Laura reviews the pros and cons of investing in stocks and five ways to own them with less risk.
Laura reviews the pros and cons of investing in stocks and five ways to own them with less risk.
Transcript: https://money-girl.simplecast.com/episodes/how-to-invest-in-stocks-with-less-risk/transcript
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If you want to invest in the stock market but lack experience, it can seem complicated and risky. I believe that every investor should own stocks; however, there’s a right and a wrong way to buy them.
This post will explain stocks, their advantages, and disadvantages for investors. I’ll review five simple ways to own stocks while taking as little risk as possible, so you can confidently build wealth for the future.
Welcome back to episode 938 of Money Girl–I appreciate you spending time with me! I'm Laura Adams, an award-winning author, on-camera spokesperson, female money speaker, and founder of The Money Stack, a Substack newsletter. I've been providing personal finance tips and advice on this podcast weekly since 2008, with over 44 million downloads.
You can learn more, ask questions, and sign up for the Money Stack at LauraDAdams.com. Newsletter subscribers automatically receive my Money Success Toolkit with the exact templates I use to manage money.
What is a stock?
A stock, also known as a share or equity, represents ownership in a company. A company might issue stock to raise money from investors. For example, Nvidia might want to launch a new product or invest in research and development. Selling shares of stock to the public allows a company to raise capital without incurring debt.
Therefore, if you buy shares of Nvidia stock, you purchase a small piece of the company. You become an equity holder, which is why stocks are called equities.
There are different classifications of stock based on the rights owners receive, but the two main types are common stock and preferred stock.
Common stock is ordinary equity that represents basic ownership in a company. It typically allows you to vote on critical company issues and may come with dividends, a share of company profits.
Preferred stock may not come with voting rights, but it typically pays dividends. Preferred shares give owners a higher claim on the company’s assets than common stockholders in the event of bankruptcy.
There are hundreds of thousands of companies that offer their stocks on public marketplaces known as exchanges or stock markets. The New York Stock Exchange (NYSE) is the world's largest stock market.
A company’s stock price can be influenced by many factors. Some key influences include its performance, like earnings reports and demand for its goods or services.
If a company is profitable or investors believe it will perform well in the future, they may buy more of its stock, which pushes the price up. Alternatively, if a company reports lower-than-expected earnings or gets bad press, investors may sell their shares, resulting in a decline in the stock’s price.
Our global and national economies also affect corporate profits and consumer behavior.
For instance, broadcast news, a social media trend, or recommendations from a financial analyst can significantly influence an investor’s perception of a company and impact its stock price.
To sum up, a stock’s price is constantly moving and influenced by a complicated interplay of its financials, the broader economy, and the collective psychology of investors.
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What are the different types of stock?
Investors categorize stocks based on various factors, such as a company’s size, location, profitability, and potential. Here are some terms that characterize different types of stocks.
Growth stocks are shares of companies that are expected to grow faster than the overall market. They often reinvest profits back into the company and may not pay dividends to shareholders. Some examples of growth stocks include Uber and Meta.
Dividend or income stocks are shares of mature companies that regularly pay dividends to owners in the form of cash or additional shares of stock. Some examples include Procter & Gamble and Coca-Cola.
Blue-chip stocks are shares of large, well-established, profitable companies that have a history of regularly paying dividends to shareholders, such as Johnson & Johnson and Pfizer.
Value stocks are shares of companies that appear to be trading at prices lower than the market or their competitors. Investors purchase these in the hope that the market will eventually recognize their value, causing prices to rise significantly.
Large-cap stocks refer to shares of companies with a market capitalization exceeding $10 billion. You calculate market capitalization by multiplying the current price per share by the total number of shares outstanding in the market. Some examples of large caps include Apple and Microsoft.
Small-cap stocks are shares of companies with a market capitalization usually under $2 billion, such as Sally Beauty and Kohl’s.
International stocks are shares of companies that are based overseas and not listed on a U.S. exchange (like the NYSE or NASDAQ). Some examples include Shell and Nestle.
Pros and cons of owning stocks
The primary advantage of investing in stocks is that they’re a convenient and straightforward way to earn money. For instance, the Standard & Poor’s 500 (S&P 500) is a stock market index that tracks the performance of 500 leading companies in the United States. Since the mid-1920s, the average annual return of companies listed on the S&P 500 has been approximately 10%.
Stocks are excellent investments when you want to build wealth over the long term. No other mainstream investment, such as bonds or money market funds, outperforms stocks over the long run.
The downside of investing in stocks is that their prices can be volatile due to short-term fluctuations in trading volume. As previously mentioned, if a company releases a lower-than-expected quarterly earnings report or has a product recall, investors can quickly sell their shares, causing the price to drop.
ALSO READ: Investing by lump sum vs dollar-cost averaging (DCA)
5 ways to invest in stocks with less risk
While investing in stocks always carries risk, there are ways to mitigate it. Consider the following five ways to purchase stocks with less risk.
