Stock investing can be a great way to save up and have the money you need in the future for things like a new car, a home down payment, and retirement. It is a great way to be ready to send your kids to college and then help your grandkids get started in life. It can require fairly little time and attention.
Stock trading can be a form of entertainment where you try to time short-term movements of stocks, getting in before a rise and out before a fall. You can even add option writing and try to generate income from your stock holdings. Using stocks this way can become a full-time job where you need to spend substantial time watching your positions and making adjustments as events occur.
Stocks can be used in different ways and the amount of effort involved will vary. In this article, we’ll talk about what the stock investing experience is like and the effort required for those who might be interested in getting started in stocks. We’ll go from least effort to most effort.
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Mutual fund stock investing
The easiest way to invest in stocks is with mutual funds. This includes using Exchange Traded Funds (ETFs) and index funds, which are just specific kinds of mutual funds. If you’re investing in a 401k of 403B plan, mutual funds are probably your only choice. You can also choose to use mutual funds if you’re investing on your own, either through a mutual fund company or in a brokerage account.
With a mutual fund, you send in your money to the company and a professional manager invests the money for you. He buys a portfolio of stocks using the money you send plus that of many other people. You then get a share of any profits the portfolio as a whole makes. If the manager does well, the value of the portfolio should go up, making your portion worth more. Most of the money you’ll make from investing in stocks, including through mutual funds, will be from the value of your investments going up.
If you’re investing with mutual funds, you’ll need to develop an asset allocation strategy, which just means that you decide into what kind of assets you want to invest your money and how much you want to invest where. For example, you could decide that you want to invest 50% of your money into large US stocks and 50% of your money into developing regions of the world. (This is not a very good asset allocation plan and carries a lot of risk. This is just an example for illustration of the process.) You then would need to find mutual funds that invest in the assets you’re wanting. For this example, that would be something like a S&P500 fund or a large-cap US stock fund and an emerging markets fund. There are many funds out there that invest in each of these areas.
You would establish an account with a mutual fund company (or a brokerage account, if you so choose). Once you’ve developed your asset allocation strategy and found the specific funds, you’d send in your money via an electronic transfer or by just sending them a check. You’d then use their web app (or, maybe, the phone) to place orders to buy shares of the mutual funds you selected. Obviously, you’d invest your money in the proportions in your asset allocation plan. For our example, you’d invest half in the large-cap fund and half in the emerging markets fund.
After that, little would need to be done. You could actually just leave your investments alone and let them do what they do. In a mutual fund, you’re invested in a large number of stocks, so while some might drop in price and go bankrupt, there would be others that grow and become more valuable. Over long periods of time (10-20 years), you should receive the returns for the areas of the markets your funds invest in. For US large-caps, that would be about 10% annualized per year. The returns of the emerging markets fund would be less predictable because the investments are very volatile, so it could be more or less than 10%.
Doing better with your mutual fund investing
You could do as described above and then never do anything else until you were ready to take the money out years later. If you actually want to grow wealth, however, you should be continually investing. You would be sending in more money to invest each month. You could even have an auto-draft from your checking account and automate your investing.
You would also need to invest the new money as it came in. You would invest this based on your asset allocation plan. You could just invest new money based on your plan, putting 50% to each of the two funds for our example. This would be the simplest option. You could also invest in such a way as to try to maintain the desired investment percentages. For example, let’s say that after a few months, your large-cap fund has done really well and is now 60% of your portfolio and the emerging market fund is only 40%. You could invest most or all of the new money into the emerging market fund to try to bring the ratio back up to 50%-50%. This has the advantage that you’re investing new money in the area that has not done as well, meaning you’re investing where stocks are cheaper, rather than investing in the areas that have done well and where stocks are more expensive.
As your portfolio grows, you’ll probably get to the point where sending in new money isn’t sufficient to rebalance. For example, if your portfolio becomes worth $100,000 and you’re sending in $500/month, if the portfolio becomes 60%/40% large caps/emerging markets, sending $500 into the emerging market fund wouldn’t make much difference. You have a $20,000 deficit and you’re only sending in $500, or $6000 per year.
