How to Invest in Stocks: A Quick-Start Guide
We tell you everything you need to know to get started investing in stocks.
Investing your money in the stock market can be intimidating, but it doesn’t have to be!
The Motley Fool has been cutting through Wall Street jargon and giving people common-sense, actionable insights for over a quarter century.
First, let’s help you choose your adventure. Are you more #1 or #2?
“Just tell me which stocks to consider buying! I already have a plan, a brokerage account, an understanding of the basics of credit card debt, emergency funds, and asset allocation. ”
“Walk me step-by-step through The Motley Fool’s proven framework for money decisions, including investing in stocks.”
If you just want the stocks, proceed directly to the next section. If you want all the knowledge, save the next section for last.
Top Stock Ideas
We believe that the best way to invest your money in stocks is to buy great companies and hold them for the long term. The best investments don’t need you to check in on them daily because they are solid companies with competitive advantages and strong leadership. Patience is the secret to investing and making money grow.
You can do this the super-easy way by buying the entire market of stocks via index ETFs or index mutual funds. You can get exposure to virtually all the investable public companies in the world with just two low-cost ETFs. See them below.
Or you can try to beat the market by picking your own individual stocks.
Even if you do try to beat the market, the great majority of us are best served with having index funds as the core of our stock portfolio (think 50% to 90%).
For some of our best stock ideas to consider, start with a list of 20 stocks we recently compiled. It includes…
2 exchange-traded funds (ETFs) that work together as the core of any stock portfolio:
The first is a bet on the entire U.S. stock market, from the S&P 500 to smaller-cap stocks. The second is a bet on the rest of the world’s stock markets. A reasonable allocation for a U.S.-based investor would be something like 70%/30%.
The Vanguard Total Stock Market ETF (NYSE: VTI)
The Vanguard Total International Stock ETF (NASDAQ:VXUS)
5 stocks for beginning investors:
Intuitive Surgical (NASDAQ:ISRG)
Axon Enterprises (NASDAQ:AAXN)
8 dividend stocks:
Verizon Communications (NYSE:VZ)
Ford Motor Company (NYSE:F)
General Motors Company (NYSE:GM)
TerraForm Power (NASDAQ:TERP)
Brookfield Infrastructure Partners L.P. (NYSE:BIP)
CareTrust REIT (NASDAQ:CTRE)
5 growth stocks:
lululemon athletica (NASDAQ:LULU)
Constellation Brands (NYSE:STZ)
For analysis on each stock, read on: 20 of the Top Stocks to Buy in 2019 (Including the 2 Every Investor Should Own)
2 Priorities BEFORE Buying Stocks: High-Interest Debt and Emergency Fund
Yes, we love the stock market and believe it’s an amazing creator of wealth. But if you don’t do these two things with your money before investing in the stock market, you may regret it.
1) Pay Off High-Interest Debt
Under nearly every set of circumstances, the best use of your cash is to pay down high-interest debt (rule of thumb: interest 10% or higher). For most, that means credit-card debt.
It’s very easy to underestimate the power of compound interest combined with time.
A 20-year-old lucky enough to invest $10,000 and achieve the historical stock market average of 10% returns would be a millionaire before age 70. That’s multiplying your money by 100!
Unfortunately, that math works the same way in reverse. If you’re accruing 10% interest, $10,000 in credit card debt becomes $1,000,000 before age 70. At an all-too-common 20%, that dubious milestone is hit well before your 50th birthday.
2) Establish an Emergency Fund
Stuff happens — stuff that requires money to fix. (Think job loss, car transmission issues, medical bills, or anything else that Murphy or life throws your way.) If you don’t have that money on hand, you’ll have to improvise to make ends meet, which could mean patching over the problem with an expensive solution like a credit card (see above) or worse.
That’s why everyone should have an emergency fund — a cash hoard you can raid if unexpected expenses show up. Your emergency fund needs to be readily accessible in a high-yield savings account. Don’t expect to make a killing on this investment — the interest you can get on most savings accounts won’t even keep up with inflation — but the peace of mind it will buy is priceless.