1. Don’t buy individual stocks.
Buying an individual stock is significantly riskier than owning a diversified portfolio of many stocks. If your entire portfolio is tied to the performance of just one company’s stock and it declines due to economic conditions, bad management, or a lawsuit, your investment could be wiped out. In other words, the volatility of a single stock could create an emotional rollercoaster.
Additionally, it requires time and expertise to research and analyze a company’s financials and market potential. For most investors who don’t want to make a career out of stock picking, buying individual stocks is a bad idea. Trying to find one or two winning stocks is gambling, not strategic investing.
However, a diversified portfolio that spreads your money across different companies and industries reduces the impact of any one underperforming stock. Diversification protects you by smoothing out the performance of winners and losers over time.
If creating a diversified portfolio sounds difficult or time-consuming, don’t worry! Buying shares of diversified funds that I’ll cover next is an easy and inexpensive way to invest in stocks. Unlike other types of investments, such as real estate or businesses, you don’t need much money to buy stock funds.
2. Buy a stock mutual fund.
Mutual funds are collections of assets managed by a fund professional. A stock mutual fund is made up of hundreds or thousands of different company stocks. They’re exclusively sold by fund families, like Vanguard or Charles Schwab. Shares of a mutual fund can only be bought and sold at the end of the trading day when the fund’s net asset value is calculated.
A mutual fund might focus exclusively on stocks classified as growth, income, international, or large-cap. It could be as narrow as stocks in specific industries, such as technology, utilities, or real estate.
All mutual funds charge fees, known as an expense ratio, to cover costs such as administration and management. For instance, a 2% expense ratio means that 2% of a fund’s total assets will be used to pay expenses.
The problem with fund fees is that they reduce your net earnings. Therefore, it’s wise to select funds with relatively low fees, ideally 1% or less, to earn returns that are as high as possible.
3. Buy a stock exchange-traded fund (ETF).
An ETF is similar to a mutual fund because it’s also a collection of assets. However, unlike a mutual fund, which can only be bought and sold through a fund family, an ETF trades on an exchange and experiences price fluctuations throughout the day, just like a stock.
Compared to a mutual fund, ETFs typically have lower expenses, which get passed along to investors in the form of lower fees.
4. Buy an index fund.
An index fund aims to match or outperform a particular index, such as the S&P 500, NASDAQ, or Russel 2000. Index funds may comprise hundreds or thousands of underlying investments and typically come with low fees, which makes them popular.
An index fund can be either a mutual fund or an ETF and is passively managed. So, instead of having a fund manager actively select individual stocks and attempt to outperform the market, the goal is to closely replicate the performance of an index.
Index funds typically use a computer algorithm to buy and hold the same stocks in the index, in the same proportions. Therefore, if Amazon accounts for 4% of the S&P 500, an S&P 500 index fund would allocate 4% of its portfolio to Amazon stock.
When the underlying index changes, such as when a new company is added or removed, or the weighting shifts, the index fund adjusts its holdings accordingly to maintain a mirrored strategy.
It would be challenging for the average investor to purchase hundreds or thousands of stocks independently. Index funds provide a simple and cost-effective way for investors to own a diversified portfolio of stocks.
5. Buy a target-date fund.
Target-date funds, also known as lifecycle funds, are among the newest and most innovative investment options. You can buy them within a mutual fund family or as an ETF.
You’ll recognize a target-date fund by its typical naming convention, which often includes a year, such as Retirement 2040 Fund or Retirement 2055 Fund. The date should correspond to when you want to retire. For instance, if you’re 35 years old and want to retire 30 years from now, in 2055, choose the fund with the target date closest to your desired retirement date.
What’s unique about target-date funds is that they’re made up of different types of investments, such as stocks and bonds, that slowly change allocation according to a selected time frame, such as your estimated retirement date.
This is known as a “glide path” that gradually and automatically reduces the proportion of stocks and increases the proportion of bonds as the target date approaches. That helps you become more financially conservative as you approach retirement.
Because target-date funds already include a mix of asset classes, you only need to own one of them. The right amount of stocks is baked into the investment, making it an easy, one-size-fits-all solution.
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How much stock should you own?
A common question investors ask is: How much stock should I own? The answer depends on your risk tolerance, as well as other factors such as your age and desired retirement date. In general, the younger you are, the more stock you should own. And by stock, I mean one or more of the stock funds covered here.
If you’re young with many decades to go before retirement, owning a high percentage of stock funds in your portfolio can help you achieve as much growth as possible. Though prices will go up and down in the short term, you're likely to see prices trend up and give you an impressive return over time.
But if you're nearing or already in retirement, take a more conservative approach to preserve your wealth. That doesn't mean eliminating stocks from your portfolio entirely, but owning a lower percentage and allocating more of your portfolio to bonds and cash to preserve the wealth you worked hard to accumulate.
That's all for now. I'll talk to you soon. Until then, here's to living a richer life!
Money Girl is a Quick and Dirty Tips podcast, and I want to thank our fantastic team! Steve Riekeberg audio-engineers the show. Holly Hutchings is our director of podcasts, Morgan Christianson is our advertising operations specialist, and Nathaniel Hoopes is our marketing contractor.