To buy or not to buy? That seems to be a question a lot of people ask when it comes to investing in stocks.
A young professional might be eager to find the next Apple or Facebook stock to add to their portfolio, while an older couple might be scared to invest their hard-earned money in stocks because of the stock market’s notorious ups and downs.
No matter where you fall on that spectrum, it’s important to understand the benefits and drawbacks of buying stocks and the different ways you can invest in them. So let’s dive right into it!
What Are Stocks?
Stocks represent tiny pieces of ownership in a company. So when you buy a company’s stock, you’re essentially becoming a part owner (or stockholder) of that company.
The price of a stock is determined by supply and demand—and demand is driven by how profitable the company is. If a bunch of people want to buy a stock (high demand) and not many people want to sell (low supply), the price will go up. But when not many people want to buy a stock (low demand) and lots of people want to sell (high supply), the price goes down.
How Do Stocks Work?
We’ll spare you the demand curve graphs from Economics 101, but let’s talk about pizza. (Bet you didn’t see that coming.)
Let’s say Papa Dave’s Pizza Restaurant is selling pizza by the slice. Dave has a fresh cheese pizza with eight slices, but he has 20 hungry customers. Rather than setting a fixed price, he decides to have a pizza auction and let the customers place bids.
As you can imagine, the limited supply and the excess demand drive up the price per slice. In economic terms, Dave let the market determine the price. The stock market works like this on a much larger scale with millions of stocks changing hands each day.
Well, we all understand the allure of a steaming slice of pizza, but what makes people want to buy a stock? Demand for a stock is mostly driven by a company’s performance. So if you own stock in a company that’s reporting big profits, the value of your stock usually goes up because more people want to buy it. That’s great!
But on the other hand, if a company is struggling or the economy is going through a downturn, that stock’s value might go down. Stock prices also can, and often do, go up and down simply on speculation about how companies will perform in the future.
Just look at Amazon. They didn’t report a net profit for about eight years after being founded. But the company was a hugely popular stock among tech investors, and its high stock price reflected that in the late 1990s.1
With stocks, you make money one of two ways (and sometimes both ways): when you receive a dividend from the company (that’s a quarterly payment that’s basically the company’s way of saying thank you for being a stockholder) and when you sell your stock for more than you paid for it.
Should You Invest in Stocks?
Yes, stocks should definitely be part of your retirement portfolio . . . but you need to be smart about how your stocks are grouped and diversified.
Historically, the stock market’s average annual return is somewhere between 10–12%.2 That means that if you invest in stocks the right way, you can grow your retirement savings so they beat inflation and set you up for the kind of retirement you’ve always wanted.
But if you’re not careful, you could be betting your retirement future on the success of just a handful of companies . . . and that usually doesn’t end well.
What’s the Best Way to Buy Stocks?
While investing in stocks always has some element of risk involved, there are ways you can reduce your risk—and that’s through diversification. That’s just a fancy investing term for spreading your investments around so that you’re not putting all of your eggs in one basket.
Market chaos, inflation, your future—work with a pro to navigate this stuff.
There are basically three different ways you can buy stocks, either through:
- Single stocks
- Exchange-traded funds (ETFs)
- Mutual funds
Which option will help you save for retirement the most? Let’s go through them one at a time.
Option 1: Single Stocks
When you buy a single stock, you’re basically betting on the performance of one company. Most people who dabble with buying and selling stocks try to “time the market.” They’ll buy a stock when its value is low and then plan to sell after its value rises in order to make a profit.
Instead of taking a “buy and hold” approach to investing—which means you hold on to your stocks for longer periods of time regardless of what the stock market is doing—most stock traders will try to sell their stocks after just a few days or weeks to make a quick profit.
The Bottom Line: Let’s be really clear here—we do not recommend investing in single stocks! There’s just too much risk in tying your investments to the performance of just a handful of companies.