How big should this essential investment be? Here are some basic guidelines:
If You … Then your emergency fund should cover living expenses for …
Have no dependents relying on your income 3 to 6 months
Are the sole breadwinner or work in an unstable industry 6 to 12 months
Are retired and living on a fixed income 5 years
While those suggestions may seem excessive, following them will put you in a position to stay the course in your investments, no matter what unexpected expenses come your way. It’s better to have it and not need it than need it and not have it.
Even beyond an emergency fund, because of the volatility of the stock market, any money you might need in the next five years DOES NOT BELONG in the stock market.
That money belongs in places like basic checking and savings accounts, high-yield savings accounts, money market accounts and funds, certificates of deposit (CD), Treasury bills, and bonds.
Keep in mind that one type of account may not best serve all of your short-term savings needs. For example, cash earmarked for a home down payment that you plan to make in a few years is ideal for something like a CD, while Junior’s summer camp tuition is better off in a high-yield savings account.
We realize at this point, your head might be spinning with all the choices. If it is, take a few minutes to read our guide to asset allocation. It slows things down and answers questions like exactly what percentage of your money to put into stocks.
Once you’ve deployed your funds for near-term needs, it’s time for the stock market!
Graph that moves up and to the right with increasingly large dollar signs underneath the curve.
How to Buy Stocks
Long-term cash — money you’re saving for retirement — belongs in accounts designed for that purpose, and it should primarily be in stocks. However, there are a number of different accounts in which you can hold your investments, and that maze of options can be confusing.
Let’s simplify. You have three broad options:
- 401(k) or a similar workplace retirement account
- Individual retirement account (IRA)
- Taxable account
Option 1: 401(k) or similar workplace retirement account
What if you could invest your money in a place where at least a portion of your contribution was guaranteed to double?
If you work full-time, you may have that opportunity through your employer-sponsored retirement account — your 401(k), 403(b), or 457. If your company offers one of these plans — with a company match — don’t pass up the free money! We typically recommend that you put your first long-term investment dollars into this type of account if it’s available. Contact your employer’s HR office to get started. Note that the company match often comes with a vesting period.
These plans allow you to contribute pre-tax money directly from your paycheck (within limits). As a result, your money grows tax-free until you withdraw it in retirement, and your contributions lower your taxable income for the year (which means a lower tax bill come April).
One catch is that you can’t withdraw the cash (except in special circumstances) before age 59 ½ without facing a steep penalty.
In addition to traditional 401(k)s, some plans also offer Roth 401(k)s. Like Roth IRAs, which you’ll read about below, you wouldn’t get an immediate tax deduction but your money grows tax-free and there are no taxes when you withdraw funds in retirement.
Unfortunately, some employers don’t offer a match, and some plans provide horrid investment choices and charge high fees. Be aware of the fees you’re paying for your 401(k), and don’t be afraid to choose different investment options if your plan is full of funds with high expense ratios and bad performance (assuming you’ve done everything you can to take advantage of your employer’s match).
Option 2: Individual retirement account (IRA)
Once you’ve maxed out your workplace retirement account (or, if it’s an atrocious plan, invested enough to get your employer match), divert your next retirement dollars into an IRA.
IRAs have one big advantage over workplace retirement accounts: They typically offer more investment options. However, Uncle Sam won’t let you contribute as much money to these accounts each year. And, depending on your income, you may not be eligible to participate fully — or at all.
Like 401(k)s, IRAs come in two garden varieties — traditional and Roth — and they offer different tax advantages:
Traditional IRA: Tax-wise, this account works just like a traditional 401(k) — the money you put into it is not taxed until you make withdrawals during retirement. Also, as with a traditional 401(k), you can deduct the money you contribute from your income, lowering your tax bill in the year you make the contribution.
Roth IRA: This account gives Future You a tax break. The money you sock away here is never deductible. However, come retirement, you get off scot-free — you pay no taxes on the gains or the principal when you withdraw the money. A Roth IRA also allows you to withdraw your contributions tax-free at any time for certain things, such as a first-time home purchase or education expenses, whereas with a traditional IRA, you’d not only pay taxes, but you’d also get hit with penalties.
Which one is right for you? Well, it’s not an either/or decision. Diversifying with both options makes a lot of sense.
If we had to choose one, we like the flexibility of the Roth. That said, the Roth is not necessarily the best choice for everyone. A lot depends on whether your current tax rate will be greater or less than your tax rate in retirement. Read more about choosing between a traditional or a Roth IRA.
