Most investors know the old adages about diversifying their portfolios and buying for the long term — and both of those recommendations are still true. But before you get into the stock market, it is important to brush up on current trends, the changing economy and evolving industries, whether you’re a smart investor who is active in managing your own 401(k) or a beginner investor identifying your short- and long-term financial goals.
For investors, stocks provide a unique opportunity to participate and share in the success of businesses around the world. By investing in stocks, you are buying into a company and giving the company money to build, pay employees, conduct research, expand or launch a new product. When the business succeeds and makes a profit, you — a part owner — profit too; likewise, if the company fails, you could lose money.
Planning stock purchases responsibly likely won’t make you rich right away, but small, regular investments can be parlayed into impressive returns given enough time. Conduct due diligence, do your homework, develop a plan and implement a strategy before you invest in stocks. Here are four investing tips to apply to your plan.
Smart Ways to Invest in Stocks
1. Pick Stock Indexes, Not Stocks
Indexes are imaginary portfolios that represent specific markets or portions of markets. Indexes use weighted averages to measure the overall health and status of an economy or a market. Among the most famous of these indexes is the Standard & Poor’s 500, which is a collection of 500 of the largest and most heavily traded public companies. The S&P 500 is the most widely used benchmark of the overall stock market.
Trying to pick individual stocks is a dangerous gamble in which the odds are against the investor, according to The Wall Street Journal. For example, even though the S&P 500 earned a robust 11 percent in 2014, 125 of its 500 holdings lost value during that time.
Average investors can do better by investing in whole indexes instead of individual stocks. Index funds are baskets of stocks that mirror the exact holdings of a given index. When an investor buys an index fund, that investor shares the returns that the index earns — without having to spend the time, effort and, of course, money that would be required to replicate the index with the piecemeal purchase of its securities.
If an investor buys shares in one of the many index funds that mirror the S&P 500, for example, the investment is instantly diversified with shares of 500 stocks. If the S&P 500 index rises or falls, so does the investor’s portfolio.
Why Index Funds Are Better Than Mutual Funds
Historically, the S&P 500 has earned annual average returns of 10 percent since 1928, which is far better than any bond, savings account and the overwhelming majority of mutual funds. In fact, fewer than 20 percent of mutual funds have even matched the S&P 500’s performance over the last 10 years, according to The Motley Fool.
Moreover, mutual funds are managed by professionals who take a hefty fee for their services. Index funds only mirror the holdings of their index, meaning no one is paid to make decisions about what stocks to buy or sell. This structure is called passive management. Passively managed index funds are almost always far less expensive than actively managed mutual funds.
2. Use Dollar-Cost Averaging
Most advisors counsel investors — especially novice investors — not to attempt to time the market. In fact, even most professionals are unsuccessful when trying to predict market fluctuations. There are, however, mechanisms that have proven to be reliable for investors attempting to anticipate the cyclical nature of the market. When the dollar falls, the price of gold is likely to rise, for example, according to Market Realist.
But successful investors like Warren Buffett have proven that buying good, well-researched investments, and holding them essentially forever, is a strategy that is more likely to breed solid returns, according to Forbes. If you’ve decided to buy an index fund and hold it for the long term — no matter how the market behaves — you’ll want to grow it by contributing to it regularly. Enter dollar-cost averaging.
Dollar-cost averaging is a strategy of investing a fixed amount of money on a regular schedule without regard to the price of the stock or fund. Because you are buying more when it is cheap and less when it is expensive, eventually the price per share will drop. Investopedia gives this example:
- You invest $100 a month in your index fund for three months.
- The first month, your fund costs $33 per share, so you buy three shares.
- The second month, your fund loses value and only costs $25 a month, so this month, your $100 buys four shares.
- The third month, your fund drops even further to $20 a month, so this month, your $100 buys you five shares.
- In total, you’ve bought 12 shares at an average of $25 per share.
In the end, dollar-cost averaging mitigates the risk of investing too much at the wrong time and guarantees investors will buy more when shares are cheap and less when they are expensive.
3. Consider Investing in Dividend Stocks
Some companies distribute a portion of their earnings directly to their investors. These payouts, which are determined by the company’s board of directors, are called dividends. Dividends can come in several different forms, most commonly cash and stock.
Not all companies offer dividends. Most young startups or high-growth companies do not because they are forced by necessity to reinvest every dollar back into their own operations. Larger companies often give dividends to keep their shareholders happy. Once paid, shareholders have the option of reinvesting their dividends back into their portfolios or treating these incremental payouts as a stream of income.
Because dividend stocks are often issued by large, reliable companies, they generally provide a degree of security and predictability to investors who might be seeking to balance more volatile securities contained in their portfolios. But on top of that benefit, dividend stocks have historically outperformed other investments, all without the added volatility.
According to Forbes, investors don’t have to stray too far off the beaten path to find stocks that pay fat dividends. AT&T and Lockheed Martin, for example, are just a few of the “safe” blue chip stocks that reward shareholders with hefty dividend payouts.
4. Rebalance Your Portfolio Every Year
You could achieve extraordinary diversity with the purchase of just one index fund and set up an automatic dollar-cost averaging contribution schedule with your broker. This plan would make your portfolio a self-sustaining machine that continues to grow over time. You could literally just set it and forget it. But you shouldn’t.
Your portfolio changes over time whether or not you make any changes because some of your investments will do well over time and others will not. The more successful investments will incrementally begin to dominate ever-larger portions of your portfolio, according to investment research and management firm Morningstar, Inc. An often-overlooked necessity for any portfolio is an annual basic maintenance routine called rebalancing, which is an adjustment that brings your portfolio back to its original level of asset allocation.
Rebalancing controls your risk exposure and makes sure you are not too heavily dependent on the success of one investment or group of investments. Like real estate in 2007 or technology company stocks in 1999, the workhorse of your portfolio today could be its boat anchor tomorrow.
Old Stock Investing Rules That Still Apply Today
Some investment strategies are new but a few old rules are timeless. First, invest early and often. The time to start investing is right now because the more years your investments have to grow, the more your returns will compound. According to CNN, someone who starts investing $19 a week — or $1,000 a year — at 8 percent growth when they are 25 years old can stop investing when they are 35 and still have $169,000 by the time they turn 65.
If that same person waited to make the same investment at 35 years old, however, they would have to keep investing all the way until they were 65 — that’s three times as much time and money — only to end up with just $125,000.
Also, avoid fees wherever you can. Brokers take a commission with every trade, so trade as infrequently as possible and trade with the lowest-fee broker you can find. Look at the fee schedule in the prospectus of any fund you buy — managers’ fees and loads can quickly erode any gains.
Finally, stay informed. Investigate every investment you are considering and verify any advice you get from a financial advisor, broker or friend. Resources like Investor.gov can be a great place to start, but you should continue researching and learning as long as you’re investing. As your knowledge base grows, so can your portfolio.