Why People Invest in Stocks
Investing in stocks can be a good way to build wealth. Due to the magic of compound interest, a small initial investment can eventually grow to a treasure trove, if properly managed. For example, the world’s most famous investor, Warren Buffett started investing in equities around six decades ago and is now one of the richest men in the world. Grace Groner, a secretary at Abbott Laboratories, bought three special shares of Abbott in 1935 and became a millionaire multiple times over.
While skill and luck can play a part in how profitable your investments are, millions of investors have found success in saving for their retirement and financial future by makings sound investment decisions and letting compound interest do its job.
Being well-informed about the companies, funds or assets you invest in is usually the key to any investment strategy. Stocks can sometimes fall 90 percent in one day due to a bad earnings report or unexpected company, industry or political news. Companies also go bankrupt, costing many investors everything they invested. Even buying a diversified basket of stocks can be risky, as the broader market has fallen by 10 percent or more in a single session multiple times before.
Investing Flavors: Passive vs Active
Given the risk and reward of stocks, it is important to have a correct way of investing that fits one’s financial goals and risk-tolerance. Generally speaking, there are two types of investing, passive and active. Passive investing is where one accepts the broad market’s average return, which ignores short term trends for long term growth and, in turn, minimizes fees and taxes that come with frequently trading in and out of positions. This style of investing generally includes:
- Passive investing in market ETFs, such as buying the SPDR S&P 500 ETF Trust (NYSE:SPY). The SPDR S&P 500 ETF Trust ETF gives investors exposure to the S&P 500, which reflects a broad swath of diversified large cap U.S. companies. The ETF has a gross expense ratio of 0.0945% per year, which is very low versus that of other alternatives. The SPDR S&P 500 ETF Trust’s performance has also done well on a long time line.
- Passive investing in mutual funds that try and mimic market returns. These mutual funds may be a little higher priced than comparable ETFs but might be more accessible for certain retirement accounts.
Active investing is where an investor trusts himself/herself or a professional fund manager to try and exceed the market’s average return. This method generally requires a substantial amount of research and access to the latest breaking news. Although active investing can generate higher returns, the style generally has higher fees and much higher risk of underperforming the market in the long term. Active investing includes:
- Active Investing by mutuals funds, where professional mutual fund managers charge a certain annual fee and use the money to do research and pick a basket of stocks to try and beat the market.
- Active Investing by hedge funds, which is generally for high net worth individuals and institutions. Hedge fund managers differentiate themselves from mutual funds by shorting a stock at time, which means borrowing shares of a stock from a broker to sell immediately, then repurchasing the stock at a future, hopefully lower, price. This has the potential to deliver high risk-adjusted returns. Due to having more resources, the bigger hedge funds may also do more research on specific companies.
- Active investing by the individual investor. This generally means that the investor does his/her own research on a company, and buys or sells stocks based on the latest news or upcoming catalysts. The investor can generally buy a stock and hold forever (and collect dividends along the way), or he can hold for an intermediate amount of time or he can day-trade. Of the three styles, day-trading is perhaps the riskiest due to the uncertainty of the market and the high associated fees.
Financial Goals and Risk Tolerance
Generally speaking, passive investing in a low-cost market ETF such as the SPDR S&P 500 ETF Trust and holding it for the long run is perhaps the best choice for the majority of investors out there. Holding an investment for more than one year generally reduces one’s taxes if there is a capital gain, and the low annual ETF fees provide more of a return to investors.
For those who want to actively invest but don’t have the time/skills to do it themselves, picking a mutual fund/hedge fund with lower fees and a solid track record could be useful. Although past performance does not predict future returns, a long track record of success may indicate a solid research strategy and good risk controls.
For those do-it-yourself-ers who want to actively invest themselves, deciding what type of stocks to buy depends on one’s financial goals and risk tolerance. If an investor is younger, more risk tolerant, and has the goal of capital appreciation, buying a basket of riskier securities, such as tech stocks, growth stocks, and small caps, could be more of a fit. Although the securities are riskier and more volatile, they could potentially deliver higher returns in the long run.
If an investor is older, less risk tolerant, and has a goal of optimizing fixed income, buying boring stable stocks such as Dow Jones index companies and Dividend Aristocrats (companies that have raised their payouts for 25 years or more) could be a better fit. Generally, Dow Jones index companies and Dividend Aristocrats have wide moats and pay nice dividends in good times and bad. Those companies are generally less risky than tech stocks or small caps.
Investment Process for Stocks
- Research the company – In terms of the actual process to invest in stocks, an investor would first need to do some research on a company. This can be done by browsing financial statements from the SEC, checking basic price action, browsing news from Yahoo Finance, and using sentiment analysis from Twitter/Stocktwits. An investor should also determine what, if any, catalysts lie ahead so as not to get caught off guard by events that could move the stock. Potential catalysts, or events that cause a stock to move, include quarterly earnings report dates, investor presentation days, or industry events etc. While no company’s stock can grow indefinitely, it’s best to invest in companies with policies that align with your own. Companies with a strong track record of stable growth and reinvestment can be great for long-term investors. Companies who rely on big announcements or product releases might be better for short term trades.Overall, investors like to find companies that are profitable, can maintain their profitability in good times and bad, and can grow their profits in the future.
- Determine the amount to invest – Every investor need to determine how much he or she wants to invest in a company’s stock. Buying a shares of a company’s stock gives an investor part of the ownership of the company. Generally speaking, investors should only invest an amount they could afford to lose. Since stocks can be volatile, anything can happen, and stocks can go down a lot. Shorting a stock, or profiting in case a stock falls, is generally a bad idea as it could potentially expose an investor to unlimited losses if stock spikes.
- Determine investment timeline – Beyond picking a price at which to buy, successful investors know at what price to sell the stock if things go bad, as in when a stock falls below a certain level, i.e. a pain point. There are three timelines, short term like day-trading, intermediate term like swing trading, and long term, such as buying-and-holding.
- Find the right broker – Once an investor has done research on a company, determined how much to invest, and determined what his/her timeline is, the investor can either go call a brick and mortar broker, such as Scottrade, sign up for an account, fund the account, and then place a ‘buy’ order on the stock. He/she can also sign up for an online broker such as E*Trade or Interactive Brokers, apply for an account, fund the account, and buy a stock. If an investor has a workplace retirement account, he or she would need to pick a mutual fund or another alternative that provides exposure to stocks.
- Buy the stock – There are generally two types of ‘buy’ orders, market order, and a limit order. A market order will execute the purchase at the present market price, while a limit order will only execute if the price falls at or below the limit price. Although a limit price might give an investor a lower price of entry, there is no guarantee that the limit order will execute. That might mean missing out on the trade entirely, but that can be a good thing if you can’t buy the shares at a price you think is fair.
- Sell the stock – Once an investor’s goal has been achieved or a pain point has been reached, the investor can ‘Sell’ the stock. Again, with either the market order or the limit order, and use the proceeds to reinvest.
Investing in stocks can be a good way to build wealth. Accepting the general market return and passively investing has historically been the most reliable approach for many people. Active investing, such as buying and selling stocks for oneself, has the potential generate greater returns, but is time consuming and is less cost effective. To do active investing with any success, an investor would need to do extensive research on the company, keep abreast of the latest news, determine how much he or she is willing to invest, and sign up for a broker account. Once the broker account is approved and funded, the investor can ‘buy’ and ‘sell’ a stock, and potentially profit.