If you’re new to investing or just interested in getting into it, then it will be helpful to develop a general understanding about stocks and how they work.
Let’s walk through a high-level overview of stocks to help you better understand what they are, how they work, and why they are such an important piece of a personal financial plan.
What is a Stock?
Put succinctly, a stock is a portion of ownership in a company.
When a company is starting out it’s not unusual for its leaders to have ambitions and plans that outpace the company’s available capital.
If the company has an idea or product that sounds promising to investors, then selling stock can be a helpful way to obtain large amounts of cash quickly.
Picture guys like Steve Jobs, Bill Gates, or Elon Musk who all had revolutionary ideas, but needed capital to get their businesses going.
In the case of these three guys, selling stock in Apple, Microsoft, or Tesla provided a path to raise money to make their dreams a reality.
Once shares are sold by a company, those shares become the property of the shareholder who buys them.
As a result, shareholders can buy and sell their shares of stock much like anyone can buy and sell houses, cars, or other items of value.
Rarely do shareholders end up selling their stock back to the company that issued it. Instead, most of the time, shares of stock are bought and sold to other individuals or institutions who want to invest in that company.
The stock buying and selling process is facilitated by a stock exchange like the New York Stock Exchange or NASDAQ, though stocks can also be purchased in over-the-counter transactions.
In order to have access to trade on the exchange, you have to be a licensed broker.
Obviously, most of us are not licensed brokers, so we must trade through someone who is. Normally, these individuals work for larger investment companies or brokerages.
Some of the larger, more popular brokerages are Fidelity, Vanguard, Charles Schwab, Merrill, JP Morgan Chase, etc.
There are many ways brokerages benefit from facilitating the buying and selling of stocks through a variety of potential fees and commissions charged to their investing customers.
These fees were much higher in the past, but technology has greatly reduced the cost and complexity of buy and sell transactions which has made stock ownership far more accessible to the public.
Why Should I Buy Stocks?
So, why should you buy stocks?
This probably seems like an obvious question. You’re probably reading this because you have either heard or know from experience that people buy and sell stocks to make money.
But why do they buy and sell stocks? Why not invest in other things?
This is a bit of a generalization, but the primary reason people choose to trade stocks is that the combination of appreciation in the value of a stock, along with their simplicity to own and hold, makes them an attractive investment option.
The appreciation piece should be quite clear.
You buy a stock in a company. The company generates earnings. The stock price increases, pays a dividend, or both, and the stockholders are better for it.
The ease of ownership part isn’t quite as obvious, but when you compare it to other assets it makes a bit more sense.
Think for a minute about other appreciating assets and some of the headaches that come with owning them.
For example, what if you owned some gold?
Gold does generally appreciate in value, but you have to keep it somewhere safe while you own it. It could also be a challenge to sell to someone else quickly.
Or what if you bought real estate as an investment? The returns can be excellent in real estate, but you have to maintain a property and real estate takes time to sell. Not to mention the potential tax, risk, and legal headaches that may come with owning a property.
Stocks are highly liquid, meaning you can sell them almost instantly on an exchange. Furthermore, stocks primarily exist in electronic form only nowadays, so there’s nothing to store or keep safe from theft or some other casualty.
Additionally, the federal government provides a significant level of oversight in stock markets that mostly protects investors from being victimized by companies or individuals selling shares.
Are there higher gains than stocks elsewhere? Potentially, yes.
Are chasing those gains worth the hassle that may come with them? Maybe. That’s up to you as an investor.
Millions of investors have decided stocks are at least one way they want to invest their money.
In fact, the S&P500 (which is basically a large-cap index) has averaged a return of 10.67% annually since its inception in 1957.
The total U.S. stock market has returned closer to 8.6%.
Those are really solid returns for an investment that requires so little effort and trouble to own.
Where Do I Buy Stocks?
As I mentioned before, stocks are bought and sold on exchanges that limit access to those with a license.
You and I will have to go through a broker to buy stocks.
According to FINRA, there are about 3,300 registered broker-dealers in the United States.
Most commonly investors will use a large brokerage firm like those I mentioned earlier.
This is not meant to serve as an advertisement for brokerages, but you should choose one that has a website or other platforms that are easy to access and use, along with transparent and low fees.
Most of the larger brokerages do not charge a fee for trading stocks anymore, or at least not if you have a certain amount invested through them.
Generally speaking, the more complex you get with your trading, the more you’re going to run into fees. If you’re planning on just buying domestic stocks, bonds, or mutual funds and ETFs then your fees will probably be pretty low.
To open an account you’ll need to link a checking or savings account so you can fund it. Once you have money in the account, you’ll be able to buy, sell, and trade nearly any registered stock there is.
Which Stocks Should I Buy?
To begin, you need to understand that there are risks associated with investing in stocks. You can lose some or all of your investment.
The price of any given stock could drop suddenly because of a litany of risk factors. Several of these risks include:
- Political Risk
- Market Risk
- Business Risk
- Inflation
- Interest Rate Risk
- Risk of Default
- Liquidity Risk
- Currency Risk
- Equity Risk
- Concentration Risk
Unfortunately, the impact of these risks on the value of a stock is unpredictable, which is why I do not recommend buying individual stocks.
Instead, I would suggest that you invest in a large group of stocks at one time by purchasing either a Mutual Fund or Exchange Traded Fund (ETF).
Mutual Funds and ETFs buy up a broad basket of stocks (or other securities) and consolidate them into a single investment allowing investors to potentially capture broad market diversification in one place.
Additionally, Mutual Funds and ETFs are managed so that they support a stated investment strategy.
Some examples include:
- De-risking a portfolio over time to support a particular retirement date (Target Date Funds)
- Targeting a particular industry, commodity, market sector, or country
- Strategies for accessing alternative investments like real estate or cryptocurrencies
- Offering low-expense funds by following market indexes instead of active management (Index Funds)
- Focusing on rapid growth over price stability or vice versa
- And many others
Selecting the correct mutual fund or ETF will require some research, but if you want a quick and easy way to set it and forget it, start with Indexed Target Date Retirement Funds (inside retirement accounts only), index funds that track a common market index like the S&P500, or a Total Stock Market index fund.
A second consideration on where to buy stocks is the account type you are using to buy the stock.
Tax-advantaged retirement accounts like IRAs, 401(k)s, 403(b)s, 457s, HSAs, and TSPs all enjoy tax benefits that you can’t get in a taxable brokerage account.
If you are investing for your retirement, you can’t beat the tax benefits these accounts provide so you should start with them.
I recommend reading through the Next Dollar Roadmap for a more comprehensive explanation of how you should use tax-advantaged retirement accounts to boost your net worth.
Finally, I don’t recommend buying stocks at all (through a mutual fund, ETF, or otherwise) if you plan to use the money within the next 5 to 7 years.
There is a chance that you could invest at a particularly bad time, leaving you with the option of either waiting years for your investment to recover or having to sell it at a loss.
If you are looking to invest for 5 years or less, look at cash equivalents or fixed-income securities depending on interest rates and the shape of the bond curve when you make your investment.
The odds of these investments outperforming stocks are low, but you are also much less likely to lose your money in the near term by investing in these safer spots.
Wrap Up
I wanted to make this a quick overview of stock ownership and I feel like I have succeeded.
But you should also know that there is so much more to know about investing than this 1600-word blog post.
For more, check our posts about investing or The Next Dollar Roadmap which covers finances from negative net worth to financial independence.
Thanks for reading!
