What to Consider Before Investing in Stocks

What to Consider Before Investing in Stocks article image.

Investing in stocks can be a risky endeavor, especially in the short term. Buying shares in a publicly traded company can make it possible to earn money as the price of each share grows, but it can also expose you to losses if the price goes down.

In general, investing in the stock market is a given if you're saving for retirement since most retirement accounts are made up of mutual funds and exchange-traded funds (ETFs) consisting of stock market holdings. But if you're considering buying individual stocks as well, you may want to make sure you're on firm financial footing first and understand the risks involved.

When Is It a Good Idea to Invest in Stocks?

The right decision about whether it's a good idea to buy individual stocks depends on your financial situation. Because of the volatility of the the stock market, there are some things you'll want to take care of before you start investing:

  • Emergency savings: If the market experiences a downturn and your portfolio loses a significant of its value, you can't get that money back, at least not immediately. As such, it's a good idea to have a robust emergency fund before you start investing, just in case the downturn coincides with a financial emergency, such as a job loss.
  • Budget: Managing your expenses well is a key element in any successful financial plan. As long as you have a budget in place and you're spending less than you earn, you may be able to use some of the remaining funds to invest in the market.
  • Debt: There's nothing wrong with investing while you have debt. But if you have high-interest credit card debt, you'll be better off paying that down first. This is because credit cards typically charge higher interest rates than the value of the average return you can get in the stock market.
  • Long-term savings: Investing in individual stocks at the expense of your retirement may come back to haunt you. Retirement savings accounts offer tax advantages you can't get with a traditional brokerage account, and neglecting your long-term savings can put you in a position later in life where you have to save more to catch up.

Stock market basics tell you it's always a good idea to buy low and sell high. If the economy is in a recession there may be more market volatility than usual, which can present opportunity, but chances for a large return are higher than when the market is doing well.

If you do plan to invest, consider the buy-and-hold strategy. It may be tempting to trade stocks regularly to try to capture big short-term gains. But as a so-called retail investor, fees and other factors put you at a disadvantage compared with investment banking firms, and you could end up losing money if you're always chasing the next big thing.

If you buy and hold a stock, you'll still be subject to short-term fluctuations in its price, but the likelihood of the value going up in the long run may be higher.

What Are the Risks of Investing in Stocks?

Investing in individual stocks can be exciting, but it's important to understand the risks associated with the practice:

  • Requires time and effort: Unless you're using a buy-and-hold strategy, you may spend a lot of time monitoring your portfolio and trying to buy and sell at the right times.
  • Less diversity: If you focus your investments on only one industry, your portfolio will take a big hit if that industry experiences a major downturn. Diversifying your portfolio helps mitigate some of this risk by including stocks from different sectors and potentially including other assets, such as bonds, that carry lower risk. Mutual funds are often considered the gold standard of diversification.
  • Difficult to keep emotions at bay: Watching a stock's price fluctuate can cause you to feel excited and scared. These emotions can trigger impulsive investment decisions, such as selling when the price goes down to avoid losses or buying when it's on the rise trying to capitalize on an upswing. Successful investors have strategies in place to avoid making emotional decisions, but it can be difficult to do that when you're just starting out.

Investing in stocks is best for people who have a high risk tolerance—this means you're not bothered by short-term volatility. Make sure you understand how you view risk before you start investing.

Also, consider your timeline. The stock market is best for people who don't need the money they're investing anytime soon. If you're looking for somewhere to stash your emergency fund or cash for a down payment on a home, keep it in a high-yield savings account or another type of account instead.

How to Lower Investment Risk

Everyone who invests in the stock market is exposed to risk. However, there are some steps you can take to avoid more risk than is necessary for your situation:

  • Consider a financial advisor. A financial advisor can help you by providing expert guidance and also by acting as a buffer between your portfolio and your emotions. Keep in mind, though, that financial advisors charge for their services, and those fees can eat into your return. It's best to consider this option only if you have a large portfolio to manage and can easily afford the fees.
  • Diversify your stock portfolio. Take some time to learn about how you can diversify your stock portfolio. For example, tech stocks typically provide a higher return potential than stocks in the defense sector, but they also carry higher risk. Investing in both sectors can diversify your portfolio a little and mitigate some of those risks. The more you can diversify your investments, the less risk you'll experience.
  • Utilize a robo-advisor. Robo-advisors use algorithms to invest in the stock market on your behalf, and they're typically much cheaper than working with a human advisor. That said, robo-advisors typically don't let you choose your investments, and you won't be able to buy individual stocks.
  • Use dollar cost averaging. The concept of dollar cost averaging involves investing the same dollar amount in regular intervals—typically monthly—regardless of how the price of the stock has changed. This approach can help reduce the impact of volatility on your investment.

Where to Buy Stocks

You can purchase stocks by opening an account with one of many brokerage firms. That includes companies like:

  • Fidelity
  • Vanguard
  • Charles Schwab
  • Merrill Edge
  • Robinhood
  • Webull
  • E-Trade

These are only a few examples of brokers you can work with to buy stocks. Before you choose a brokerage, it's a good idea to compare features from each, such as fees, resources, education, investment options and more.

Once you pick a brokerage firm, you can buy stocks by transferring cash to the brokerage account, then choosing the stock and how many shares you want to purchase.

Alternative Ways to Invest Your Money

While buying individual stocks can be one way to grow your money, it's far from the only way to do it. Here are some options to look into if you want to start investing:

  • Mutual funds: Mutual funds pool money from multiple investors to invest in various securities, which are dictated by the fund itself. For example, some funds follow certain indexes, such as the S&P 500, while others may invest in a mix of stocks, bonds, real estate and other securities. Mutual funds are great for diversification, but they don't allow you to control how your money is invested.
  • Exchange-traded funds (ETFs): These are similar to mutual funds but offer some key differences. For starters, ETFs trade on stock exchanges, which means you'll get real-time pricing and lower minimums—some brokers even allow you to buy into them with fractional shares. But like mutual funds, you have little control over how an ETF is managed or which securities it invests in.
  • Real estate investment trusts (REITs): REITs allow you to invest in income-producing properties without needing the funds to buy them directly or manage them. REITs can generate a steady stream of dividend income and can help you diversify your portfolio beyond the stock market. But they can be sensitive to interest rate increases and generally aren't good as short-term investments.
  • Bonds: Bonds are issued by corporations and government entities as debt. When you buy one, you essentially become a lender, for which you'll receive regular interest income for a predetermined period. Bonds are generally much safer investments than stocks, but they also typically offer lower returns.

Keep in mind, too, that you can invest in one or more of these vehicles at the same time. In fact, this strategy is an excellent way to diversify your portfolio because it allocates your funds into different assets whose values aren't determined by the same factors.

Does Your Credit Score Come Into Play With Investing?

Investment brokers typically don't run a credit check when you apply for an account. That said, building and maintaining a good credit score can make a huge positive difference in your financial plan. Check your credit score often to determine its health, and take steps to develop good credit habits.

This includes paying your bills on time every month, keeping your credit card balances low, avoiding new credit applications unless you need it and keeping an eye on your credit report in case inaccurate or fraudulent shows up on your file.

Having great credit can help you save money on loans and credit cards, as well as on insurance premiums, which can give you more cash flow to invest and achieve other financial goals.

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