What to Invest in, Part I—Stocks, Funds, and ETFs
In today’s lesson, we’ll look at how you can invest in the stock market.
According to Investopedia, the stock market:
“…refers to the collection of markets and exchanges where the issuing and trading of equities (stocks of publicly held companies), bonds and other sorts of securities takes place, either through formal exchanges or over-the-counter markets.”
Put simply, the stock market is where you can buy and sell your stocks and bonds (we’ll talk about bonds in the next lesson).
When you purchase a stock in a company through the stock market, you essentially become one of the owners (along with other investors) of the company. You are a shareholder (or stockholder) of the company. Investors buy individual stocks because they believe that the stock price will grow, meaning that they can make a profit when they sell. They can make huge gains and sometimes a 100% return. However, if the stock price doesn’t increase and they sell their investment to reduce further losses, they will lose money. You also can earn an income from stocks if the company chooses to pay dividends (sharing profits with their investors).
When an individual wishes to invest in a company but doesn’t just want to buy a stock in one company, they can invest in a fund. A fund pools the money of many investors to purchase stocks in several companies, allowing investors to gain exposure whilst managing risk. Funds help reduce the risk of putting all your eggs in one basket. The performance of the fund depends on the performance of the companies invested through the fund. Funds can be divided into two categories: active and passive.
Active. An active fund is managed by a fund manager. A fund manager buys stocks in several companies that they believe will perform better than the companies in an index. When you buy an active fund, you’ll usually pay a fee of 1% or more.
Passive. A passive fund does not have a fund manager. Instead, a passive fund usually tracks an index. The fund invests in the same companies that make up an index with the aim of achieving the same returns. An index is used as a statistical measure of a segment of the stock market, e.g. the Standard & Poor’s 500 index (S&P 500) is an index of 500 stocks, seen as giving an indication of the strength of US equities. Since there is no fund manager to pay, a passive fund charges low fees.
Exchange Traded Funds (ETFs)
An exchange traded fund is similar to an index fund in that it usually invests in companies in an index but can be traded on stock exchanges, like stocks. What attracts investors to use an ETF over an index fund is that, like stocks, ETFs are priced continuously throughout the day, which enables investors to profit from short-term movements. There’s also the added benefit of being able to access less traditional markets, such as Brazil and Eastern Europe.
Income vs. Growth
People invest money in funds and shares to gain from capital growth and/or earn income. As such, many funds or shares available allow you to pick between achieving growth (growing your initial investment) and earning a regular income (receiving dividends with your capital invested and staying roughly the same value).
If you’re starting out in investing and want to grow your capital, it makes sense to invest in growth products, i.e. ones that don’t pay dividends. However, just because you’ve chosen a growth or an income approach, it doesn’t mean that you can’t change your mind. If your growth investment has performed exceptionally well, you can always create income by selling some of your holdings every year. If you’ve chosen to invest in dividend-paying shares or funds, you can always reinvest the dividends each year in new shares or funds to grow your pot instead of taking the dividends as income.
For all the investments from this lesson, a rule of thumb is to be committed to holding for five years. This is enough time to ride out a few bumps in the market. If you need access to your money sooner, consider investing in a different asset that we’ll explore in upcoming lessons.
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