Stocks are an essential component of investment portfolios due to their potential for long-term growth, surpassing other asset classes like bonds and commodities. However, high upside potential also comes with a certain level of risk. The economy and stock market experience cyclical corrections that can result in significant losses if stocks are sold at the wrong time.
Despite the risks, the stock market has historically generated positive returns. A reliable indicator of the U.S. stock market’s health is the S&P 500 Index. Over the period from 1996 to mid-June 2022, the S&P 500 had an average unadjusted return of 9%, according to a report by McKinsey & Co in August 2022. Interestingly, during the same period, the S&P 500 only experienced annual declines in returns five times.
Investing in the stock market for the long term and not getting distracted by short-term fluctuations can be advantageous. However, successful stock market investment also requires considering other factors. Determining your risk tolerance, comfort level with short-term losses, and investment goals are crucial aspects of this process.
A general rule of thumb is that the longer your time horizon, the more risk you can take on. It’s important to strike a balance between risk and time frame; taking on excessive risk with a short time horizon may hinder your ability to achieve investment goals, particularly if your investments encounter a downturn.
Opening an investment account
Investing in the stock market begins with the crucial step of opening an investment account. These accounts come in three main types: taxable brokerage accounts, employer-sponsored retirement accounts, and individual retirement accounts.
For individuals aged 18 and over, a taxable brokerage account can be easily set up with an online brokerage. This allows you to start buying and selling stocks. You have the option of either depositing money into a cash account to use for stock purchases or opening a margin account, which enables you to borrow money from the brokerage to invest in stocks.
Employer-sponsored retirement accounts are another popular option, provided by many companies to their employees. Examples include 401(k) plans and 403(b) retirement accounts. With traditional 401(k) plans, investors can make tax-free contributions, and some employers even match a portion of their employees’ contributions, up to a certain percentage of their salaries. However, it’s important to be aware of withdrawal restrictions and penalties associated with these retirement accounts.
An alternative to employer-sponsored accounts is an individual retirement account (IRA). The maximum annual individual contribution to a traditional IRA is $6,500 or $7,500 for those aged 50 and older in 2023. The tax deductibility of your IRA contribution depends on various factors, including your income and whether you have a retirement plan at work. For example, if you earn $73,000 or less for your adjusted gross income and file as “single” or “head of household,” you might be eligible to deduct the full amount of your contribution.
Determine your stock strategy
Once you open an investment account, one of the key steps is to choose a stock market strategy that aligns with your personal investing goals, time horizon, and risk tolerance. While the concept of buying low and selling high seems simple, the actual process of selecting winning stocks and timing the right moments to buy and sell can be quite challenging.
Nicholas Colas, co-founder of DataTrek Research, emphasizes that investing is never truly easy, even though historical returns might make it appear that way. The stock market is a dynamic place with numerous buyers and sellers at any given time. However, human beings have inherent psychological biases that can hinder making smart and rational decisions, especially when significant amounts of money are at stake.
Interestingly, sellers who have a pessimistic view and predict a downward trend in the stock market might appear more knowledgeable or informed than buyers. It may seem as though they possess a secret insight that other investors lack. But as Colas points out, there will always be a bearish case.
In the end, successful investing often boils down to a crucial decision: whether to focus on sounding smart or actually making money. This highlights the importance of balancing knowledge and expertise with sound investment decisions.
Here are some common stock market investing strategies:
Buy-and-hold investing is a straightforward and low-risk strategy suitable for long-term investors. Instead of focusing on day-to-day or even yearly returns, investors construct a diversified portfolio of high-quality stocks and/or exchange-traded funds, aiming to ride out long-term market trends through various market conditions. Economic recessions or bear market downturns do not deter these long-haul investors as they have a longer time horizon in mind.
