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How to start investing in stocks
Just starting out on your investment journey? Read this post to learn about the stock market, indices, ETFs, and mutual funds!
Disclaimer: I am neither a CPA nor a CFP. All opinions represented in this post are my own and are meant for you to learn the basics of stock investing. Any mention of particular equities is not to be construed as an indication to invest in those equities, but you can look into them and see if they are equities you'd like to invest in.
If you're a beginner, investing in stocks is hard. How do you know what to pick? What allocation should you use? What do "market cap", "ETF", and "NASDAQ" mean? Not to worry, padawan. I shall show you the ways of the Force, er, um, the stock market.
Before we jump into the basics, I just want to state that "investment" is a very broad term. When applied to finance, it's usually referring to allocating your own money into certain ventures or equities with the expectation that your initial allocation will rise in value. In other words, you want to increase the amount of money you have instead of just holding onto cash (and, as you'll see in this post, you'll actually want to invest some money anyway because with inflation, the value of your cash will drop over time).
What does "diversify your portfolio" mean?
There are a variety of investment vehicles and they differ in risk as well as reward. In an ideal world, you could minimize risk while maximizing reward, but there is usually a spectrum: take on more risk and you can maximize your reward (but also have potential loss), take on less risk and your potential reward is lower (but potential loss is also lower). If you choose something like cryptocurrencies, they have a lot of volatility (meaning they can swing very wildly up or down in value), but they could potentially be a good long term play. For example, if you think that in the long term, a cryptocurrency like Bitcoin will rise faster than some other investment vehicle, then maybe you will allocate some of your money into Bitcoin.
Possible investment choices include but are not limited to:
ETFs (Exchange-Traded Funds)
Small startups (through angel investing)
First, what is a portfolio? A portfolio is a collection of assets an investor has (this includes cash). When people say to "diversify your portfolio", they could be referring to the types of investment vehicles you choose, as well as within an investment vehicle type, which equities you allocate your money into. For example, a diversified investor could own real estate, as well as stocks, and in his/her stock ownership there could be companies of all sizes and in a variety of sectors. In this way, the investor has spread out, or "diversified", his/her allocations of cash into different investment types and specific equities.
Why not just hold cash?
Excellent question. From every paycheck, after taxes are taken out (refer to this post to see how taxes work), the remainder is deposited into your bank account. Nice! But, that money is just sitting there, not growing.
Over time, there is a thing called inflation that is eating away at your purchasing power. Inflation can be observed by tracking increases in the average price level of a basket of goods. By "basket", I just mean "a bunch of consumer products whose price can be tracked regularly". So if inflation is at a non-zero rate, what it means is that over time, the prices of goods are increasing. But your money is not increasing in value (because it's just cash), so you're able to buy less in the future than you can now.
This is horrible! What are we to do to make sure our purchasing power does not erode?!
Investing is the answer!
For this post, I am going to focus on stocks, which would cover "Individual Stocks", "Mutual Funds", and "ETFs" in the above list.
Baby Step 1: What is an individual stock?
An individual stock is exactly what it sounds like: a unit of equity for one company. If you want to buy shares of Apple, you would buy AAPL. If you want to buy shares of Disney, then you would buy DIS. Notice that the lengths of stock tickers do not all have to be 4 characters.
Buying individual stocks is perfectly fine, especially if you are quite bullish on a company (but still, do your research). However, there's some risk involved in that because you are consolidating money into only 1 or a small number of equities. Also, what if you just didn't know what to pick?
There's another stock investment vehicle that we should consider called an "index fund", which will allow you to diversify your risk (there's that word "diversify" again!) by spreading some money across multiple equities. Before we get into index funds, we need to first discuss indices.
Baby Step 2: What are indices?
There are literally thousands of stocks, mutual funds, and ETFs (we'll get to mutual funds and ETFs later in this post) you can trade. In order to make sense of it all, indices were created to track particular groups of equities. Charles Dow launched the first stock index, called the Dow Jones Transportation Index, in 1884, and it was made up of 11 transportation companies (a large majority of them were railway companies). This index is still in use today, under the ticker symbol DJT!
Ticker symbol: This term comes from the ticker tape that would run in exchanges, showing the values of particular equities during a trading day. To shorten names of equities, "ticker symbols" were created, like "AAPL" for "Apple".
