(Money Magazine) -- Question: I'm 25 and want to start investing in the stock market, but I'm unsure of how to do it. Any advice? --Kyle, Bentonville, Arkansas
Answer: After all the lousy news of the past few years -- the collapse and near-collapse of some of the nation's largest financial institutions, the long and deep recession, the horrendous job losses and a more than 50% decline in stock prices from 2007's high to 2009's low -- it's heartening to hear from
young investors like you who still recognize the value of investing in stocks.
That's important because even though recent events have reminded us that investing in equities isn't anything close to the all-gain-no-pain path to riches it was once portrayed as, stocks still offer the best shot at the long-term gains needed to achieve financial security and a comfortable retirement.
To realize stocks' long-term potential, however, it's imperative that you get off to a good start. Here are three of the most effective ways to do that.
1. Don't start with stocks. I'm not trying to be cute here. Rather, my point is that neophytes -- or, for that matter, even more experienced individual investors -- simply should not be buying individual stocks.
Why? Well, to do it right, stock picking requires that you know your way around a company's financial statements, understand how to analyze its prospects and then figure out whether those prospects justify its current stock price. I'm not saying that doing this requires more brainpower than the average person possesses. It doesn't. But it does require time and effort that most people aren't able or willing to devote to their investments.
Besides, there's a much more convenient way to own stocks -- invest in mutual funds, which give you a share of a portfolio of anywhere from a couple dozen to a couple of thousand stocks.
With thousands of mutual funds to choose from, you'll still have to decide which ones are right for you. But there are a couple of ways to make that task manageable. One is to stick to index funds, which can give you an entire sector of the stock market or even the entire market in one fund. Or you can cut through the clutter by checking out our Money 70 list of recommended funds.
2. Concentrate on building a portfolio. Because the investing world focuses so much on the performance of specific investments, it's easy to get the impression that success as an investor depends on being able to predict which funds will generate the biggest returns for the year. But that's impossible to do on a regular basis. And unnecessary.
Research shows that your exposure to broad asset classes, more than owning specific investments, largely determines returns over the long term. By creating a portfolio of different assets that don't all move in sync, you may be able to boost your potential return for however much risk you're willing to take.
Fortunately, creating a well-rounded portfolio doesn't have to be complicated. You can do it with five or six funds that cover such core asset groups as large and small U.S. stocks, foreign shares, bonds and maybe a fund that invests in an inflation hedge like natural resources or real estate.
If you want to keep things really simple, you can get pretty much all the diversification you need with just three funds: a total U.S. stock market index fund, a total U.S. bond market index fund and a total international stock index fund. That trio will give you exposure to domestic and foreign equities, large and small stocks, value and growth shares and developed and emerging economies, not to mention a broadly diversified bond stake that includes everything from U.S. Treasuries to mortgage-backed securities to investment-grade corporate bonds.
Of course, at your age bonds will likely represent only a small portion of your holdings. As you get older, though, you'll want to bulk up more on bonds to prevent your accumulated wealth from taking too big a hit during a market meltdown.
3. Tune out the Wall Street chatter. Once you've chosen some funds and created your portfolio, you'll want to monitor the progress of your investments as well as keep tabs on the financial markets and the economy overall. As you do that, you'll notice that there are all sorts of poobahs, pundits and prognosticators out there constantly urging you to react to the market's latest wiggle or the Fed's latest pronouncement, whether it's to sell stocks, buy bonds, get into gold, unload gold, blah, blah, blah.
My advice: ignore these "nattering nabobs." There's no way you're going to time your moves in and out of the market or dart in and out of different sectors to capitalize on upswings and avoid downturns. The more you try, the more likely you'll just end up buying into investments at inflated prices, selling at depressed ones and generating trading and transaction costs that will eat up your potential return.
So listen to the Eagles (the band, not the football team) and "Take it Easy," so to speak. Aside from periodically rebalancing your portfolio, keep changes to a minimum. Do that and, if nothing else, you'll reduce your chances of becoming one of those investors who, by doing too much, do themselves in.
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