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When you purchase stock, you’re buying a small unit of ownership in a company with the hope that investment will generate a bigger payoff in the future. Building a portfolio of diversified stocks and other investments is a way to generate returns on your savings that compound into more savings over time. Investing in stocks can be a way to reach major savings goals such as buying a home, paying for a child’s university tuition, or retirement.
Like all types of investments, stocks come with certain risks. Individual stocks and entire markets can go up and down, and it’s possible to lose the money you invest if you need to make withdrawals during market downturns. Investment returns can be affected by factors like company performance, industry or sector movements, inflation, interest rates, recessions and major world events.
But even with dips, stock markets have historically trended upward over the long run and generate higher returns compared to savings accounts. For example, most savings accounts in Canada offer interest rates around 1-2%. Average stock market returns can be calculated differently depending on the stock exchange, the length of time measured and inflation. But over the long term, investing in stocks can deliver annual average returns of 5-8%.
How the stock market works
The stock market is a broad term for a group of global financial exchanges where shares of publicly traded companies are issued, purchased and sold. Stock is more of a broad term, and a share is a specific unit of ownership in a publicly-traded company. However, the two terms are often used interchangeably. When you buy stock, you become a shareholder with certain voting rights and access to dividends, if the company issues them.
Companies sell shares on stock exchanges to raise money to develop and grow their business operations. In Canada, the main stock exchanges are the Toronto Stock Exchange (TSX) and the TSX Venture Exchange. In the U.S., major stock exchanges include the New York Stock Exchange, the Nasdaq and the American Stock Exchange. There are dozens of major stock exchanges around the world, including the U.K., Germany, Japan, China, India, Hong Kong, Australia and Brazil.
Stock markets in North America trade on weekdays between 9:30 a.m. to 4 p.m. EST. During the trading day, stock prices may fluctuate based on supply and demand and can move up or down based on quarterly corporate earnings reports, central bank interest rate announcements and general industry news and outlooks, as well as wildcard occurrences such as large-scale political or civil unrest, terrorism or natural disasters.
How to begin investing in the stock market
With a little preparation and research, it’s fairly easy to buy stocks. Here’s a step-by-step guide on how to do it.
1. Choose how you want to invest
First, think about how active you want to be in choosing and managing your investments. There are a few different ways to approach investing, but the easiest way to buy individual stocks is by setting up a trading account through a discount brokerage. You can also get investment advice through a financial advisor, or take a more automated approach by using a robo-advisor. Each has different costs associated with trading, advising and managing your account.
Automated approach: Robo-advisors offer a set-it-and-forget-it approach by asking you a few questions, assessing your risk profile and using algorithms to appropriately invest your money. You’re normally invested in a broad section of the market (passive/automated investing). Robo-advisors have low opening balance requirements and are inexpensive, with fees much lower than the cost of a financial advisor (0.4%-1% of your investments). Robo-advisors often require little human interaction, but many platforms provide some financial advice in the form of online tools or access to a financial advisor. Robo-advisors mostly invest in ETFs, so if you want to pick and choose specific stocks, you should look into opening a brokerage trading account.
DIY approach: A discount brokerage is much more hands on. You can pick your own stocks, bonds or funds that you want to invest in and, as the name suggests, trading fees are low (from between $0-$10 per trade depending on the institution). They can be a good fit for investors who want to trade frequently, though trading fees can add up. Discount brokerages don’t offer any financial advice.
Financial advisor approach: A financial advisor is someone who provides financial planning and can invest money on your behalf. The fees for a financial advisor are generally higher than a robo-advisor or a discount brokerage–often 1% to 2% of the assets they manage. Now that there are more low-cost options for investors, some financial advisors are only taking on higher net worth clients, often those with investable assets of $100,000 or above. Still, there are many advisors who will work with people across the income spectrum. They can be useful if you have a complicated financial situation, or if you need help budgeting.
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2. Determine your risk tolerance and portfolio allocation
In general, younger people can take more risk with their money because they have a longer investing time horizon. For example, if you’re in your 20s or 30s, you can allocate a larger portion of your portfolio toward stocks because you have a long period of time to recover any losses.
When it comes to individual stocks, there’s a philosophy called the “5 percent rule”: No single stock should represent more than 5% of your investment portfolio.
If you’re in your 50s and starting to plan for retirement, you may want to shift away from stocks and move toward more fixed-income investments such as bonds, as well as cash, as you will have less time to recover from a big market decline before you need the money.