The DJT predates the Dow Jones Industrial Average (DJI), a price-weighted index that tracks 30 large, publicly traded blue-chip companies. "The Dow", as it's commonly referred to, is widely considered to be a signal of health of the U.S. stock market.
Definitions Aside: Price-weighted: Each company in the index is weighted by share price. Blue chip companies: Mature, established, stable leaders in their industries who frequently give out dividends.
Two other important indices are the S&P 500 (^GSPC, .INX) and the NASDAQ Composite Index (.IXIC). The S&P 500 tracks the 500 largest publicly traded U.S. companies. The NASDAQ Composite tracks more than 2,500 companies, the majority of which are tech companies, but there are some other sectors too, such as financial and consumer.
Aside: Those of you shrewd readers may be wondering why I didn't initially say "the NASDAQ". "The NASDAQ" can either refer to the National Association of Securities Dealers Automated Quotations, which was the first electronic exchange, or the NASDAQ Composite Index, which is an index. From this point on, I will refer to the NASDAQ Composite by "the NASDAQ".
As for why these indices have such unguessable ticker symbols, or why the S&P 500 has multiple tickers, I have no clue (note to self: research this so you can have it in your back pocket at a dinner party 🤣). The important thing to remember is the names of the indices so you can search them by name in a service like Google Finance, or Apple's Stocks app.
Beyond the Dow Jones Industrial Average, the S&P 500, and the NASDAQ, there are many other indices. For example, there is one called the VIX, which indicates volatility in S&P 500 index options (and is therefore sometimes referred to as "the fear index"), but the VIX is a topic for another post.
So now that we know what indices are, and we can see that they track multiple equities in one place, sounds like they would be a fantastic way to spread out risk without being an expert stock picker. We can just buy some stocks of those indices, right?
Not quite, padawan. The indices are just numerical representations of how the companies they track are performing. There is no underlying equity to buy. In order to "buy indices", we need to make use of index funds.
Baby Step 3: What are index funds?
Index funds are equities that you can trade which mirror particular indices. Meaning, they are made up of all the companies that are present within an index, with the same component weighting of each company in the index. When you buy an index fund, you are buying small amounts of each of the companies within the index the fund is tracking.
For example, the S&P 500 index has some popular index funds, like VFIAX, VOO, IVV, and SPY. VFIAX and VOO are both offered by Vanguard, but VFIAX is a mutual fund and VOO is an ETF. IVV is an ETF offered by iShares and SPY is an ETF offered by SPDR. All of these index funds are passively managed, meaning they automatically rebalance with the S&P 500 index component weightings (for example, if AAPL was initially 5% of the S&P 500 by market cap and then it changed to 5.1%, then these index funds mentioned above would automatically reflect that after a quarter or so).
Aside: Passively managed vs. Actively managed Passively managed index funds automatically rebalance, meaning there is no human-level intervention, or if there is, it's very minimal. Due to minimal human intervention, there's less upkeep required for these funds, so their expense ratios are quite low (think of "expense ratios" as percentage fees you pay for owning those funds). Actively managed index funds are called "active" because asset managers rebalance the funds. These kinds of index funds tend to have higher expense ratios because there is more effort required from the funds' managers.
The most popular index fund for the NASDAQ is QQQ, which is an ETF.
As for the Dow Jones Industrial Average, DIA is a popular ETF. DIA is offered by SPDR, like SPY. Note though that DIA is based on 30 stocks, so it can be a bit riskier than an S&P 500 index fund (since that is tracking 500 companies and thus risk is diversified).
Now, a natural next question you may be asking is "if mutual funds and ETFs are both basket equities, what's the difference between them?" Read on to the next section, Padawan 😁.
Baby Step 4: Difference between mutual funds and ETFs
As we observed in the previous section, the S&P 500 has multiple index funds that you can choose from and one of them is a mutual fund, whereas the others are ETFs. For both mutual funds and ETFs, you can select either passively or actively managed funds.
You'll frequently see mutual fund offerings that are passively managed within 401(k) retirement plan choices. Remember back to my earlier post about evaluating a SWE offer when I mentioned that your company will provide you with 401(k) plans and you can pick what to invest in, among a set of choices. Some of those choices will be mutual funds, normally created by the 401(k) provider, like Fidelity or Vanguard, for example.
