What does it really mean to invest in the stock market? When you purchase stocks, you are really buying a piece of a business or industry. Even though many people, including investment professionals and some of your friends, relatives and business associates may recommend this practice, there are good reasons and bad reasons to make this investment. Consider these advantages and disadvantages before investing in stocks.
Stocks generally fall into two different categories:
- Common stock: When people talk about investing in the stock market, they are usually referring to buying common stock. When you own common stock, you get one vote per share when electing your company's Board of Directors. Over the long-term, common stock — by means of capital growth — yields higher returns than almost every other form of investment.
- Preferred stock: You will still own part of a company with preferred stock, but in most cases, you will not get the same voting rights as you have with common stock. In addition, with preferred shares, investors are usually guaranteed a fixed dividend (unlike common stock, which offers variable dividends that are never guaranteed).
Stocks can be purchased individually or within a mutual fund. Here are the differences:
- Buying shares in a stock: When you buy shares in an individual stock, you are buying a small piece of that company. When its shares rise or fall in value, your own holdings rise and fall commensurately. Any dividend payout is made directly to you, based on your proportional stock ownership. When buying individual shares like this, experts generally advise that you diversify your holdings among many companies, so that poor market performance by any one of these companies will not unduly harm the value of your portfolio. Put simply, when you invest in individual stocks, you are on your own.
- Buying shares in a stock mutual fund: When you buy shares in a mutual fund, you are buying shares in a large, diversified portfolio of individual stock issues. You are also buying professional management and administration of the fund. There are two main types of stock mutual funds: Actively Managed and Index. Actively managed funds employ the judgment of professional money managers who buy and sell stocks with the intent of maximizing portfolio return. Index funds, on the other hand, use computer trading programs to simply replicate an existing stock index, such as the S&P 500. All mutual funds charge fees for management and administration of the fund. Actively managed funds have higher expenses and payroll, so they assess higher fees than index funds. Some mutual funds also charge sales fees, known as loads. Put simply, when you invest in a stock mutual fund you have the benefit of broad portfolio diversification, along with management by a large investment company.
Benefits of investing in stocks
- Limited liability: The advantage of investing in common stock is that you can only lose the amount of money you put into the stock and no more. This is encouraging for the investor who fears owing money to creditors should the business they have backed go bankrupt.
- You can make a lot of money: It is true! Compared to bonds or certificates of deposit, where you know exactly how much you stand to gain, the stock market offers unlimited earning potential. For example, if you had invested $1,000 in Apple stock ten years ago, it would be worth more than $50,000 at the time of this writing.
Disadvantages of investing in stocks
- You can lose a lot of money: If you have invested in a company whose stock value falls sharply – or worse yet, goes bankrupt -- you may lose a great deal of money. In the case of bankruptcy, you can lose everything, because — unlike preferred stockholders, bondholders and other debt holders — common stockholders are last in line to receive money after a business liquidation. Because of this risk of substantial loss with any one company, it is wise to diversify your stock investments among many companies.
- Long time to recover losses: If you should lose a substantial amount of money in the stock market, it could take years to get your investment portfolio back on track. In some cases, you may never reach that point. So if you plan to invest in stocks, be prepared to stay in the market for the long haul. As you get closer to retirement, many experts suggest that you begin allocating more of your funds into less risky investments such as money market funds, as you will have less time to recover potential stock market losses. Let the free Retirement Planner by MoneyTips help you calculate when you can retire without jeopardizing your lifestyle.
- It is a time-consuming affair: Watching over your stock investments can be very time-consuming, and some investors can become fixated by it. Pay attention to what is going on in the market, but leave your investments alone on a day-to-day basis. Just because you can use your work computer to check your portfolio's value one hundred times a day does not mean that is the best use of your time! Over $5 trillion, 20% of all US stock investments, are placed into mutual funds today, which tend not to be as volatile as individual stocks. The safety of diversification, combined with professional management, is very appealing to many investors.
Investing in stocks can be a rich, rewarding and fascinating experience. However, before you take the plunge, be sure to do your research. There are literally hundreds — if not thousands — of books written on the subject of investing in stocks, not to mention the wealth of information from business news stations and the web.
While direct investing in stocks is not for everyone, if you make the right choices and get out at the right time, you could increase your financial standing in ways you never imagined possible. And if direct investing is too intimidating -- or time-consuming -- for you, it is easy to invest in one or more stock mutual funds. The wisdom of investing in the stock market has been proven repeatedly, for stocks outperform all other asset classes over the long haul. Consequently, if you have time to weather the short-term gyrations of the market, your stock investments are likely to reward you in the end.