3. Decide on the type of account
You can hold stocks and other investments in registered or unregistered accounts. Registered accounts are designated by the federal government to have certain tax advantages, but they also have rules around contribution limits, withdrawals and age limits. You can open and contribute to more than one type of account over the course of your life to meet different saving and investing goals.
Tax-free savings account (TFSA): A TFSA is a type of registered account for Canadian residents aged 18 or older. A TFSA acts as a tax shelter: any interest, dividends and capital gains grow tax-free, and no taxes are charged on withdrawals. TFSAs have flat annual contribution limits, and unused room rolls over to the next year. TFSAs can hold cash for accessible savings such as an emergency fund, and they can also hold investments for long-term goals.
Registered retirement savings plan (RRSP): An RRSP is another type of registered account that is used to save for retirement. When you deposit money into an RRSP, you receive a tax deduction for that amount on your annual personal income tax return. As long as the money stays in the account, all investment gains grow tax-free. When you withdraw funds, the funds are taxed according to your marginal tax rate. RRSPs have annual contribution limits that are based on your income. You can open an RRSP and start contributing at any age, as long as you earn money and file an annual tax return.
Registered education savings plan (RESP): An RESP is a registered account specifically used to save for post-secondary education and pay for tuition, textbooks, and living expenses. Contributions are eligible for government grant matching, and there’s a lifetime contribution limit of $50,000 per person. When the RESP beneficiary withdraws contribution money, it’s taxed as their income with the idea that as a student, their tax burden will be extremely low.
Non-registered investment account: A non-registered account is any other type of account that can hold investments, but doesn’t offer any tax shelter or deferral. When you hold investments in a non-registered account, you’re required to pay annual taxes on any dividends or on any gains made on that investment from the time you buy to the time you sell (called capital gains). There are no annual or lifetime contribution limits for non-registered accounts, so they’re a good option if you’ve maxed out your TFSA and RRSP.
4. Set a budget for your investments
If you’re a first-time investor, how much you should invest in stocks depends on your comfort level and how much money you have to invest. It also depends on the share price of the stock you want to buy, because prices can range from a few dollars to hundreds or even more than a thousand dollars per share. Some discount brokerages don’t have investment minimums. Many do have account trading fees and commission that you may have to pay.
5. Choose your stocks
Picking individual stocks isn’t easy—doing your own research and analysis can be time consuming, which is part of the reason why ETFs and index funds have become so popular. However, if you’re keen to invest in a certain company or industry and want to allocate a slice of your portfolio to stocks you’ve selected yourself, there are a few ways to investigate the companies you want to invest in.
First, it’s important to understand how the company works and where its revenue comes from. You should look at a company’s quarterly financial results and annual reports to see its revenue, net income, earnings per share and price-to-earnings ratio. You can also evaluate companies based on qualitative factors such as their leadership team and their management style, the company’s mission statement and whether its business practices align with your personal values.
Once you’ve determined your risk tolerance and how you want to manage your investments, set a budget and portfolio allocation and choose what kind of account you want to hold those stocks in. Then you’re ready to buy.
Types of stocks
Companies tend to issue shares that are either common or preferred. Shares may be further divided into series (Class A, Class B, etc.), each with different types of voting rights.
Common shares make up the majority of stock issued by publicly traded companies. Common shareholders may receive dividends (if the company issues them), and can exercise voting rights to elect the company’s board of directors and decide on corporate policies. But if a company goes bankrupt and its assets are liquidated, common stockholders are the last to be paid after creditors, bondholders and preferred stockholders.
Preferred shareholders receive the VIP treatment, and have first claim to a company’s dividends and liquidated assets ahead of common stockholders. It depends on the company, but preferred shares usually don’t have voting rights. Common shares generally see higher gains over the long term, but preferred shares offer the security of guaranteed fixed dividends.
Different classes of stock
Common and preferred shares can be subdivided into series, usually to differentiate between voting rights. For example, a company may issue Class A shares where each share gets five votes, while Class B shares get one vote per share.
Different categories of stock
Stocks can also be grouped by different characteristics including company size, performance record, growth potential, industry, sector, or location.
Domestic stock and international stock
Your investing options aren’t limited to Canadian stocks. Investing in foreign markets is a way to diversify your portfolio and spread out the economic, geographical and political risks associated with different markets. Foreign stocks can be distinguished by country, region, currency, or type of economy, from frontier and emerging to more developed.
Stock market sectors
If an industry exists, there’s probably a number of stocks representing it. Broad stock market industry categories include technology, energy, real estate, consumer discretionary, consumer staples, financial, healthcare, industrials, materials, communication services and utilities.