At this point, it would make sense to actually sell some shares of the large cap fund and invest into the emerging market fund to bring things back to your asset allocation strategy. You should only do this once or twice a year since letting your winning funds grow for a while before you cut your positions back is normally a good strategy. You’ll also trigger capital gains taxes if you’re investing in a taxable account, so be ready to pay those taxes if needed.
So, investing through mutual funds will just be a matter of developing your plan, implementing it, and then spending a little bit of time periodically doing a little bit of maintenance on your portfolio. If you automate sending in money via auto drafts, you’ll just need to specify how to invest the money about once per month. This will only take a few minutes. Some mutual fund companies even allow you to specify how to invest new money, so even that becomes automatic. Investing through mutual funds can take very little of your time.
If you’d like to learn more about how to decide how much you should put in different types of assets, Sample Mutual Fund Portfolios gives lots of information and examples of how to make allocations for all sorts of different goals, including retirement.)
Long-term individual stock investing
If you are willing to spend a little more time or just have an interest, you can do better by investing in individual stocks. By far the best way to do this is by making long-term investments in companies you believe will do well. This strategy, including how to select the best companies for this type of investing, is described in detail in Investing to Win. Note that instead of only investing in individual stocks, you could just buy a few individual stocks and have most of your money invested in mutual funds. This would protect you from the increased risks that individual stocks create while still having the chance to increase your returns if you are talented at finding companies that grow faster than the overall market.
In general, you’ll want to invest like an owner, buying shares of stocks in companies that you want to own and profit from their business activities. This is different from stock trading where you’d mainly buy and sell based upon the price movements of the stock. Because you’re buying companies, you would trade very rarely, usually only when the company has fundamentally changed or you have decided you were wrong about the company. Otherwise, you would just stay invested and ride out any price movements. If you’re right about the business doing well and growing, you’d know that the price of the company will go up over the long-term.
Investing this way would require that you develop a list of companies you like and want to make long-term holdings. You’d also decide how much you want to make as an investment with each company to start and how large you are willing to let a position get before you cut it back and reallocate the money to other positions. You would then start investing in stocks from the list each time that you had some money to invest.
You would choose which stock you sent new money to buy based on how “good a buy” the company was based on stock price (for example, if the stock price were low compared to its fair value. You would also choose stocks from your list based on how much of the company stock you already own compared to your whole portfolio. You’d want to add to positions where you had little invested.
Trading stocks
The most time-consuming way to use stocks is to trade stocks. This includes doing short-term trades of stocks trying to make money over the period of a few weeks or months or even trying to make money with really small fluctuations within a day. The first type of trading is known as “swing trading” and the second type is “day trading.” You can also buy and sell options on stocks, which are contracts that let you either make big returns if you guess the direction of a stock correctly or receive money from people who think they can predict the direction of the stocks you own.
This use of stocks is more akin to gambling than it is to investing. Most people will make far less this way than they would just buying and holding stocks. Many people will actually lose money. The costs of using stocks this way are also high with high fees and high taxes. It also can require specialized trading systems and subscriptions. Your chances of doing better than a mutual fund investor or a long-term individual stock investor are very low.
Large amounts of time are also required to use stocks this way. Anytime the markets are open, you’ll need to be watching. You’ll also be spending time after hours planning and doing paperwork to track your trades for planning purposes and for taxes. You’ll need to trade often and pick the right times. You’ll need to be right about not just what stocks will go up or down but when.
This is a poor use of your time and effort. If you use stocks for entertainment, you might do this with a little bit of your investment money. Having most of your money sitting in boring mutual funds while you trade with a portion would be a good idea if you choose this path.
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Disclaimer: This blog is not meant to give financial planning or tax advice. It gives general information on investment strategy, picking stocks, and generally managing money to build wealth. It is not a solicitation to buy or sell stocks or any security. Financial planning advice should be sought from a certified financial planner, which the author is not. Tax advice should be sought from a CPA. All investments involve risk and the reader as urged to consider risks carefully and seek the advice of experts if needed before investing..
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