Stock Market Investing Guide
Stocks have been one of the strongest-performing asset classes over long periods, which is why they sit at the center of most long-term portfolios. The catch is that those long-run returns come with deep, sometimes frightening declines along the way. Successful stock market investing is less about finding the perfect stock than about building a portfolio you can stick with through those declines.
The investor's dilemma
Safer choices such as savings accounts and short-term bonds protect your principal, but their returns may barely keep up with inflation over time. Stocks offer more growth potential in exchange for volatility you cannot control. In the short run, a stock's price is whatever another investor will pay for it today, and that price is driven by shifting moods of optimism and fear as much as by the company's results. Over the long run, prices tend to follow the earnings and growth of the underlying businesses.
Why many investors trail the market
Many individual investors earn less than the funds they own, and two habits explain much of the gap.
Trying to time the market
It is tempting to buy after prices have risen and everyone is optimistic, then sell after a drop when fear takes over. That buy-high, sell-low pattern locks in losses and often means missing the rebound. Some of the market's best days have come shortly after its worst, so being out of the market for even a few of them can noticeably lower long-term returns. Frequent trading also adds costs and, in taxable accounts, short-term capital gains taxes.
Too little diversification
Many investors are confident in their stock picks and so hold only a few. With so many people picking stocks, some will have impressive streaks simply by chance. Money often floods into the fund or manager with the hottest record just before performance cools. Spreading money broadly, through index funds or a large number of holdings, removes the risk that one bad pick will sink the portfolio.
Habits that work
- Invest for the long term. Money you need within a few years generally belongs somewhere safer than stocks.
- Diversify broadly. Own many companies across sectors and countries, and add bonds to match your risk tolerance.
- Keep costs low. Commission-free trading is now standard at major brokers, so focus on fund expense ratios and avoid unnecessary trading.
- Invest automatically. Regular contributions through a retirement plan or automatic transfer take emotion out of timing.
- Use tax-advantaged accounts. See Retirement Accounts.
- Don't borrow to buy stocks. Margin and other debt magnify losses and can force you to sell at the worst time. See Finding Money to Invest.
- Rebalance occasionally rather than reacting to headlines.
Ways to own stocks
You can buy individual stocks, but many investors use broadly diversified mutual funds and ETFs instead. Some also add bonds or more conservative funds to soften declines, accepting lower expected returns in exchange. Options, futures and leveraged products can be used to hedge, but they add complexity and risk and are not a starting point. Compare the main choices in Stocks vs ETFs vs Mutual Funds.
Sources
- Investor.gov: Stocks
- Investor.gov: Diversify your investments
- Investor.gov: Asset allocation
- FINRA: Margin accounts