Ways for individuals to invest in stocks

Ways for individuals to invest in stocks

Buy stocks through mutual funds

Because of problems with IPOs, liquidity, execution and commissions, most people should invest in stocks through mutual funds. Mutual funds offer professional management at low cost.

Mutual funds also offer diversification which any stock investor needs. Buying individual stocks exposes you to unnecessary risk.

Buying individual stocks exposes you to volatility

The typical individual stock offers a return ranging from a loss of 40 percent to a gain of 60 percent a year. This volatility happens to some of the largest, most stable companies in America, so if a broker calls you up and tells you about how he foresaw a 50 percent gain in a particular stock, don't be impressed. It happens all the time.

The entire market, however, is less risky. In a given year you'll probably see the entire market return anywhere from minus 10 percent to plus 30 percent, with a long-term average of 10 percent. As you can see, buying the entire market exposes you to a smaller range of volatility while providing the same average return as investing in a single company.

Mutual funds must invest in at least 20 different securities

The best way to diversify your stock holdings is through a mutual fund. By law, mutual funds must invest in at least 20 different companies, but most funds invest in scores or even hundreds of stocks.

By investing in 20 or more stocks, you almost completely eliminate so-called specific risk. Specific risk is the risk that arises from investing in a single firm.

Diversification eliminates specific risk

Suppose you think computer companies will be a good investment, so you place all your money into one computer firm. Unfortunately, a major fire strikes your company, and the firm's buildings are burned to the ground.

The firm had insurance, but it's design labs are inoperable for six months. This downtime means death in the fast-moving computer industry, and your company files for bankruptcy.

In this case, specific risk means that you probably lost your entire investment. If, however, you had purchased stock in the top 20 computer companies, your exposure to specific risk would be reduced greatly. What one company loses will be picked up by other companies.

Mutual funds are a bargain

The diversification and professional management offered by mutual funds normally comes at a low price. Minimum initial investments for mutual funds vary, but they usually start at $1,000 or less if you're investing through an IRA. Subsequent investments can be made for as little as $50.

For more information about diversification and investing in mutual funds, listen to my tape, "Mutual Fund Investing for Everyone".

Variable annuities

Another way to invest in equities is through variable annuities. Variable annuities are tax-sheltered investments offered by insurance companies that are similar to a mutual fund because they pool assets from many investors to buy stocks.

Variable annuities are also like IRAs because the earnings from the variable annuity are sheltered from federal income tax until you begin to draw down the account upon retirement. To discourage withdrawals before retirement, variable annuities place a 10 percent tax penalty on distributions before age 59.5.

However, unlike most IRAs or other retirement accounts like 401(k)s, variable annuities do not offer up-front tax deductions. All contributions to a variable annuity are made with after-tax dollars.

Because of this, you should not invest in variable annuities until you have taken full advantage of the deductible 401(k), IRA and other retirement accounts you have available to you.

DRIPs

Another way to buy stocks is through a dividend reinvestment program, also called a DRIP. In this case the company you're investing in acts like a stock broker.

The main attraction of DRIPs is that you can avoid paying brokerage costs. However, I can't get excited about DRIPs for several reasons.

First, they tend to concentrate your holdings in one company's stock. They also complicate capital gains calculations. Plus, with discount brokerage fees coming down, DRIPs don't offer much of a cost savings.