Option 3: Taxable Account
If you’ve still got investable cash left over after maxing out all your tax-advantaged accounts, congratulations! The only special thing to know about taxable accounts is that … wait for it … they’re taxable; otherwise, you can manage these accounts very similarly to their tax-advantaged siblings. However, there are a few rules of thumb to follow when utilizing taxable accounts that might save you a few dollars.
1) Don’t invest in dividend stocks or bonds in a taxable account (if possible)
Dividends from stocks and real estate investment trusts (REITs), as well as bond coupon payments, are taxed at ordinary income tax rates. As a result, these investments are best held in tax-advantaged accounts. In these accounts, you can enjoy the benefits of their regular payments without having to pay a share of them back to the government through taxes.
2) Use taxable accounts for more tax-efficient investments
Tax-efficient investments include long-term, buy-and-hold vehicles such as stocks that pay few or no dividends, as well as tax-managed stock funds. You won’t pay taxes on these investments until you sell them, providing a built-in tax deferment (assuming you plan to Foolishly hold your investments for many years). When you do sell, the gains are taxed at the long-term capital gains rate, which is generally much lower than the rate for ordinary income tax.
Managing Your Money: Putting It All Together
We’ve presented the various choices above in a step-by-step way for simplicity. However, it gets messier when theory becomes practice.
For example, we list paying off high-interest credit card debt before starting a 401(k) at work. But behaviorally you might want to allocate a little money to start those automatic 401(k) payments even as you pay off credit cards.
It doesn’t hurt that there’s the match to think about, but there’s a human element, too. You want to guard against procrastination, and starting automatic savings from each paycheck is a good idea. It may be better to start with a small amount today and raise it as you pay off debts and shore up your emergency fund.
Consider how much more of your income you’ll have to save for a decent 30-year retirement the longer you wait.
Your Age Percentage of Income to Save*
80s Vegas, baby!
*Assumes you haven’t saved anything to this point.
For a more colorful example of how starting a 401(k) early can save you, read about this financially irresponsible guy.
Here’s another example of nuance. Because of tax advantages, we list retirement accounts like 401(k)s and IRAs ahead of traditional brokerage accounts. However, even if you’re not maxed out on your retirement accounts, there are flexibility considerations for having some money in a regular old taxable brokerage account.
How to Open a Brokerage Account
To buy stocks outside of a workplace retirement account, you’ll need a brokerage account. Think of a brokerage as the store where you shop for your stocks or funds.
You have three general choices for a brokerage: A full-service broker, a robo-advisor, and (our favorite) a discount broker.
Full-service broker: As the name would suggest, your stockbroker at these places provides personal service and advice on your portfolio. The downsides are that the fees (both explicit and hidden) are much higher than other choices and the broker’s incentives are often not aligned with yours (e.g. the way you make money is to buy-and-hold funds or stocks for the long term with the lowest-cost options. On the other hand, a broker can only make money at your expense, often through churning stocks or high-fee funds). Examples include Edward Jones, Raymond James, and Wall Street banks like Merrill Lynch, Morgan Stanley, Goldman Sachs, and Wells Fargo.
Robo-advisor: This is an option for people who don’t want to make asset allocation decisions for themselves, don’t want to pick individual stocks, and don’t mind paying a fee. The simplicity may help you get over the hump to start investing more quickly; however, even the relatively low fees they charge can hurt your returns over time, and there are much cheaper options like buying a target date fund via a discount broker. Examples include Betterment, Wealthfront, Ellevest, and SoFi. Many discount brokers are also getting into the game.
Discount broker: This is our favorite option because it minimizes fees and commissions while giving you the most flexibility. You can invest in ETFs or mutual funds, buy and sell individual stocks, and diversify further with other assets as well. There are many choices. There are differences in services and pricing, but the choices are far more tightly bound than the difference between choosing a full-service broker or robo-advisor vs. a discount broker. Examples include TDAmeritrade, E*Trade, Fidelity, Charles Schwab, Merrill Edge, Robinhood, and Ally Invest. Compare many of the most popular options at our broker center.
Investing With $100, $500 or $1,000 per Month
For those who like to think in budgeting terms, here’s another way to think about some of the concepts we’ve been discussing. Putting money into the market each and every month is a great way to invest. It helps make your investing automatic and allows you to dollar cost average into a market that goes up and down in an untimeable way.
