2 questions to ask yourself before investing in the stock market
If you want to build wealth, it is almost guaranteed that you will need to invest in stocks. Sure, you can invent the next hit mobile app or make money by becoming an influencer on Instagram, but for people earning a paycheck, regularly investing money in stocks is the best way to build up a nest egg.
On average, the global stock market returns around 7% per year, a rate that would double your initial investment in just over 10 years. The catch is that over the course of a year, stocks almost never return 7%.
Let’s look at the Standard & Poor’s 500, an index of 500 major companies listed on US stock exchanges, also known as the S&P 500 for short. It is considered an indicator of the US stock market as a whole.
In 2020, the S&P 500 gained 16.26% after delivering a whopping 28.8% in 2019. But for 2018, not so good: a loss of 6.24%. Beginning in 2000, the index hit investors with three consecutive years of double-digit losses, followed by four years of gains ranging from 3% to over 26%. This is what investment experts call volatility.
The volatility means equity investors need to take a disciplined, long-term approach to the market that aligns with their goals, time frame and ability to sleep through the night, even though stocks have fallen 20% this week ( also called risk tolerance). Over the long term, stock values tend to rise and beat inflation, even if recovery from a period of losses takes several years.
Any investment expert can tell you where stocks will be in 20 years – up – but no one really knows where stocks will be in six months. As one anonymous trader advised, “It’s time, not timing, that makes money in the market.”
Bottom line: you need to invest in stocks over time to build wealth. Stocks tend to beat inflation over the long term and can make money for a disciplined investor who takes the time to understand how things work.
When deciding where to start investing, you have a few choices to make:
Taxes, no taxes or taxes later?
You can start investing in a simple account with a brokerage firm or an online financial company. Your profits will be taxed, but you may be able to deduct some of your losses. Or you can invest through an Individual Retirement Account (IRA) – a type of retirement account where contributions could be tax deductible in the year you make them. Or you can use a Roth IRA to invest after-tax money and avoid being taxed on your retirement earnings or withdrawals. You can invest up to $6,000 in all of your IRAs combined for 2022, $7,000 if you’re over 50.
Individual stocks or funds?
Investing in large groups of stocks through a mutual fund or exchange-traded fund (ETF) reduces your risk and diversifies your profit opportunities. That doesn’t quite give the boost to, say, buying Tesla stock at $69 in November 2019 and skyrocketing to $795 per share in less than two years. On the other hand, shares of the former General Motors Corp. once traded above $90 before plummeting to 75 cents and then collapsing, wiping out all of the automaker’s shareholders when the company filed for bankruptcy in 2007. Exciting, yes, but no fun (or profit ) at all.
Mutual funds and ETFs invest in a wide range of stocks. Some focus on different sectors of the economy, while others focus on stocks that are good deals or companies with the best growth potential. If you are investing through a 401(k) or other workplace plan, you will be limited to mutual funds offered by your employer.
If you want to trade individual company stocks, consider limiting this activity to no more than 5% of your investments. A good option is to buy shares of companies that sell shares directly to the public through a direct purchase of shares plan. These are usually large, well-established companies with regular dividends that investors can reinvest in fractions of new shares.
Some brokerages will require a minimum investment of $1,000 to $2,000, but you can open an account on several online platforms for free with no minimum investment.
A good place to start investing is a fund that tracks the S&P 500, investing in all the companies that appear on the index. Management fees will be minimal and you will capture the general direction of the entire US stock market. Make a regular, automated weekly or monthly investment, say $50 a payday, keep your hands free, and fasten your financial safety belt.