Stocks are a powerful tool for building wealth, but they also come with risk. Here are some key things to know about them so you can make informed decisions and create a portfolio that aligns with your financial goals.

What are stocks?

Stocks are one of the most common investment vehicles out there, but what exactly is a stock? People who purchase company stocks become what’s known as “shareholders” and thus own a tiny portion of that same business. As companies welcome the ability to bring shareholders into the fold as it allows them to raise capital, the stock market is inherently symbiotic; businesses issue stocks to help fund operations, expansion, and other financial needs while investors buy stocks in the hope of profiting from said company's success.

Investors can make money from stocks in two primary ways: capital appreciation and dividends. The former occurs when stock prices increase, giving investors the means to sell their shares at a higher price than they initially paid (e.g., buying a stock at $50 per share and later selling it for $75 creates a profit of $25 per share). Some companies also pay dividends—periodic cash payments distributed to shareholders from company profits—though others instead prefer to reinvest earnings back into the business in order to fuel growth. Dividend-paying stocks are particularly popular among retirees and income-focused investors.

Are different types of stocks available?

Investors can choose between two primary types of stocks: common and preferred. While common stocks are most widely held and provide shareholders with voting rights at company meetings (as well as potential dividend payments and capital appreciation), their shareholders are last in line to receive any remaining assets should the business go bankrupt. Preferred stocks, on the other hand, don’t typically come with voting rights but offer shareholders a higher claim on dividends and the ability to receive assets prior to common stockholders in the event of bankruptcy.

What impacts stock prices?

The news is chock-full of information about rising or falling stock prices, but what exactly causes such fluctuations? While a stock’s price is (in theory) tied to company financials (more on that later), it’s important to understand this price—as with the cost of almost anything—is based on what people are willing to pay for it. Investor sentiments about a company thus impact the price of its stock, further influenced by a host of factors ranging from company performance and industry trends to broader economic conditions.

Stock-evaluation techniques

While market sentiment (how investors feel about a company) impacts stocks, company fundamentals are in play here as well; a fundamental analysis likewise involves evaluating a company’s financial health, profitability, and valuation in order to discover a stock’s “true” or intrinsic value.

For example, let’s say a new federal official is elected. This may create uncertainty, which in turn leads to broad investor fear that causes a company’s stock price to drop. In this case, investors with an approach rooted in fundamental analysis will believe that while the market may have caused a temporary price reduction, the company’s robust fundamentals will help the stock price rebound and reflect this over the long-term.

Several key metrics are involved in this fundamental analysis, including:

Earnings per share (EPS)
Price-to-earnings (P/E) ratio
Price-to-book (P/B) ratio
Dividend yield

Let’s briefly examine each of these metrics and what they tell investors about a company.

Earnings per share (EPS)

Earnings per share (EPS) represents the portion of a company’s net earnings allocated to each outstanding share of stock. A higher EPS generally indicates a more profitable company—making it a desirable investment—and investors often compare a company's EPS over time to ascertain if earnings are growing. For example, if a company reports an EPS of $3.00 one year and $4.50 the next, this signals increased profitability that can in turn drive stock prices higher.

Price-to earnings (P/E) ratio

As a widely used metric for evaluating whether a stock is overvalued or undervalued, the P/E ratio compares a company's stock price to its earnings per share. While a high P/E ratio may indicate a stock is expensive relative to its earnings, a low ratio could mean the stock is undervalued.

Price-to-book (P/B) ratio

The P/B ratio compares a company’s stock price to its book value, meaning the net value of its assets after liabilities; a ratio less than 1 suggests a stock is undervalued, with company assets worth more than its market valuation.

Dividend yield

Dividend yield indicates the percentage of a company’s stock price paid out in dividends annually. For example, if a stock pays an annual dividend of $4 and trades at $100 per share, the dividend yield is 4%. A higher yield is often attractive, but investors should also consider whether the company can sustain its dividend payments over time.