Similarities between mutual funds and ETFs:
They both track multiple equities and offer a single basket equity for you to trade.
They both can be either actively or passively managed.
Differences between mutual funds and ETFs:
Mutual funds are only traded at the end of the trading day. If you place an order to buy or to sell, you will not see it execute immediately, but your brokerage will likely send you a notification after the end of the trading day stating the value you purchased or sold.
Unlike ETFs, some mutual funds may have minimum values to invest (meaning, you may have to put in something like $3000 to begin; double check the rules for the fund).
Mutual funds do not trade in shares: you can buy or sell an exact amount of the fund in dollars, which makes mutual funds a bit easier to work with if you are dollar-cost averaging (regularly investing some set amount of money at some cadence, like monthly or quarterly). Now that fractional trading is offered by nearly all brokerages, you can theoretically put in an exact amount of money into ETFs too, but you will get fractional shares, which some early investors might find a bit harder to keep track of.
Baby Step 5: Performance of different indices
Each of the major indices I mentioned in Baby Step 3 (the Dow Jones Industrial Average, S&P 500, and NASDAQ Composite) have all performed differently over various ranges of time. Try out this comparison I created on Google Finance to see how the indices performed over various time ranges. Especially pay attention to when they eclipsed each other. The criss-crossing that you see is part of the reason why it's important to diversify your portfolio. When one index is not performing as well as another, you can get gains from the second index.
Baby Step 6: Tying it all together
Okay, on second read, maybe this step is not as small as its title would suggest. But I will summarize:
There are different investment vehicles you can choose, stocks being one of them.
Indices can track multiple single equities across sectors and that index funds are mirrored on the indices they track. They offer a good way to diversify your risk while not having to pick different single equity stocks.
While both mutual funds and ETFs are basket equities (they represent a collection of equities), there are some high-level differences between them that may make them more or less suitable for beginners depending on their goals (dollar cost averaging, requirement to have minimum investment, etc.).
The indices all perform a little differently, so make sure that your portfolio contains a couple or so index funds that track different indices.
The first thing for you to decide is which brokerage platform you would like to use. There are many options, like Fidelity, Schwab, E-Trade, and Robinhood among others. Each brokerage comes with different features and ease of performing trades.
I personally use Fidelity and have for awhile because I like the design of their platform, both on web and mobile. I can see my entire portfolio at a glance and have the ability to drill into specific tax lots (batches of stock purchases) to see what their return has been since I bought them. I also think Fidelity's research tools are top notch. When I wanted to learn more about different ETFs and mutual funds for sectors I had not invested in before, I found it was quite easy to filter search results and see performance of various funds. In addition to brokerage accounts, you can also open a Cash Management Account and a Fidelity Visa credit card if you'd like. Lastly, I have found Fidelity customer service to be excellent. They have customer representatives who really want to help you learn how to be a financial master, while mitigating risk.
I have some friends who use Schwab, others in my network use E-Trade, and there's even a group of them that uses Robinhood. Your choice of brokerage is up to you, but make sure you do your research into any fees the platform charges. I'd also recommend researching the total breadth of the investment vehicles the platform can service. This way, as your investment knowledge grows, you have the ability to try out more complicated things like conditional orders.
After you decide which brokerage platform to use, start deciding on what asset mix you'd like. In other words, what percentage of your portfolio do you want to be single equities (and which ones), which percentage do you want to be for basket equities (and which ones), and lastly how much you'd like to maintain as just cash. This last bit is important to consider because if you have to move funds into your brokerage account, that can take time (transfers between Fidelity's Cash Management accounts and brokerage accounts are basically instantaneous, so that's just another reason I like the platform).
Once you've decided, this strategy is not set in stone. You can dial up investment in a particular equity or you could even make a bet on a new one if you'd like (but I'd recommend not just immediately placing a large investment in something new; do some research and dollar cost average yourself in). And you'll find that your initial asset mix will not be static anyway: as time goes on, the relative percentages of each equity will change as certain equities grow in value.
You now have the basics of stock investing! Give yourself a pat on the back! This was a fairly long post and you read through to the end like a warrior!
I hope that this post elucidated the often acronym-laden, esoteric world of stock investing to the point where you feel comfortable dipping your toes in.
The sky is the limit, padawan! You're on your way!