I didn’t start investing for a long time because I found it scary. My family didn’t have investments and I didn’t know anyone I could talk to about investments. My first investments were rental houses – I could see them, touch them, knew I will get a rental check at the end of the month. The stock market on the other hand was a mystery to me. How do you pick stocks that will go up? Seems impossible.
It turns out picking winning stocks is indeed very hard, but fear not – there is no need for you to do that! This is why index funds were created! So, in this blog post, I will tell you everything you need to know to invest in the stock market. Please note that this is not advice about what you should do. I don’t know your personal financial situation and I am not a money manager. This is meant to be a basic introduction to the world of investing.
Owning a stock means that you own a tiny little piece of the company. Not enough to be involved in any decisions that the company makes, but enough to get a little bit of their profits. You get money in two ways – dividends and increase in the stock value. Dividends are regular (often quarterly) payments to you because you hold stock in the company. They are kind of like the rent checks you get when you own a rental property. The increase in the stock value is like the increase of the value of your rental house. You only cash that in when you sell your stocks. Of course you can’t guarantee that your stock will grow, just like you cant’t guarantee that a rental’s house value will go up. The neighborhood your rental is in can go down in value and drag your rental’s value with it. But many stocks, given long enough time, will grow in value.
When you buy a rental house, you actually take quite a lot of risk. Crime could increase in your area and send the value of the house plummeting, a big employer in town can close making it impossible for you to find tenants, the city could redraw the lines of the school district sending your tenant’s kids from the best school in town to the worst. When you buy a single stock, very similar things can happen. Say you buy Apple stock. Seems like a great buy but what if Motorola comes up with a phone that can project a 3-D image of the speaker into the room of their conversation partner. Suddenly, everyone will stop buying the latest Apple phone because they will want a 3-D image projector and Apple stock will fall.
While if you want to own a physical rental, you have to actually buy a house and accept all the risks that come with it, when you buy stocks, you don’t have to buy just one. This is where index funds come in. And index fund is essentially a basket of stocks that represent the entire market the fund indexes. Most people like to buy index funds that index the S&P 500 or the Dow. Owning an index fund means that as long as most companies are doing OK, your investments will grow. Let’s say you get a fund that indexes the S&P. Both Apple and Motorola are components of the S&P so if Motorola comes up with a 3-D image projector, their stock price will sky-rocket. Apple’s stock will go down but because you own a little bit of both companies, you will probably make money overall.
If you believe that the U.S. economy is generally headed up, investing in an index fund is the easiest thing to do. You don’t have to pick stocks, read the Wall Street Journal, or be able to predict the future. Just buy a little bit of everything.
But wouldn’t it be better if you just bought a whole bunch of Motorola stock right before they unveiled their 3-D projector? Yes, it would be better. The problem is that that is impossible to do with any level of consistency. The market prices in new developments quickly and there are professionals whose entire job is to try to beat the market so your chances of accomplishing that are about the same as being the winner of the Boston marathon if your normal exercise routine is walking your dog around the block. You simply can’t expect to compete with the people who make marathon-training their full time job.
How about hiring one of those professional money managers to beat the stock-market for you? Well, it turns out statistically, they are actually not very good at beating the market either. I won’t go into the data on this here but you can read this article if you don’t want to take my word for it. Also, professionals will charge you a percent of your total investment (not just your profits) for their services so they have to beat the market by quite a lot to make up for their fee before you see actual gains.
So, you have decided that you do want to invest in an index fund. How do you actually do that? I recommend Vanguard (they have the lowest fees) where you can set up an account (takes just a couple of minutes) and buy their most popular index funds.
- Vanguard Balanced Index Fund (ticker: VBIAX)
- Vanguard Total Stock Market Index Fund (VTSAX)
- Vanguard Total International Stock Index Fund (VTIAX)
- Vanguard Total Bond Market Fund (VBTLX)
Remember that an index fund follows that market in whatever the market does. In early 2020, the stock market fell briefly by about 30% so investing has risks. Overall though, given a long enough period of time, the markets have always gone up. Past performance is not a guarantee for future returns but ultimately I have decided that investing in an index fund is safer and much easier than owning rental properties.
Disclaimer: Investing is a personal decision and your investment strategy should reflect your risk tolerance. This post is not professional advice and I am not a professional money manager (remember, I am a math professor). Talk to a financial advisor to discuss your personal situation. Any investment, including the ones mentioned in this post, can lose value.