Our last post covered how to start investing in the stock market and which types of accounts you can use. You may need several different types of accounts if you’re fortunate enough to have maxed out your 401(k) and IRA! Needing to use a taxable account because you’ve exhausted your tax favored options is a great problem to have. Now, lets go over what to invest in! You might be surprised to know that you shouldn’t pick stocks.
First, here’s the 10,000 foot overview of the stock market:
In order to raise capital (money), companies may sell shares of their company on the stock market. These shares are publicly traded and there is a fixed number available. If someone wants to buy a share, someone else who owns a share must be selling it. It’s this supply and demand that determines the price of a company’s shares, usually driven by how the company is doing (or predicted to do).
Now that we are all on the same page, lets get down to the nitty gritty.
Humans Cannot Predict the Future
Picking stocks is hard. No one has a crystal ball to predict which company’s shares will go through the roof and which will tank. If there was a simple way to reliably predict which stocks would outperform the rest, then every financial adviser in every corner of our country would be a billionaire! For every billionaire made by the stock market, there are countless more going broke.
You may be asking, “But if the stock market is so risky and unpredictable, how do people make so much money”?
Let us introduce you to the index fund. An index fund is a group of stocks that you can buy as a bundle. By purchasing an index fund, you will own a whole group of stocks. This will protect yourself from some of the risk of picking the wrong stocks. In that index fund, some stocks will go up and some will go down. However, as John Bogle, founder of Vanguard, has pointed out in his books, the stock market as a whole has always gone up over the long term. This means that if your portfolio (investments) reflects the broader stock market, your investment will grow over a long period of time even as some individual stocks go down.
How Do You Invest in the Entire Stock Market?
You don’t need to be a millionaire to own the entire stock market. By buying index funds that reflect the S&P 500 (which includes 500 of the largest companies on the stock exchanges), your investments (tax favored or taxable) will track the performance of the greater stock market!
This may sound too simple, but its not. In fact, in 2007 Warren Buffett bet $1 million that an S&P 500 index fund could outperform a group of hedge funds (professional investment managers) over 10 years. Needless to say, he won the bet! The S&P 500 index fund beat out a lot of really smart finance professionals who spend ALL of their time trying to make as much money as possible.
The numbers simply do not lie. Choosing individual stocks is a losing game. We want all of you to be winners! Be a winner.
But the Stock Market Doesn’t Always Go Up!
You’re right. There are good times (bull markets) and bad times (bear markets). The S&P 500 index fund not only guarantees you the profits made by the stock market, but the losses, too. In fact, the market cycles through periods of growth and decline.
We are probably due for another bear market as the last one was during the 2008 recession. Don’t freak out and sell everything when it happens. We expect it to happen. Just remember that over a long period of time (say your investment lifetime) the stock market has always grown and things should pick up. Just stick to your investing plan and have confidence that good times are ahead.
You’ll never be able to time the market perfectly, so the best advice is to invest regularly regardless of whether you think we are at the peak or the nadir (all-time low).
Still not convinced?
If you’re still unsure about whether or not you should pick individual stocks or you don’t trust us or Warren Buffet, we leave you with a quote from one of our favorite finance professors: “Don’t pick stocks. Picking individual stocks is for idiots!”.
Well, there you have it.
Our next post is on creating a diversified portfolio and we detailed what we have in our portfolios!