And unless you have a crystal ball lying around, it’s very difficult to pick out the winners from the losers. Investing in single stocks is more like going to a casino in Vegas—you walk in expecting to make a small fortune, but you’ll probably walk out with shattered dreams and empty pockets.
Option 2: Exchange-Traded Funds (ETFs)
ETFs are basically a cross between mutual funds and stocks. They’re funds that contain stocks from different companies, but they’re traded like single stocks on a stock market exchange.
They normally try to match the returns of a market index, like the Dow Jones Industrial Average or the S&P 500, by investing in the stocks that are included in that index. In other words, an ETF’s performance will normally match the performance of the stock market.
The Bottom Line: Since ETFs can be traded like stocks, investors often try to time the market in the same way they do with single stocks. Don’t do that! While they generally have lower fees than mutual funds, there are other expenses—like operation and transaction fees—that can take a huge bite out of your returns if you buy and sell them often.
Only after you’ve maxed out your retirement accounts should you even consider investing in low turnover ETFs inside of a taxable investment account. Until then, stick with mutual funds.
Option 3: Mutual Funds
Mutual funds are created when a group of investors pools their money together and buys stocks from dozens of different companies, which gives you a healthy level of diversification for your investments.
Most mutual funds are also actively managed funds, which means a team of investing professionals makes it their mission to pick and choose stocks for the fund with the goal of beating the stock market’s average returns.
The Bottom Line: We have a winner! Mutual funds are the best type of long-term investment. Investing for retirement through mutual funds does two things.
First, it diversifies your portfolio, protecting you from the huge losses that can come from investing in just a few single stocks. You’ll still experience the ups and downs of the stock market, but over time the value of your mutual funds should continue to grow. And second, it helps you reap the benefits of investing in stocks of companies of all sizes from different industries and sectors of the economy.
And on top of all that, you get the benefit of having an investment pro in your corner to help you make adjustments to your investments throughout your financial journey.
The Smart Way to Invest in Stocks
One of the biggest myths about millionaires is that they take big risks with their money on things like get-rich-quick gimmicks and fad investments. But when we talked to over 10,000 millionaires for The National Study of Millionaires, do you know how many of them said that single stocks were one of their top-three wealth-contributing factors? Zero. Not a single one!
Instead, 8 out of 10 millionaires reached a million-dollar net worth through their employer-sponsored retirement plan, like a 401(k). And they got there over time, after years of hard work and consistently investing into their retirement accounts. That’s how you become a Baby Steps Millionaire!
Once you’re out of debt and have a fully funded emergency fund, invest 15% of your gross income in growth stock mutual funds inside your tax-advantaged retirement accounts, like a 401(k) and Roth IRA.
We also recommend diversifying your portfolio even more by dividing your investments evenly across four different types of mutual funds:
- Growth and income: The calmest and most predictable funds in your portfolio, these funds contain stocks from large, stable companies you’d probably recognize.
- Growth: These funds are invested in medium to large companies that are still growing and usually bring in higher returns than growth and income funds.
- Aggressive growth: The wild child of your portfolio, aggressive growth funds have stocks from smaller companies with lots of potential, but they are all over the place—one year they could be way up and the next they could be way down.
- International: These funds contain stocks from companies all over the world and help you diversify your portfolio beyond your own borders.
And listen, if you’re already investing 15% for retirement or you’re already a millionaire and you want to put a very small percentage of your net worth into single stocks, we’re not going to yell at you. But when you’re just getting started out investing, there’s just too much at stake to put it all on the line for a single stock.
Get Help With an Investment Professional
There are two things we always tell people when it comes to investing. First, you should never invest in anything you don’t understand. And second, you don’t have to figure it all out on your own.
That’s where an investment professional comes in. Our SmartVestor Pros are here to help you get started. They’ll sit down with you and help you understand your investing options so you can make confident decisions that will help you save for the retirement you’ve always wanted. You can do this!
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This article provides general guidelines about investing topics. Your situation may be unique. If you have questions, connect with a SmartVestor Pro. Ramsey Solutions is a paid, non-client promoter of participating Pros.