Investing in stocks can be look complicated and sound intimidating, especially when you are first getting started, but if you are willing to do a little bit of homework, be patient, and learn from your mistakes it will become a normal and important way for you to build wealth for the long-term.
Most people get their first real exposure to the stock market as part of their retirement plan, as msot 401(k) plans will by default invest a significant portion of your money into the stock market. This is how they will (hopefully) meet your grow goals. Once you start saving beyond your retirement plan and you’ve got your emergency savings plan completely topped up, you will likely consider a trading account (of some sort) for next steps in your investing. This is when you’ll be presented with a myriad of choice and is the focus of this article.
In this article I’ll be covering, brokers, trade commissions, capital gains vs. dividends, stocks vs. ETFs vs. Mutual Funds, and tax considerations.
There are several choices for brokerages out there, but I tend to favor ones that have a physical presence and customer service that you can get on the phone. For that reason I’m a big fan of places like TD Ameritrade and Charles Schwab.
The reason I like there to be a branch is because it means that if there is a problem with my account I can show up and get it fixed face to face. The more money you have in your account, the more important this is, because you don’t want to be stuck in a financial hard spot and have no one to turn to. They do charge $5-9/trade, but often you can get 25-50 free trades when you open your account and if you make deposits bigger than a few thousand dollars, which means you’ll actually be trading for free. Also, if you’re a newbie then you can call them up (not do the trade itself by phone) and have them walk you through the process.
For those investing very small amounts there are some free platforms where you don’t pay commissions. Robinhood is a popular example. I have not used it myself, but have heard many people comment on the ease and intuitive nature of it. They keep it free by keeping it streamlined and by feeding trades to market makers… if you are trading blocks of 500+ shares you are probably better off paying the commission because at most brokerages they have price optimization built into their systems.
There are other options ranging from investment houses with wealth management to niche brokers, but unless you have lots of money (i.e. $5 million or more for an investment house) or a lot of trust (for the niche brokers), you are probably better off with a do-it-yourself brokerage like TD Ameritrade.
I want to briefly touch on commissions as these can eat into your profits. As I mentioned above with most brokerages with physical branches trades will be between $5-9/trade if you do it yourself online. However, if you call them they can be $50+. There are online-only brokerages with lower fees that are designed for more active traders (such as Interactive Brokers), which charge less per trade.
In general, I want to keep my commissions at less than 0.25% of my total trade, so at a $5 commission I won’t trade a block less than $4,000 ($5 buy + $5 sell divided by 0.25%). If you pay $10 per buy/sell then you need to double that amount. That is my personal rule, but you can set the bar higher or lower. The reason I do this is that I just don’t want commissions to eat into too much of my profit. So, if you are investing small chunks you need to find the lowest cost trading option – which in many cases will be an app like Robinhood.
One thing to note is that if you are doing complex trades, especially with options, then sometime you are better served by a specialist platform that will let you execute on these strategies easily and at low commissions relative to the traditional brokerages I recommended above.
Capital Gains vs. Dividends
There are two ways you make money in the stock market:
- Capital Gains: This is when the price of a stock goes up. You don’t pay taxes until you sell the stock, so if you were to buy at $50 and the stock goes to $100 you only pay taxes on that when you sell.
- Some companies elect to pay out a portion of their profits (or free cash flow) to the owners of the stock. This is a way to return money to the owners (shareholders) of the company.
Both of these are important and are not mutually exclusive. Many stocks will pay dividends and see steady share appreciation. Some companies, which are presumably re-investing heavily in the company, don’t pay dividends because they are using that cash for fund growth in the company. This should provide you with capital gains in the long term.
There are shares in some business types such as MLPs and REITs that pay out a high proportion of their profits in the form of dividends. These often see less capital appreciation, and sometimes behave more like bonds than stocks as their value is heavily dependent on the Fed’s interest rate.
It is important to note that shares can LOSE value, meaning you LOSE money. Also, although dividends can’t be taken back once paid, many companies have been forced to cut their dividends (see GE recently). Dividend decreases and stock price drops often go hand in hand, meaning you can get hit by both.
Stocks, ETFs, and Mutual Funds
There are many ways to participate in the market. Three of the most common options are stocks, exchange traded funds (ETFs) and mutual funds.
- Stock is a type of security that represents partial ownership of a company and entitles the owner to vote at general meetings of the company and to a portion of the company’s earnings. Stocks are company specific, meaning if you own one share of Coca Cola then you own 0.0000000023% of the company, and are entitled to a dividend of about $1.56/year.
- An ETF is a basket of stocks that is designed to mimic some index, such as the Dow Jones Industrial Average, S&P 500, Nasdaq 100, etc. ETFs used to be relatively simple, but now there are many varieties. However, the most common are passively managed, and hold a basket of stocks in the correct proportions to match the returns on the indexes above. These provide the benefit of diversification, but also carry some fees. Fees are often quite low, but you need to pay attention as some exotic ETFs focused on international markets or commodities, for example, can carry high fees.
- A mutual fund is an investment vehicle made up of a pool of money collected from many investors for the purpose of investing in securities such as stocks, bonds, money market instruments and other assets. Mutual funds are different from ETFs in that they can hold a variety of securities whereas most ETFs hold only shares of stock; however, some mutual funds are little more than ETFs that mimic an index. Fees can be highly variable and somewhat creative. There can be continuous fees, fees only when sold, fees when bought, and combinations thereof. Watching fees is very important for mutual fund investors.
I personally advocate for putting a large portion of one’s portfolio into ETFs that are low fee and mimic the S&P 500 and Russell 2k indices. However, if you want to “play” the market there is nothing wrong with putting money into individual stocks or sectors to provide yourself with overweight exposure to those companies/sectors.
With stock investing there are some tax considerations. First, let’s consider dividends. These are normally taxed as “ordinary” income, meaning at your usual tax rate. However, sometimes these can be “qualified” dividends meaning they are taxed the same as capital gains.
Capital gains come in two forms – short term and long-term. Short-term gains are when you own the stock for less than a year. In this case it is taxed as ordinary income. Long-term gains are capped at lower rates, with the present maximum tax rate for long-term gains being 20%. There is a definite tax advantage to long-term gains.
One thing to keep an eye on is if there are any losers in your portfolio. If so, you can sell at a loss to get some tax protection. Also, because all your gains/losses are lumped together you can use losses from one stock to offset gains from another. For example, if you bought stock ABC for $50 and it went to $100 and you sold, and at the same time you bought stock XYZ for $100 and it went to $50 and you sold, then your net capital gains would be $0. So you wouldn’t have a tax liability. If you lose more than $3000 in a year, you can carry that loss forward to subsequent years… consider it a nice parting gift from a bad trade (little consolation, I know).
Investing in stocks doesn’t need to be intimidating or complicated. If you use a long-term buy and hold strategy, and mainly use ETFs to provide diversification you should enjoy low-fees, have low commission costs, and won’t have to spend tons of time researching stocks, sectors, or trends. As you grow more comfortable you will likely want to be more adventurous in your investing, and that is okay as long as you stay diversified and only “play” with a portion of your money. There are lots of resources out there, and many of the best ones are free. Do your homework and enjoy building wealth through the market.
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