Key points
- Stock market investing is one the best ways to grow wealth.
- Each stock investing strategy carries risks.
- Dividend stocks pay investors a portion of their profits directly.
Stocks are typically the cornerstone of any investment portfolio. That’s because they have a higher potential for long-term growth than other asset classes like bonds and commodities.
Investments that offer significant upside also come with a certain amount of risk. The economy and the stock market regularly undergo cyclical corrections that can lead to significant losses if you sell at the wrong time.
That said, historically, the stock market has generated positive returns.
A good proxy to check the overall health of the U.S. stock market is the S&P 500 Index. The average unadjusted return of the S&P 500 from 1996 to mid-June 2022 was 9%, according to an August 2022 report by McKinsey & Co. The study also found that during the same period, S&P 500 returns only declined annually five times.
So investing for the long haul without being sidetracked by short-term market fluctuations definitely has its benefits.
Of course, investing in the stock market involves other factors. You’ll have to select your risk tolerance, comfort level with short-term losses, and investment goals, to name a few.
As a general rule of thumb, the longer your time horizon, the more risk you can take on. If you take on too much risk with a short time horizon, you may not reach your investment goals, especially if your investments experience a downturn.
Opening an investment account
The first step in investing in the stock market is opening an investment account. There are three main types of investment accounts:
- Taxable brokerage accounts.
- Employer-sponsored retirement accounts.
- Individual retirement accounts.
If you’re 18 and over, you can open a taxable brokerage account with an online brokerage and begin buying and selling stocks.
You can deposit money into a cash account and use those funds to buy stocks, or open a margin account, which allows you to borrow money from the brokerage to buy stocks.
Employer-sponsored retirement accounts are tax-advantaged retirement investment accounts that many companies offer to their employees. You might have one through your workplace. These accounts include 401(k) plans and 403(b) retirement accounts.
Traditional 401(k) plans allow investors to make tax-free contributions, and some employers will even match a portion of their employees’ contributions up to a certain percentage of their salaries. But there are withdrawal restrictions and penalties associated with retirement accounts.
You can also open an individual retirement account or IRA. The maximum annual individual contribution to a traditional IRA is $6,500 or $7,500 if you’re age 50 are older in 2023.
Your IRA contribution might be tax deductible depending on your income and other factors. For instance, if you have a retirement plan at work, make $73,000 or less for your adjusted gross income and file as “single” or “head of household,” you might be able to deduct the full amount of your contribution. You can see the IRS deduction limits here.
Determine your stock strategy
Once you open an investment account, you must determine a stock market strategy that fits your personal investing goals, time horizon and risk tolerance. The idea of buying low and selling high may appear straightforward. But picking winning stocks and knowing when to buy and sell can be more difficult.
“Investing is never actually easy, even if historical returns make it appear simple,” says Nicholas Colas, co-founder of market analysis company DataTrek Research.
There are plenty of buyers and sellers in the stock market at any given time, and humans have innate psychological biases that can make smart, rational decisions difficult when money is at stake.
Colas says sellers with a bearish outlook that the stock market is heading downward often seem “smarter” than buyers, as if they know a secret that other investors don’t. But there is always a bear case, he says.
“Successful investing, therefore, sometimes comes down to deciding whether you want to sound smart or make money,” he says.
Here are some common stock market investing strategies:
1. Buy-and-hold investing
Buy-and-hold investing is the simplest and lowest-risk strategy for long-term investors.
When you buy and hold a stock, you don’t necessarily focus on its return day-to-day or even year-to-year. With this strategy, you construct a diversified portfolio of high-quality stocks and/or exchange-traded funds and ride out long-term market trends through thick and thin.
Long-haul investors don’t care about economic recessions or bear market downturns because they invest for a longer time horizon.
Bear markets can be good news for buy-and-hold investors, says Kurt Spieler, chief investment officer at First National Bank of Omaha, representing a buying opportunity. A bear market is when there is a prolonged drop in investment prices. Typically, a bear market happens when a broader index falls by at least 20% from its most recent high.
“The bear market offers an opportunity for contrarian and long-term investors to add equities exposure at more attractive valuations,” Spieler says.
Buying stocks during market downturns is often called “buying the dip” and has been popularized by well-known billionaire investors such as Warren Buffett and Bill Ackman.
“History shows that investors are rewarded when they adhere to their financial plans and stay invested through market cycles,” Spieler says.