Small-cap, mid-cap and large-cap stocks
Market capitalization (or “market cap”) is the total value of a company’s shares of stock. There isn’t necessarily a hard line separating each category, but small-cap stocks are generally considered to be between $300 million and $2 billion in market cap, while mid-cap stocks run between $2 billion and 10 billion. Large-cap stocks have a market cap of $10 billion or more.
Growth stocks and value stocks
Growth stocks belong to companies that are expanding quickly and poised to become profitable in the future, such as technology companies. In the short term, growth stocks usually pay low (or no) dividends because profits are invested back into the company. Value stocks are stocks considered to be underpriced and undervalued, but with strong future prospects. Value stocks have a less shiny appeal, but they tend to pay dividends and are less volatile than growth stocks.
Blue chip stocks and penny stocks
Blue chip stocks are the household names of the stock market, and are issued by large companies that have demonstrated consistent growth and profits for a long period of time. Share prices of blue chip stocks tend to be more reliable than smaller operations and many offer solid and stable dividends.
Penny stocks are pretty much the exact opposite of blue chips: these ultra-cheap stocks are issued by small public companies and trade on smaller market exchanges. Penny stocks are risky because they’re subject to fewer standards and regulations, the shares are less liquid because it’s a smaller market, and the companies issuing them are less established.
Blue chip and penny are two categories on opposite ends of the spectrum, but there’s a wide range of stocks in between to choose from—it’s not one or the other. Penny stocks aren’t an alternative to blue chip stocks, and it’s recommended that new investors stay away from penny stocks. There are plenty of high-quality stocks trading on major exchanges that aren’t necessarily blue chip, but are still profitable, reputable and pay dividends.
How do you make money from the stock market?
In the most basic terms, you earn money on investing in shares of stock by buying them at a low price and selling them later for a higher price. Some companies pay dividends, which are portions of the company’s profits distributed to shareholders at regular intervals.
While both traders and investors can buy and sell stocks – the latter want to make a quick buck by purchasing and dumping stocks quickly, the latter holds stocks for the long-term – for the general public, it’s recommended to take that long-term approach. You’ll should money you won’t need to touch for at least the next five years. Markets can go up and down in the short term, but trends upwards over longer periods of time. The longer you stay invested, the longer your investments have to grow in value.
Remember, no investment is risk-free—one of the golden rules of investing is “don’t invest money you can’t afford to lose.” Investors should diversify their portfolio by putting money into different securities based on their appetite for risk. Diversification is a way of spreading out risk and helps protect against declines in one sector, industry, commodity or currency.
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Stocks vs. ETFs, mutual funds and index funds
Individual stocks allow you to choose specific companies to invest in. There are also investments that hold a number of stocks within a single purchase, giving you an easy way to diversify your holdings compared to assembling a portfolio of individual stocks.
Exchange traded funds (ETFs)
An ETF is a type of investment that contains a bundle of different stocks held within a single share. When you buy an ETF share, you get a diversified portfolio of stocks across a variety of industries and asset classes. Like individual stocks, ETFs are sold in shares and can be traded throughout the day on stock exchanges. Most ETFs are passive investments designed to track and replicate the holdings of a benchmark index, and often have lower management fees than other investment products.
With a mutual fund, investors pool their money into a single professionally managed account. The fund itself doesn’t trade on a stock exchange but invests in a basket of publicly traded securities chosen by the fund’s manager. Unlike stocks, which are priced per share, you buy into a mutual fund by investing set dollar contributions. For example, a single share of stock may cost $100. If you invest $100 into a mutual fund, it is combined with other fund members’ contributions and invested in a variety of different stocks and bonds. Whenever additional people invest in the mutual fund, new shares (called units) are created. Because mutual funds are active investments, they have higher management fees and commissions.
An index fund is a type of mutual fund, but takes a more passive investing approach. An index fund is very similar to an ETF: both are built to track the holdings and replicate the returns of a benchmark index, and offer investors a way to buy a diversified bundle of assets. Index funds are generally more cost effective than other types mutual funds because they require less overall input from a fund manager and have lower portfolio turnover.
The stock market can seem confusing, but there’s a simple way of looking at it: issuing stock is a way for companies to raise money, and buying stock is a way for investors to earn money if those companies (or the market as a whole) succeeds. As long as you understand the risks and make informed decisions, investing in stocks can be part of a long-term strategy to build wealth. Of course, if picking your own stocks feels too time-consuming, expensive or risky, you can always invest in ETFs or index funds.