How to invest with $100 a month.
How to invest with $500 a month.
How to invest with $1,000 a month.
Why We Prefer Index Funds to Actively Managed Mutual Funds
In an actively-managed fund, the mutual fund manager is picking stocks to try to beat the market. Meanwhile, an index fund simply buys the basket of stocks in an index like the S&P 500.
Why do we prefer the latter?
Investing in index funds (either through an ETF or mutual fund) provides instant diversification to your portfolio at an affordable price.
Plus, index funds charge very low fees relative to actively managed mutual funds, in addition to delivering superior returns on average.
Although mutual fund managers charge much higher fees for the opportunity to beat the index, few are actually able to outperform. According to data from S&P Dow Jones Indices, over the past 15 years, nearly 89% of actively managed U.S. equity mutual funds lost to their benchmarks.
As a result, investors in actively managed funds are often paying significantly more money in fees than their index-fund compatriots, only to receive returns that are the same — or, more commonly, worse. While some mutual funds do succeed in beating the market on a consistent basis, in most cases investors will achieve better returns net of fees by investing in index funds.
How to Pick an Individual Stock
We’ll warn you right now. This section is a bit of medicine, but if you’re trying to buy individual stocks and beat the market, you’re well-served by mastering these principles.
When you buy a stock, you’re buying a stake in a real business. A business where people go to work every day to make a living for themselves and their families and, if they’re lucky, make the world a little bit better. In the short term, a stock’s price might move up or down for any number of reasons: bad weather, political and military conflict, even something as seemingly insignificant as an executive’s Tweet. Over the long term, however (which is all that matters in investing), your profits or losses on a stock will depend on the output of the people who go to work for the company every day. Pay attention to what those people are doing, rather than the stock-market noise, and you’ll be positioned to succeed as an investor for the duration.
If you can identify the best companies, and do it early, you’ll be able to compound your wealth many times over. Here are a few traits to look for to identify great businesses:
Sustainable Competitive Advantages
The most successful businesses have unique, lasting competitive advantages that allow them to earn outsized profits consistently over time. Legendary investor Warren Buffett has famously compared a company’s competitive advantage to a castle’s moat, protecting the business from competitors hoping to raid the stronghold and compete away its profits. The more durable a company’s competitive advantage, the larger the “moat” that surrounds its financial fortress.
Because investors buy for the long term, and because any company making serious money will attract competitors, sustainability is the most important aspect of a competitive advantage. Sustainable competitive advantages often fall into one or more of five categories: brand advantages, technology advantages, network effects, scale advantages, and legally enforced monopolies (think patents).
1) Brand Advantages
Coca-Cola (NYSE:KO) is a prototypical example of a company with a brand advantage. Even though Coke isn’t radically different from store-brand cola, people will pay a premium for the Real Thing because of the relationship they, and society at large, have built with Coke’s brand over time. No matter how hard competitors try, they’ll likely never match the share of mind and feeling that people associate with Coke, making the business’s advantage particularly durable.
2) Technology Advantages
The best example of a technology advantage comes from Alphabet’s Google search engine. There were many search-engine companies when Google emerged, but none were able to match the quality of Google’s search algorithm. Because of the superior quality of Google search, more and more people flocked to it, in turn feeding and improving the company’s algorithm. As a result, Google was able to build a large, sustainable technology advantage, which has made it one of the most important companies in the world today.
3) Network Effects
Network effects are among the most powerful competitive advantages available to a company. A network effect is a phenomenon in which a product or service increases in value as more and more people use it. (Google’s increasing popularity, described above, is one example.)
In the public markets, Facebook provides the clearest example of a company with competitive advantages derived from network effects. As a social network, Facebook delivers value by connecting individuals and allowing them to communicate and form groups. Therefore, Facebook’s value depends on the number of users on its platform — after all, nobody wants to be part of a social network in which theirs is the only profile. Although Facebook was one of many social networks when it was founded, it has grown to become the largest and most dominant, with one in five people on the planet using one or more of its services every day.
How did Facebook become so dominant? As the company grew and more users joined the platform, Facebook allowed more and more people to connect, and the resulting network effects made Facebook more and more valuable for each subsequent user who joined. As a result, Facebook was able to offer greater value than other, smaller social networks, creating a sustainable competitive advantage for the company.
