When you start investing, stocks play a key role. But what exactly are stocks? And why are they such a critical addition to an investment portfolio?
Below, we define both stocks and investing, explore the main benefits that stocks bring to an investment portfolio, the risks, and walk you through the different options to get started investing in stocks.
What are stocks?
A stock, at its heart, is a financial instrument that conveys partial ownership of a company through the purchase of shares in the company. Stocks can be bought, sold and traded via brokerages. (You may also receive company stock from your employer as a part of your compensation package.)
When you buy shares of a company’s stock, you become a partial owner of that company. As a partial owner, or shareholder, you get to take part in any of the company’s potential success and profits.
Of course, this isn’t a guarantee, because not all businesses succeed over the long term. That’s what makes stocks a riskier investment compared to other asset classes.1 But it’s also investing in stocks can be one of the best ways to grow your wealth over time. By accepting a certain level of risk, you are opening yourself up to the possibility of a greater amount of reward than you might receive from “safer” investments.
For this reason, stocks play an important role as a growth driver in a well-diversified investment portfolio.
What is investing?
When we say the word “investing,” we’re typically talking about the process of evaluating and purchasing assets — like stocks — with the goal of making a profit over a certain period of time.
While buying and selling a handful of stocks is considered investing, this approach can be a risky way to invest. To help balance risk and reward, many investors prefer a diversified portfolio that includes stocks, bonds and other assets that all work together to grow wealth over time, while also reducing various risks that are associated with investing.
The average annual return of Large-Cap stocks between 1926 and 2022
People invest in stocks for a number of reasons, but the primary reason is that they want to share in the future value or profits generated by the companies they invest in.
Over the long term, investing in the overall stock market has proven to be a very effective means of building wealth and beating inflation. From 1926 to 2022, Large-Cap stocks enjoyed an average annual return of nearly 10.5 percent.
How to get started investing in stocks
Below are the general steps that you’ll need to follow to get started investing in stocks.
Decide how much you want to invest in stocks
Your first step is to determine how much of your investment portfolio you will allocate to stocks.
Most portfolios will include a target allocation of a certain amount of stocks and bonds (although other assets may also be considered as part of an overall financial plan). Unfortunately, there is no single target allocation that works for every person and in all circumstances. Because everyone’s financial situation is unique, the ideal portfolio allocation for you may differ significantly from someone else. It’s typically best to discuss your individual situation with a financial professional.
In determining how much of your portfolio you will dedicate to stocks, you should consider:
- Your risk tolerance: How much risk and volatility can you handle in your investments? The greater your risk tolerance, the greater the percentage of your portfolio you can likely dedicate to stocks. All investments carry some level of risk including the potential loss of all money invested.
- Your investment time horizon: How long do you plan to keep your money invested before you need to access it? The longer your investment timeline, the more risk you may be able to take.
- Your financial goals: What specific goals are you investing to achieve? How much growth is required to reach these goals according to your timeline? The more growth you require to reach your goals, the more you will likely need to dedicate to stocks in order to help reach it.
Quiz: How Much Do You Know About Investing and Your Finances?
Open an investment account
Your next step is to open an account that will allow you to purchase stocks.
There are many different types of investment accounts that you can choose from. Which type of account you choose will depend on the specific goal that you are investing for, but some of the more common include:
- Employer-sponsored retirement accounts: If you are employed by a company offering retirement benefits, you may have access to accounts designed to help you save and invest for retirement, including a 401(k) or 403(b). These types of accounts enjoy powerful tax benefits, which make them an ideal tool for saving for retirement. However, distributions prior to age 59 1/2 might be subject to a 10 percent early withdrawal penalty.
- Individual retirement account: An IRA allows you to save for retirement either in addition to or in lieu of an employer-sponsored retirement account. These tax-deferred accounts enjoy many of the same tax attributes as 401(k)s but have much lower contribution limits.
- Brokerage account: A brokerage account allows you to purchase different investment assets, including stocks. Brokerage accounts are taxable accounts and do not have the contribution and distribution limitations that retirement accounts have. Therefore, they are better suited to individuals who are saving for goals other than retirement (or who have maxed out those tax-advantaged accounts).
- College savings account: If you are specifically investing for education-related expenses for your child, then a college savings account like a 529 plan may be the best way to go. Like retirement accounts, these enjoy certain tax advantages as long as you use the money for qualified educational costs.
- Custodial account: A custodial account is a specific type of investment account that you can open for a minor in order to put money away for their future. Once that person turns 18 or 21 (depending on the state) it transfers to them. Like brokerage accounts, custodial accounts are taxable accounts.
Armed with your target allocation and the proper investment account, you can now construct your stock portfolio by selecting investments. Typically, this is achieved by purchasing individual stocks, one or multiple mutual funds, or a mixture of individual stocks and mutual funds. Additionally, there are many funds that include stocks with a mix of other assets. You can also choose to work with a financial advisor, who can help you build a portfolio and may even help manage your investments on an ongoing basis.
