A stock market is a place where investors can buy shares in publicly-traded companies. When an investor buys shares of company stock, they become a shareholder and have a stake in the company. As a shareholder, you can monitor the performance of your shares and sell them if you want to cash out or exchange them for another security. There are two ways to invest in stocks: directly with an individual company or indirectly through a mutual fund or exchange-traded fund (ETF). In general, investing directly is riskier than investing indirectly because it exposes you to the volatility of that single stock. However, there are advantages and disadvantages to both methods of investing. Understanding these differences can help you make the right decision for your circumstances and risk tolerance.
How to Invest in Stocks
Stocks are the shares of ownership in a company that you purchase through a brokerage. Before you can invest in stocks, you’ll need to open a brokerage account and transfer money from your savings into that brokerage account. You can do this by setting up a periodic investment plan (PIP) where a set amount is transferred to your brokerage account on a regular schedule. If you have an existing 401(k) or IRA, some brokers allow you to transfer these funds into a brokerage account. Stocks are an attractive investment vehicle because they provide the potential for significant long-term growth. While no investment is risk-free, stocks give investors the potential to earn higher returns over the long run. They also provide a way to diversify a portfolio, which can help you manage risk.
Investing Indirectly: Mutual Funds and ETFs
Mutual funds are investment funds that pool money from many individual investors and distribute it among a variety of stocks and bonds. Mutual funds are managed by a professional fund manager who chooses which stocks to buy and when to sell them. An exchange-traded fund (ETF) is similar to a mutual fund, but it trades on a stock exchange like a stock and is bought and sold throughout the day like a stock. ETFs often track a particular sector or index, such as the S&P 500. The advantage of investing in mutual funds or ETFs is that they are diversified by design. This means that you own a piece of many different companies and have less risk of losing everything if one company goes bankrupt. Having a broad array of investments can help you manage risk by reducing your exposure to any one sector or company.
Advantages of Investing Indirectly
- Low cost: Mutual funds and ETFs are inexpensive to buy and have low or no fees for managing the fund. You can find low-cost funds through various online resources or financial advisors.
- Automatic rebalancing: Mutual funds and ETFs automatically buy and sell stocks to balance your portfolio to your desired asset allocation, such as having a certain percentage of stocks in your portfolio. This rebalancing helps you manage risk and stay on track with your investment goals.
- Access to stocks: Mutual funds and ETFs offer investors broad exposure to a variety of stocks. You can invest in industries, countries, or a number of specific stocks to diversify your portfolio.
- Professional fund managers: A mutual fund or ETF offers more diversification than buying stocks individually. A good fund manager buys stocks when they are cheap and sells them when they are expensive, providing a smoother ride during a bear market.
- Tax advantages: Mutual funds and ETFs are tax-efficient, which means they are designed to minimize taxes that you have to pay on gains.
Disadvantages of Investing Indirectly
- Risk of unwise investment choices: Some mutual funds or ETFs have a history of making unwise investment choices that result in poor returns. A fund that buys only growth stocks when the market is overvalued, for example, might do poorly in a bear market. You can check fund ratings and reviews to get a sense of how a mutual fund or ETF has performed in the past and how risky it is.
- Lack of control: Mutual funds and ETFs can be difficult to exit, which means you could be forced to stay in the fund during a market downturn. If a fund you own has poor performance, you might not be able-or willing-to stay with it.
- Lack of diversification: Owning a single mutual fund or ETF gives you exposure to a limited number of stocks and can be riskier than owning a variety of stocks individually.
- Lack of expertise: While mutual funds and ETFs offer broad diversification and may be managed by professional fund managers, you don’t have control over the selection of stocks.
How to Invest Directly in Stocks
If you don’t like the idea of investing indirectly through a mutual fund or ETF, you can buy individual stocks directly. The advantage of buying individual stocks directly is that you have full control over the stocks you buy. You can buy the stocks of companies you know and understand, such as your employer or a family business. You can also diversify your portfolio with individual stocks by buying different stocks in different industries. The main risk of buying individual stocks is that you will have less diversification than in a mutual fund or ETF. If a particular company goes under, you will lose 100% of your investment, not just a small percentage. You will also have to pay more brokerage fees because you are buying and selling stocks often.
Bottom Line
A stock market is a place where investors can buy shares in publicly-traded companies. When an investor buys shares of company stock, they become a shareholder and have a stake in the company. Stocks are an attractive investment vehicle because they provide the potential for significant long-term growth. However, only buy stocks when the market is in a long-term uptrend and when you understand the company’s business model and prospects.
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