stocks. It is the ratio of a company's share price to the per-share earnings (profits) which the company is expected to earn from its operations in the next year or two. More here.
Seventh, I don't recommend that beginning investors put their money in firms outside the U.S. However, as your experience grows, and if the amount of money you have for investing is large, then you should diversify even beyond the United States. Some analysts believe that because of growth opportunities in other countries, such as China and India, investments in companies there offer greater potential for profits (along, of course, with greater risk).
Finally, back in the day, the rule of thumb was that stocks make more sense for younger people, but those at or nearing retirement should instead own bonds instead of stocks. That's no longer the case; for more on this go here.
Please click on one of the buttons below to go to one of the other chapters on Investing.
1 I am NOT an investment professional -- I'm an aerospace engineer with a Master's from Caltech. After spending the last half of my 30-year career on the business side, I retired and have spent the last 20+ years investing in stocks, bonds and real estate. Although this was first updated in October 2019, I've been reviewing it regularly and make changes/additions in RED when warranted. 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.