2. Swing trading
Swing trading is a strategy in which investors aim to take advantage of swings in stock prices that take place over one day to several weeks. Swing traders often attempt to profit from the momentum that stocks can gain when they break out of trading ranges to new highs or lows.
Swing traders can use stop-loss orders to close out trades automatically if the stock loses its momentum and reverses in the opposite direction.
These traders often analyze a stock’s price chart to identify patterns and tendencies, so they can become familiar with a stock’s trading action and potentially anticipate how it will react under certain circ*mstances.
Swing traders identify key price levels on a stock chart that may serve as effective buy or sell signals when levels have been reached or breached.
3. Day trading
Day trading is an action-packed and extremely active investing strategy that involves buying and selling stocks multiple times within the same trading day in an attempt to profit from relatively small fluctuations in stock price.
Day traders capitalize on the intraday volatility that occurs in the stock market. Intraday volatility refers to the ups and downs of equity prices between the open and close on a given trading day.
One popular day trading strategy is scalping. This involves making many minimally profitable trades rather than a handful of larger profits. A scalp trader may seek to complete 40 trades that return 0.1% to 0.2% each rather than four trades that return 1% to 2% each.
Dennis Dick, equity trader and market structure analyst at Triple D Trading, says day traders employ several strategies to gain an edge.
He often tries to identify market inefficiencies in the relative prices of highly correlated stocks. But he says other day traders look for trades that become temporarily overcrowded in one direction and are likely to correct in the opposite direction.
“Good day traders have more than one tool in their toolbox. They employ a number of different strategies and quickly adjust those strategies for changes in the overall market environment,” Dick says.
He adds that the keys to successful day trading are discipline and willingness to admit you’re wrong quickly.
Day trading may be the most exciting way to invest, but it is also the most difficult. A June 2020 study of day traders found that only 3% of all investors who persisted for more than 300 days in the Brazilian futures market made money.
The study asserts that it’s nearly impossible for individuals to day trade for a living, contrary to what others may claim.
4. Dividend stocks
Many profitable, high-quality stocks reward loyal investors by paying dividends, which are regular direct cash payments to investors. The average dividend yield of S&P 500 companies is currently 1.6%, but several S&P 500 companies pay significantly higher dividends.
Examples of high-dividend stocks
| STOCK (TICKER) | YIELD |
|---|---|
Pioneer Natural Resources Co. (PXD) | 14.90% |
Coterra Energy (CTRA) | 9.00% |
Devon Energy Corp. (DVN) | 7.60% |
Altria Group (MO) | 8.30% |
*Dividend yields are sourced from Yahoo! Finance, current as of 4 p.m. EST on March 20, 2023.
Dividend reinvestment plans
Dividend reinvestment plans, or DRIPs, allow investors to take advantage of the power of dividend compounding.
If you enroll in a DRIP program through your brokerage, the brokerage will automatically reinvest any dividend cash payments by buying additional shares of the dividend-paying stock.
DRIPs allow you to earn more market returns (and more dividends) from each dividend payment they receive. According to Hartford Funds, 84% of the S&P 500’s total return since 1960 can be attributed to reinvested dividends.
5. Stock funds
One of the best ways to reduce the inherent risk of investing in the stock market is by diversifying your portfolio. By investing money in a large number of stocks, you can reduce the risk associated with each stock and company.
One of the quickest and easiest ways to diversify a portfolio is by buying stock mutual funds, exchange-traded funds, or ETFs. These funds often give investors access to dozens, hundreds or even thousands of stocks in one easy investment.
The SPDR S&P 500 ETF Trust (SPY) is the world’s largest and most popular ETF, providing investors with exposure to all 500 stocks in the S&P 500 at around $390 per share.
There are subtle differences between mutual funds and ETFs, including how they are managed, traded and taxed. Before buying, investors should also understand the fees that fund managers charge for maintaining a fund.
Frequently asked questions (FAQs)
Beginners can invest in the stock market by opening a brokerage account or other investment account and depositing money into the account.
If you’re new to investing, you should always have a clear investment strategy based on your personal goals, time horizon and risk tolerance. If you are unsure about your plans, you should consider meeting with a certified financial professional.
Historically, the stock market has been the most reliable way for the average person to build wealth by investing passively over time, producing better long-term returns than bonds, savings accounts, commodities and other investments.
But the most aggressive stock market investing strategies also come with the greatest risk, and poor risk management can lead to catastrophic losses.