For buy-and-hold investors, bear markets can present an opportunity. When there is a prolonged drop in investment prices, known as a bear market, it represents a chance for contrarian and long-term investors to add equities exposure at more attractive valuations. The concept of “buying the dip” during market downturns has been popularized by successful investors like Warren Buffett and Bill Ackman, who believe in staying invested through market cycles.
swing trading involves capitalizing on short to medium-term swings in stock prices. Swing traders look to profit from the momentum that stocks gain when they break out of trading ranges to reach new highs or lows. Utilizing stop-loss orders, swing traders can automatically close out trades if the stock loses its momentum and reverses direction. Analyzing price charts to identify patterns and tendencies is a common practice for swing traders to anticipate how a stock will react under certain circumstances.
Day trading is an action-packed and highly active strategy where investors buy and sell stocks multiple times within the same trading day to capitalize on small fluctuations in stock price. Day traders focus on intraday volatility—the ups and downs of equity prices between the market’s open and close on a trading day. One popular day trading strategy is scalping, involving numerous minimally profitable trades instead of a few larger ones. Successful day traders employ multiple strategies and quickly adjust them based on market conditions.
However, day trading is widely considered the most challenging and least successful method of investing. Studies have shown that only a small percentage of day traders manage to make profits consistently over time. Many individuals find it nearly impossible to day trade for a living, despite the claims made by some proponents of this approach. Discipline and the ability to admit mistakes quickly are crucial for those who attempt day trading as an investment strategy.
Stocks that offer dividends are an attractive option for investors as they provide regular direct cash payments. These dividends are a way for companies to reward their loyal shareholders. The average dividend yield for companies listed in the S&P 500 index stands at 1.6%. However, there are some companies within the S&P 500 that offer even higher dividend yields.
Dividends are not the only factor to consider when evaluating a stock’s potential. Investors should also analyze the company’s growth prospects, financial performance, and overall market conditions. While dividends can be attractive, it’s essential to have a well-rounded investment approach and consider various factors before making investment decisions.
Examples of high-dividend stocks
|Pioneer Natural Resources Co. (PXD)||14.9%|
|Coterra Energy (CTRA)||9.0%|
|Devon Energy Corp. (DVN)||7.6%|
|Altria Group (MO)||8.3%|
Dividend reinvestment plans
Dividend reinvestment plans, known as DRIPs, offer investors a powerful way to benefit from dividend compounding. By participating in a DRIP program through your brokerage, you can automatically reinvest any dividend cash payments to acquire additional shares of the dividend-paying stock. This setup enables you to capitalize on the potential for increased market returns and more dividends with each payment you receive. Notably, Hartford Funds highlights that an impressive 84% of the S&P 500’s total return since 1960 can be attributed to reinvested dividends.
DRIPs are designed to provide a seamless process for investors to grow their investment over time. As dividends are reinvested into more shares of the same stock, the overall investment base expands. Consequently, future dividend payments are calculated based on a larger number of shares, resulting in a compounding effect that can significantly enhance returns over the long term.
One of the key advantages of DRIPs is that they eliminate the need for investors to actively time the market or make decisions about when to reinvest their dividends. By automatically reinvesting dividends, investors can benefit from dollar-cost averaging, which smoothens out the impact of market fluctuations and may lower the overall average cost per share.
One effective method to mitigate the inherent risks of investing in the stock market involves diversifying your portfolio. By spreading your investments across a wide range of stocks, you can lower the risk associated with each individual stock and company.
A convenient and rapid approach to achieve diversification is by investing in stock mutual funds, exchange-traded funds (ETFs), or ETFs. These investment vehicles provide access to a diversified pool of dozens, hundreds, or even thousands of stocks, simplifying the investment process for individuals.
For instance, the SPDR S&P 500 ETF Trust (SPY) stands out as the world’s largest and most popular ETF. It grants investors exposure to all 500 stocks listed in the S&P 500, with an approximate share price of $390.
It’s essential to recognize that there are subtle differences between mutual funds and ETFs. These differences encompass various aspects such as management, trading, and tax treatment. Thus, investors should take the time to understand these distinctions before making investment decisions.