Investing in the stock market is now easier than ever. Inexpensive Internet-based brokers such as E*Trade, TD Ameritrade and Schwab allow you to trade stocks as quickly as you can type and double-click. But should students really be buying individual stocks? Are mutual funds or index funds a better option?
First, let's define our terms. A stock is a type of security that signifies ownership in a company. By owning stock in a company, one is entitled to a proportional share of that company's assets and earnings. Investors make money on stocks either by a) dividend payments or b) an increase in stock price. Stocks are inherently risky and subject to large swings in value. To reduce some of this risk, many people invest in mutual funds, which are pools of money managed by investment professionals. Mutual funds contain an assortment of stocks; the riskiness of these stocks varies across different types of mutual funds. An index fund is a type of security that can be bought on an exchange, much like a stock and behaves like the overall market. One of the most popular index funds is the SPDR Trust, which moves directly with the S&P 500 Index.
So why should you avoid picking individual stocks and invest in mutual funds and index finds instead? Well, despite the recent turmoil, the stock market as a whole has historically been a pretty good bet. The S&P 500 Index historical average annual return is around 10 percent, quite a step up from the 3 percent your savings account is earning now. By investing in index funds, young people, especially those lacking experience or insight into financial markets, can earn returns in lockstep with the overall market while avoiding the volatility of individual stocks.
Mutual funds provide the same benefits of diversification as do index funds, but allow investors to target a specific class of investments. For example, if you want to invest in small, growing Chinese companies, there's likely a mutual fund designed to do just that. Investors in mutual funds don't have to worry about any of the stock-picking or the related risks. The money managers running your mutual fund probably spend 70 to 80 hours a week making sure your money is being invested effectively and efficiently.
So if these Wall Street-types spend all that time and energy analyzing the market, why should you even consider trying to outperform them by buying and selling your own stocks? I believe there is some value in researching and betting on individual companies you believe in. And while it may not be smart to put the entirety of your life savings into the "sure thing" you read about on the Internet this morning, here are some reasons for investing at least some of your money in individual stocks:
1.) Believe it or not, you may know more about the true value of a brand than Wall Street does. Think back a couple of years, back when UGG boots were just getting popular. The investment professionals on Wall Street had no idea how popular these boots were becoming on high school and college campuses, but I'm sure you noticed all of your friends were buying them. If you bought stock in Deckers, Inc., the company that makes UGG boots, in the beginning of 2006, you would have quadrupled your money by now. Observation can be a very powerful tool, so keep an eye out.
2.) You're only 20 years old. Take a risk -- you might just make some money! It's a lot easier to make risky bets on individual stocks when you don't have to worry about mortgage payments and putting your kids through college. If you believe in a company, buy a little bit of stock. Worst-case scenario: You lose a little bit of money. In the grand scheme of things, you'll have plenty of time to make it back.
3.) It's a great opportunity to learn. There is no better way to gain investing experience than by actually buying and selling stocks. It will keep you interested in financial news and give you a keener eye for potential investment opportunities.
Regardless of whether you invest in individual stocks, mutual funds, index funds or a combination, I encourage you to put some of your extra money into the market. It's a great way to learn, gain experience and maybe even make some money.
Pete Cobos is the vice president of the McIntire Investment Institute, a student-run equity fund.
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