While financial metrics are valuable tools, their value is in how you use them (as with any tool). One of the most common investor mistakes, likewise, is using financial metrics to compare companies from different industries. For example, tech companies often have high P/E ratios as investors expect rapid growth, while utility companies typically have lower P/E ratios due to stable but slower growth; drawing comparisons between them may cause the utility stock to appear undervalued when, in reality, it simply reflects the industry norm.

Major market indices

A stock market index measures the performance of a group of stocks representing a specific market or sector, either focusing on a small niche or seeking to measure the performance of the entire US economy. The S&P 500, the Nasdaq, and the Dow are three of the most commonly used indices in the U.S., and while all three aim to track stock market performance as a whole, they each do so differently. The better you can understand these seemingly subtle differences, the better you can leverage them in your decision-making.

S&P 500

The S&P 500 (Standard & Poor’s 500) tracks 500 of the largest publicly traded companies in the U.S. and covers various sectors including technology, healthcare, and finance to make it a strong indicator of overall market health.

Nasdaq

The Nasdaq Composite primarily tracks companies listed on the Nasdaq Stock Exchange, known for being home to many technology and growth-oriented firms such as Apple, Microsoft, and Tesla. The Nasdaq is organically more volatile than others due to its heavy concentration of tech stocks.

Dow Jones Industrial Average

The Dow Jones Industrial Average tracks 30 large, well-established U.S. companies. Unlike the S&P 500—weighted by market cap—the Dow is a price-weighted index, meaning higher-priced stocks influence the index more than lower-priced ones.

Each of these three indices provides valuable insight into the market, with the S&P 500 reflecting broad market performance, the Nasdaq focusing on tech-heavy growth stocks, and the Dow representing more stable, industry-leading companies. Experienced investors monitor all three to best understand various aspects of the stock market.

Investing in funds vs. individual stocks

Individual stocks and funds reflect the two primary ways to invest in stocks. The former represents ownership in a single company—investor returns directly tied to company performance—and can thus lead to significant gains if the business thrives but also comes with higher risk as poor performance can cause sharp declines in value. Funds, on the other hand, are investment vehicles that pool money from multiple investors to buy a diversified portfolio of stocks. With funds spreading investments across multiple companies or sectors, such built-in diversification reduces the risk associated with holding a single stock. Several types of funds each have unique structures and objectives, as follows:

Mutual Funds

Mutual funds, either actively or passively managed, are purchased directly from fund companies rather than on stock exchanges.

Exchange-Traded Funds (ETFs)

Exchange-traded funds (ETFs) function similarly to mutual funds but trade on stock exchanges just like individual stocks.

Index Funds

Index funds, either mutual funds or ETFs, are designed to replicate the performance of a specific market index (e.g., the S&P 500).

Hedge Funds

Hedge funds—which cater to accredited investors—employ high-risk strategies such as leveraging and short-selling, requiring large minimum investments and charging high performance-based fees that make them less accessible to the average investor.

Fund investments support portfolio diversification by spreading them across multiple assets and thus reducing the impact of a single stock’s poor performance. As the S&P 500 index fund invests in 500 different companies, for example, the risk is inherently lower than holding a few individual stocks.

Common investment strategies

Investors can select from hundreds of different investment strategies, some straightforward and others not so much. A few of the most common and accessible include…

Dollar-cost averaging

With dollar-cost averaging, investors commit to investing a fixed amount of money at regular intervals regardless of market conditions. For example, in investing $500 in a specific index fund on the first of each month, the goal is to reduce market volatility impacts and avoid the temptation to time the market by consistently investing over time (buying more shares when prices are low and fewer shares when prices are high).

Dividend investing

Dividend investing, which focuses on buying stocks of companies that regularly pay dividends, is an attractive option for those looking to generate income.

Growth investing

This approach zeroes in on companies expected to grow faster than the overall market, with these stocks—often found in the technology or healthcare sectors—prone to reinvesting profits rather than pay dividends. While they offer good potential for returns, they’re also often volatile with no guarantee anticipated growth will come to fruition.

Value investing

In seeking out stocks undervalued by the market, investors who employ this strategy pinpoint companies that appear to be trading below their intrinsic value (often due to temporary challenges or market overreactions) and then buy these stocks at a discount: aiming to profit when the market eventually recognizes their “true” worth.