4) Scale Advantages
Scale is one of the oldest and best-known forms of competitive advantage, and it’s one of the easiest to understand. Scale advantages derive from the concept of economies of scale, which just means that the cost per unit of producing something decreases as the number of goods produced increases.
Think about how the fixed costs of a factory (like the machinery) can be spread out as you move from producing one car per year to thousands per year. Industrial companies of all stripes benefit from these types of scale advantages, including stalwarts like GM, Ford, and Boeing (NYSE:BA).
5) Legally Enforced Monopolies
The last form of sustainable competitive advantage comes in the form of legal monopolies. Although there are several kinds of legally enforced monopolies, such as regulated monopolies for utility companies, the most common example is patent protection. A patent allows its holder to exclude others from offering, selling, making, or using an invention for the duration of the patent, commonly 20 years from the date of the patent’s filing.
A patent provides arguably the most powerful competitive advantage, although it has a fixed expiration date. Patents incentivize companies to invest heavily in inventions that cost a lot to create by providing a set period of time for those companies to extract profits from those inventions without competition. As an investor, you’ll most often encounter companies dependent on patents for their competitive advantage in the healthcare sector. There, businesses invest large amounts of capital upfront to develop new therapies, and the money is then earned back over time while the company benefits from patent protection for the drug(s).
Other Key Characteristics of Winning Companies
Beyond sustainable competitive advantages, there are also other things to pay attention to when evaluating a company. Two big things are:
1) Cash — Follow the Money!
Cash is the lifeblood of any business. Without cash, a company can’t pay its bills, and it can’t invest in growth. Look for low-debt, cash-rich balance sheets and steady cash flows. Specifically, focus on free cash flow — the cash left over after funding operations and growth. This cash allows management to reinvest back in growing the business, fuels share repurchases, and pays a company’s quarterly dividend.
2) Strong Leadership with a Long-Term Focus
As we’ve discussed, it’s important for investors to focus on the long term when buying stock in a business. However, you can’t be the only one focused on the far future — after all, you won’t be there running the business every day. Thus, it’s important to identify management teams who operate their companies with the long term in mind and whose interests are aligned with yours as an individual shareholder.
While identifying quality, well-aligned management teams is more art than science, here are a few questions to ask yourself when evaluating whether a management team is worth your trust.
Is the company founder-led?
Founder-led companies often have a more coherent long-term vision than other businesses, likely because founders tend to remain with their companies for a long period of time, retaining the initial intentions behind the business. Time and time again, founder-led companies have delivered market-beating returns for investors.
Is management invested alongside you?
When management holds stock in their company, their interests are better aligned with investors’ because they are shareholders themselves. While it might sound a little cynical, there’s no interest more powerful than self-interest. Founder-led companies are often disproportionately held by insiders, adding to their appeal.
Does management have a history of creating value for shareholders?
Do you really want a management team that doesn’t do this?
Does the management team have years and years of relevant experience?
Seasoned leaders hopefully have learned lessons and can avoid making some first-time mistakes. Ideally, they’ve weathered the ups and downs of industry and market cycles.
Do they treat outside shareholders (business partners) with respect?
As a shareholder, you are a part-owner of a business. Therefore, it’s important that you — and other common shareholders — be treated as such. If a company is reluctant to share information with its shareholders, it’s difficult to know where that company stands. It’s best to avoid these sorts of secretive businesses.
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John Mackey, CEO of Whole Foods Market, an Amazon subsidiary, is a member of The Motley Fool’s board of directors. Suzanne Frey, an executive at Alphabet, is a member of The Motley Fool’s board of directors. Randi Zuckerberg, a former director of market development and spokeswoman for Facebook and sister to its CEO, Mark Zuckerberg, is a member of The Motley Fool’s board of directors. The Motley Fool owns shares of and recommends Alphabet (A shares), Alphabet (C shares), Amazon, Axon Enterprise, Facebook, Intuitive Surgical, iRobot, Lululemon Athletica, Netflix, and Wayfair. The Motley Fool recommends Brookfield Infrastructure Partners, Constellation Brands, ONEOK, and Verizon Communications. The Motley Fool has a disclosure policy.