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. If you're in a hurry, this page on stocks is summarized in the box on the right, and this 3-minute Summary summarizes all the chapters. To start on the first chapter, please go here. A glossary of investment terms is here.
We’re going to cover stocks first because, if held for the long term (~ 5 years and desirably 10 years), they perform better than most other investments and, as we'll see, my recommendation for investment in stocks has historically returned an annual average of about 9% (15% more recently) and is super-easy to implement; although that recommendation is highlighted in yellow below, I stronly recommend that you read this entire chapter on stocks.
Your first thought may be to go to a financial advisor, but as indicated in Chapter 1 I don't recommend this and suggest you spend roughly an hour reading these Chapters and then decide whether you need an advisor. Why? For two reasons. First, they don't come cheap. Second, after you read these Chapters you can do as well or better than they can; for instance, in the the 10-year period ending in June 2019 only 8% of mutual funds run by expert advisors trying to beat the market were able to do better than the stock market recommendation in these Chapters.
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 the company’s future earnings and growth, and the resulting increase in the stock’s value. You can generally expect that the stock of a company will rise in value when that company is doing well and, equally important, when it's expected to do even better in the years ahead. The stock of a company doing poorly or with little prospects for growth is likely to lose 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 largely 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 an investment in stocks 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.
Stock mutual funds can be divided in two classes.
In conventional stock mutual funds (often called "managed funds"), started nearly 100 years ago, management hires many experts to try to beat the market (if the stock market as a whole had a return of 5% in a given year, those mutual funds try to deliver 8% or 10% or more). Sadly, roughly 90% of them fail to do so2.
However, there is an alternative. 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. The money from investors is simply spread among a fixed number of companies representative of the whole market. These funds have no expensive analysts, so management fees are very low, and stocks are not bought and sold regularly. The absence of analysts, and the avoidance of commissions and taxes that occur from frequent selling by managed funds to try to beat the market, means that nearly all the gains of index funds 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. With dividends reinvested, the S&P 500 Index has had an average annual return of over 10% for the 59-year period from 1960 to October 2019, and over 15% annually from 2015 to October 20253,
considerably higher returns than you get with savings like Certificates of Deposit (CDs). And there is a tax advantage4. And don't underestimate these returns; because of compounding, where you earn money on your investment and also on your earnings, your account grows faster every year, like a snowball gaining size as it rolls down a mountain, and your money grows quickly. My recommendation for someone who has an average risk tolerance and is starting with stocks is to invest equally in two different S&P 500 index mutual funds. One is the traditional more-common S&P 500 index mutual fund, where money in the fund is apportioned among the 500 companies based on company size, and which tracks the S&P 500 Index you see in the news and shown in the chart on the right. The other one is the S&P 500 equal-weight index mutual fund, where money in the fund is apportioned equally among the 500 companies, and which has performed similarly to the traditional S&P 500 index. The reasoning behind this, and suggested mutual funds to buy, may be found here.
For investors with different risk tolerance, more aggressive or more conservative, or other objectives (like more income from dividends), I offer other suggestions here.
Aside from performance, investing in S&P 500 index funds 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 annually 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. To further illustrate Buffett's view, in 2007 he waged a million dollars that over a 10-year period his choice of the S&P 500 Index would beat the performance of top hedge funds typically seen as exclusive options for the ultra-rich -- he won handily (details here).
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 the Index has had 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 funds. It's also a good idea to add a set amount to the funds 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.
I want to leave you with a few additional points about stocks, aside from the most important one mentioned earlier: investment in stocks is for the long term, 5 years and desirably 10 years.
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 the decade ending in 2019 (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. Another article finds that market performance on a given year is relatively independent of how it did the prior year. And Ray Dalio, a legendary investor, says that timing the market is a fool’s errand, harder than competing in the Olympics (details here). 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. A popular mantra, whether in a good or a bad market, is "time in the market beats timing the market." And investing in S&P 500 index funds allows you to do this, stay invested knowing that the stocks in the fund will always be the top 500 due to the annual adjustment mentioned earlier.
Third, while the two S&P 500 funds recommended above may be the only investing the average person may need to do, especially beginners, persons with more money or different needs (like more income) may wish to first read the remaining chapters here. These chapters cover other types of investments, which adds diversification, 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. Plus, there is another investment which can be structured to yield the growth of stocks without the volatility; that investment is real estate, which is covered in Chapter 4 and I urge you to read it. It may require more money and a bit more work than just calling your broker, and depending on which real-estate investment you choose it can have lower liquidity (the ability to sell quickly if you need to get your money out), but it's worth having in a diversified portfolio along with stocks.
Fourth, as mentioned earlier, stocks have tax advantages compared to some other investments -- see footnote4.
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 funds. In October 2022 I bought Nvidia, whose GPU chips initially made for gamers became the go-to chips for Artificial Intelligence, and by June 2024 it had increased by 900%; maybe luck but more likely my aerospace engineering background.
Sixth, a term you might hear often is Price-to-Earnings Ratio, or simply PE or P/E. It's one of the key points when valuing individual 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 India, investments in companies there offer greater potential for profits (along, of course, with greater risk). Just make sure you analyze the risks carefully.
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.
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1 I am NOT an investment professional -- I'm an aerospace engineer with a Master's from Caltech who drifted to the business side and spent the last half of my 30-year career dealing mostly with financial matters. After retiring I've 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 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.2 A study reported in this article found that only 8% of conventional funds (also called "managed funds") were able to beat the market over the 10-year period ending in June 2019, and this trend continues, with 85% of U.S. managed stock funds failing to beat the market in 2021 and 90 % of European funds unable to beat the market in the 10 years to 2022. 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 high-paying 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. Some of these funds 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).
3 If these average annual returns aren't compelling, let's look at it not on an annualized basis, but the TOTAL RETURN over an extended period: the S&P 500 Index increased by 120% from the start of 2019 to June 2024, which means you would have more than doubled your money over that 5.5 year period.
4 The tax advantage comes from not having to pay taxes on the gains until you finally take the money out. On CDs, you pay taxes on the gains each time a CD matures and you redeem it, so, if you set money aside from the proceeds to pay the tax, the amount that you can re-invest in another CD is NOT the whole gain from the CD you just redeemed but the after-tax amount. In a long-term investment in an S&P 500 index mutual fund, you pay taxes only when you finally take the money out, in 10, 20 or 30 years, so the whole gain from each year remains invested -- and gaining -- thereafter. And if held over a year, it’s taxed at a lower tax rate than interest from a CD or savings account or a salary.