Investing in individual stocks
If you are interested in purchasing specific companies’ stocks, you can buy shares of any publicly listed company and hold those shares in your investment account.
If you decide that you want to build your own portfolio of individual stocks, it’s a good idea to think carefully about diversification. Holding the stocks of too few companies, or of companies that all operate in the same industry, opens your portfolio up to the possibility of a lot of volatility and risk.
That’s why most financial professionals recommend building a diversified stock portfolio that spans multiple industries or sectors, and which includes multiple companies from each sector. However, no investment strategy can guarantee a profit or protect against loss.
Investing in funds
If you don’t want to pick individual stocks, you might instead choose to invest in funds which hold a variety of stocks (and other assets). Mutual funds or exchange-traded funds (ETFs) all fall into this investment category.
When you purchase funds, you’re really purchasing exposure to different investments. This makes funds an excellent means of instantly diversifying your portfolio, but it comes with a catch — fees. Nearly all funds charge management fees, which makes sense, as the fund is performing a service for you. But it’s worth paying attention to fees as they can eat into your portfolio’s return over time.
Additionally, most financial advisors recommend holding different types of funds in order to ensure that you are properly diversified. For example, you might own shares of a large-cap fund, a mid-cap fund, a small-cap stock fund and an emerging-markets fund (with specific allocations tied back to your risk tolerance and investment horizon).
Working with a financial advisor
A third option is to work with a financial advisor, who will build and manage your portfolio for you.
Financial advisors will first seek to understand the factors discussed above — your risk tolerance, investment timeline and financial goals — and will use that understanding to craft a portfolio that best suits your needs. In addition to stocks, this may include other assets such as bonds, real estate investment trusts, commodities and more.
Additionally, most financial advisors will aim to help you understand the ways that different parts of your financial plan — such as life insurance, annuities, and estate planning — all work together and how your investment portfolio plays a part in your plan.
How do fees work?
As previously mentioned, when you invest in stocks individually or through mutual funds, you may have to pay different types of fees. While there are many different types of fees that you should be aware of, the most common include:
- Transaction fees: These are fees paid whenever you purchase or sell shares of a stock. You may need to pay transaction fees, whether you purchase stock through a brokerage account, funds or an advisor.
- Management fees: These are fees paid either to fund managers or financial advisors. They are meant to cover the costs of administering either a fund or your portfolio.
- Commission or sales loads: When working with an investment advisor, you may pay a commission or sales load when you buy or sell an investment.
How are investments taxed?
The good news about investments is that you can earn a return on your investment. But when you earn a return, you may owe tax.
Your return could be in the form of a dividend, which, depending on the type of dividend, is taxed either as a qualified dividend at the same tax rate as capital gains or as part of your ordinary income.
When you sell stocks, you may also owe tax if you sell the investment for more than you paid for it. You’ll owe tax on your realized capital gain, or profit. If you hold a stock for a year or less, then your gains will be taxed at the short-term capital gains tax rate. This will be the same tax rate as your ordinary income tax rate.
If you hold stock for more than a year prior to selling it, any gains will be taxed at the long-term capital gains tax rate. The exact tax rate you will pay on your long-term capital gains will depend on your income level and tax-filing status, but it will be lower than your short-term capital gains tax rate.
If you sell your stock at a loss (for less than what you paid), you realize a short-term or long-term capital loss. Any capital losses are first used to offset capital gains. Then, any remaining capital losses can offset up to $3,000 of your ordinary income annually ($1,500 for married filing separately). You can carry forward excess capital losses to be utilized in future years. Many people strategically use this to their advantage through a process known as tax-loss harvesting.
Retirement accounts are subject to their own unique tax structure, depending on the type of account you are investing in. For example, when you invest through a traditional 401(k) or IRA (tax-deferred retirement account), you lower your income level, and thus your tax liability, in the year that you make the contribution; then, when you withdraw your funds in retirement you will owe income taxes on that withdrawal. Early withdrawals prior to age 59 ½ subject you to income tax and possibly a 10 percent penalty. When you invest with a Roth account, on the other hand, you invest post-tax income and typically do not pay taxes when you make a withdrawal.2 In both cases, you do not pay capital gains taxes.
Building your portfolio
When building your investment portfolio, it’s important to consider the role that each piece of your portfolio plays in working toward your financial goals.
Stocks can provide many benefits to your portfolio — acting as a growth driver and potentially providing income in the form of dividends and capital gains — but they typically cannot perform all roles. That’s why your portfolio should consist of different types of assets. While this includes stocks, it should also include other assets like bonds, commodities, cash, real estate and more, all depending on your unique goals.