Stocks are one of the most well-known asset classes to invest in. Putting your money in the stock market is a great and reliable way to compound your wealth and make a fortune thanks to the principle of compound interest and therefore, exponential returns.
The following chart shows the performance of the S&P 500, a market-capitalization-weighted index of the 500 largest U.S. publicly traded companies:
Every dollar invested in 1980 would be worth more than 50 dollars today. Any invested amount of money would have increased by 5000%. That’s a return, which no other regular asset class can provide.
The average return of the S&P 500 since inception, heads towards 10%. If you compare that to current treasury bonds (2.69%) and online saving accounts (2.20%), you can already see why stocks enjoy such a massive amount of popularity.
Therefore, it is no surprise that investing in stocks is considered for everyone who is looking to build serious wealth over the long term.
This guide is going to walk you through the different steps, to help you get started investing in stocks as a beginner.
The Difference Between Speculating and Investing
You may have already heard of terms like ‘day trading’ or ‘swing trading.’ Those are other approaches, where people also put their money into stocks, but they are entirely different from investing. This path is certainly not the best way to go if you are looking for a less risky and more consistent return over the long term.
Trading is based on technical analysis where people try to predict the behavior of stock prices within an extremely short period (often days or weeks). They are essentially speculating with their capital on the stock market.
Your chances to make a consistent return out of trading are very low because you are technically playing against all the professional traders on wall street, who are provided with much more financial and technical advantages.
On the other side, investing requires you to buy and hold businesses for a longer time horizon in order to achieve positive returns through a dividend or capital gain.
This approach is less risky because stock prices don’t fluctuate that much over a longer time horizon. Investors also call that volatility.
You simply invest your capital in great companies which can make you money as any other business does for its owners.
That’s essentially what you are doing by buying stocks. You become an owner of a company by purchasing a stake in it.
Choosing Your Investment Type
In general, there are two types of investors. Before you start investing, it would be wise to determine what kind of investor you want to be in the first place.
Passive investing is mostly referred to index investing whereas people invest their money in indices like the S&P 500, DJIA, or NASDAQ. The purpose of passive investing is to minimize your trading actions by completely relying on the market’s performance.
Some benefits of index investing are:
- Lower cost, index funds, and ETFs have meager fees which do make a significant difference on your return in the long run.
- Diversification, by index investing, you invest in the whole market, your risk is automatically being spread out over all kinds of companies and industries.
- Minimal effort, there is no analysis or decision-making and therefore, time which has to spend, because index funds seek to track the market while investors stay passive.
Investing in an index like the S&P 500 is what can be recommended for most people. The average annual return of the S&P 500 over the last 60 years is approximately 8%, which is already great when you consider the time and effort that has to be put in for that return.
According to data from Bank of America Merril Lynch, nearly half of the stock market consists of passively managed funds. Passive investing is getting more and more attractive for many investors, and there are good reasons why it may also suit you. However, the only way to achieve a greater return than the average is to beat the market. This can only be done with active portfolio management.
Active investing requires you to either invest in an actively managed fund or to pick individual stocks for yourself, which automatically includes a lot of time of learning and understanding of how the stock market works and to analyze and find attractive companies that can be bought at proper times.
It is not easy to beat the market. In fact, according to statistics from SPIVA, around 82% of active funds underperformed the S&P 500 over the last five years, while only 18% managed to outperform the market
Benefits of active investing are:
- Much more flexibility, only because indices cover a large proportion of the stock market, it doesn’t mean that all those companies are good, active investing allows to choose individual stocks which could have the potential to be hidden gems within the market.
- Possibly higher returns, the greatest investors didn’t get to their current wealth just by passive investing, Warren Buffett consistently outperformed the market with an average return of about 21% over the last decades.
People who are much interested in stocks shouldn’t be discouraged to actively manage their own portfolio. While the majority of actively managed funds are underperforming the market, it has to be said that professional managers have to deal with many difficulties and disadvantages that small investors don’t have.
Following the teachings of famous investors like Warren Buffett, Peter Lynch and several others can make you a great investor as well, but as already mentioned, it does take a lot of time and effort.
Taking Further Steps
After deciding whether you want to be active, passive, or imply a mixture of both, it is time to invest in yourself. Reading books and articles, taking courses or listening to podcasts are the common ways to get a deeper understanding of specific investment strategies that you want to follow.
Examples of steps for passive investors:
- Comparing different funds regarding their costs and options.
- Reading reviews about several brokers to find the best suiting for one’s personal circumstances.
- Finding out which index to pick.
Examples of steps for active investors:
- Reading books from famous investors to learn from their experience.
- Learning how to analyze businesses and understand their balance sheets.
- Interact with other active investors to share different points of view.
Investing in stocks doesn’t have to be complicated and risky. The stock market has turned dollars into millions, and everyone who can, should consider the opportunity to let their wealth get compounded as soon as possible.