Index investing

Index investing provides broad market exposure by tracking major indexes (e.g., the S&P 500) as part of a passive strategy that requires little effort and historically delivers consistent returns with less risk than individual stocks.

Factors to consider when creating an investment portfolio

Asset allocation, risk tolerance, and time horizon are three critical factors to consider when creating a stock portfolio. Here’s a bit about each…

Risk tolerance

Risk tolerance goes beyond one’s emotional willingness to take on risk to also consider his/her financial situation as a whole. A single retiree on a fixed income will likely have a lower risk tolerance, for example, than a married couple with no children, two incomes, and no major anticipated expenses.

Time horizon

Time horizon is simply a fancy way to express how long an investor plans to keep his/her money invested before accessing it. A longer time horizon typically allows for a more aggressive investment approach, with more time available to recover from market downturns.

Asset allocation

Asset allocation refers to how an investor distributes his/her money across different asset classes such as stocks, bonds, and cash. While stocks typically offer higher returns albeit with greater volatility and risk, bonds provide more stability and steady income. Cash or cash equivalents (e.g., money market funds), meanwhile, add liquidity but generally have lower returns. No one single asset allocation will work for all investors, as the goal is to create a diversified portfolio balancing risk and return based on individual financial needs.

How to invest in the stock market

Having now covered the basics, let’s discuss how to get started when setting out to create your own personal investment portfolio using the following five steps…

Step 1: Establish your investment goals

Before diving into the stock market, it’s important to define your financial objectives. Are you investing for retirement, to buy a home, or to build wealth over time? Your investment goals will influence the types of stocks or funds you choose as well as your risk tolerance.

Step 2: Choose the right investment account

As you need an investment account to buy stocks, you can choose from several types including:

Brokerage accounts: These accounts allow you to buy and sell stocks, ETFs, and other securities. Many brokerage firms offer user-friendly platforms and some provide commission-free trading, making it easier for beginners to get started.

Retirement accounts (IRAs, 401(k)s): If you’re investing for retirement, tax-advantaged accounts such as a traditional or Roth IRA can help your money grow with tax benefits (though withdrawals may have restrictions).

Step 3: Choose your investment vehicle

Determine whether you’ll invest in individual stocks, ETFS, mutual funds, index funds, or a combination of the above. Research is key if you decide to invest in individual stocks, dictating you consider related factors such as company fundamentals and industry trends.

Step 4: Diversify your portfolio

Diversification helps manage risk by spreading investments across different companies, industries, countries, and asset types. While funds provide an easy way to diversify without the need to select multiple individual stocks, a single ETF or mutual fund doesn’t mean you’re fully diversified. As the S&P 500 consists of large-cap US stocks, for example, this means you’d lack international diversification and diversification across different-sized companies if you invest in a fund that tracks S&P 500 performance specifically.

Step 5: Monitor and adjust your investments

As investing is by no means a one-time event, you’ll need to regularly review your portfolio to ensure alignment with your goals and risk tolerance and avoid emotional reactions to short-term market fluctuations—which often cost far more in the long run.

DIY investing vs professional guidance

Questions swirl around whether it’s better to personally manage your own investments or work with a financial advisor instead. If you have the time, knowledge, and interest in self-management, a DIY approach may be right for you—just remember to learn and keep current on various influencing factors extending beyond the value of your portfolio (e.g., taxes primed to significantly impact your investments as well as ever-evolving tax laws). Those who lack the ability or desire to keep up with the fluid financial landscape and balance elements comprising a cohesive financial plan, meanwhile, are perhaps better served to enlist the help of a professional.

In sum: how to invest in stocks

Investing can feel overwhelming, especially when it comes to stocks given thousands of options to choose from. That’s precisely where Vision Retirement comes in, offering advice and investment options for both DIYers and those seeking guidance from a financial advisor. Schedule a FREE discovery call with one of our CFP® professionals to learn more.

How to Invest in Stocks: A Guide for Beginners