Investing 101: Buy Your First Stock Or Fund

You say you want to invest, but you don’t know where to start? This investing primer walks beginners through each step along the way to becoming a shareholder.

By Harry Domash

It's a question we get a lot around here: How do I buy stocks? It sounds simple to experienced investors, but getting started can seem daunting. With this column (and in one to follow), I'll take new investors through each step of becoming a shareholder.

What's a stock?

First, let me answer this question: What is a share of stock?

Corporations sell shares of stock to raise cash to fund their operations. The first time that a company sells its shares is termed its initial public offering (IPO). Most companies make additional stock offerings from time to time to raise additional funds.

When you buy stock, you are buying ownership in the underlying corporation. For instance, if XYZ Corporation has issued 100 shares, and you buy one share, you have purchased a 1% ownership stake in XYZ.

Once a corporation sells its shares, it doesn't receive any direct benefit if its share price goes up further (although its executives may hold shares and thus be motivated to try and increase the share price -- hopefully by making the company more profitable).

The intermediaries

The first step in buying shares is deciding who will help you buy them. The most likely middle-man is a stockbroker, of which there are two main types:

• Full-service brokers offer financial planning and advice on selecting investments such as stocks and mutual funds. They usually have offices you can visit, and an individual broker is usually assigned to each customer. Full-service brokers are the most expensive way to buy shares. You'll typically pay around $70 to buy or sell a batch of shares, compared to $20 or less with a so-called discount broker. That can be money well spent if you don't have the time or interest required to manage your portfolio on your own.

• Discount brokers cater to investors willing to do their own research and make their own investing decisions. Most don't have local offices -- they typically operate online or over the phone -- and don't offer investing advice. Because their trading commissions are low, discount brokers are a good choice if you pick your own funds and stocks. Some brokers, such as Charles Schwab, straddle the line between full-service and discount, operating branch offices and offering some financial advice. Click here to learn how to pick a stockbroker.

Funds versus stocks

There are two basic ways to invest in the stock market: You can buy stocks of individual corporations, or you can buy mutual funds.

The balance of this column deals with mutual funds. In my next column, I'll describe how to buy stocks.

Mutual funds invest the pooled funds of thousands of investors. By investing in mutual funds you gain the advantages of professional management. Because most funds hold dozens, if not hundreds, of stocks in their portfolios, investing in funds also gives you automatic diversification.

That is an important advantage. Even if you're a gifted stock-picker, inevitably something unexpected will happen that will sink the share price of one of your stocks. Such an event could be a disaster if you only own a few stocks, but would be no big deal for a mutual fund holding a hundred or so stocks.

Mutual funds often specialize in specific market niches, such as small companies, health-care stocks, fast-growing companies, etc. You can buy mutual-fund shares directly from a fund company -- such as Fidelity Investments or the Vanguard Group, which offer a variety of fund types -- or through a stockbroker.

Even if you use a broker, you are actually buying from the mutual-fund company itself. The funds are technically freestanding companies. They create new shares when investors buy more fund shares than they sell, and eliminate shares when more shares are sold (redeemed) than bought.

Stock prices rise or fall depending on investor demand. If more people want to buy a stock, its price typically goes up, and vice versa. But mutual-fund share prices reflect the value of a fund's holdings, not supply vs. demand.

Most mutual funds establish minimum purchase requirements. Once you own a fund, you can usually add to your holdings in smaller increments. For instance, the Vanguard 500 Index (VFINX, news, msgs) fund requires a $3,000 minimum initial investment. After that, you can add to it in $100 increments.

What you pay

Unlike individual stocks, where you can trade any stock listed on a major stock exchange through any broker, no broker makes all mutual funds available to its customers. They pick and choose.

But most brokers have more than enough funds to meet an investor's needs. By using a broker, you'll only get one statement each month showing the performance and balances in each of your funds. It's also convenient when you want to sell one fund and buy another, as you will have a much wider selection to choose from.

However, that strategy may be more costly if your broker charges a transaction fee to trade the funds you've selected.

Some funds levy charges known as loads, essentially sales commissions that the fund pays to the financial advisor or stockbroker who sells you the fund. Funds that charge such fees are called "load" funds, and those that don't are "no-load" funds."

Loads can be charged when you buy (front-end loads) or when you sell (deferred loads). Front-end loads, typically 5.75%, are subtracted from your funds right away, reducing the amount that actually gets invested and your gains over the long term.

Those loads eat into your investment gains, so there is no reason to buy a load fund unless you are relying on a financial advisor or broker to help you pick funds. In theory, it's that advice you're paying for.

Managed funds vs. index funds

Managed funds employ a fund manager, who picks the stocks he or she thinks have the best chance to rise in price.

By contrast, index funds attempt to match the composite investment gains of all stocks making up a particular category, such as large companies, small companies or technology companies. Or, in some cases, to match the investment gains of the entire stock market.

Since, in theory, fund managers wouldn't choose obvious losers, you'd think that most managed funds would readily outperform index funds. But that's not necessarily the case. Sometimes they do and sometimes they don't. The relative performance of managed funds vs. index funds depends on the particular index and time period that you analyze.

Here are two no-load managed funds that have consistently outperformed the overall market over the past five years:

• Fairholme (FAIRX, news, msgs): a blend of small-, mid- and large-cap stocks in both the value- and growth-priced categories.

• Kinetics Paradigm (WWNPX, news, msgs): mostly mid- and large-cap stocks in both the value- and growth-priced categories.

• Fidelity Select Medical Equip/Systems (FSMEX, news, msgs): a blend of mid- and large-cap growth-priced stocks in the health-care industry.

Here are two no-load index funds:

• Wilshire 5000 Index Portfolio (WFIVX, news, msgs): It emulates the Wilshire 5000 Index ($TMW.X, news, msgs), which essentially tracks the entire U.S. stock market.

• Vanguard Small-Cap Index (NAESX, news, msgs): It emulates the Russell 2000 Index ($RUT.X, news, msgs), which tracks small-cap stocks.

Index funds vs. exchange-traded funds

Within the index fund category, you have another choice: traditional index funds vs. the new kid on the block -- exchange-traded funds (ETFs).

The primary difference between exchange-traded funds and conventional funds is that ETFs trade just like stocks. You pay the same commissions you would for buying or selling stocks, and there is no limitation on trading activity.

For that reason, active traders prefer ETFs. However, because you pay a commission every time you buy, ETFs are not suitable for investors who want to invest on a regular basis -- say, monthly (a smart strategy known as dollar-cost averaging.)

Here are two index funds available as ETFs:

• Diamonds Trust (DIA, news, msgs): It tracks the Dow Jones Industrial Average, a group of large, established companies chosen by the editors of The Wall Street Journal.

• NASDAQ 100 Trust (QQQQ, news, msgs): It tracks the Nasdaq 100 Index, which in turn tracks the 100 largest nonfinancial stocks listed on the Nasdaq stock exchange.

Buying and selling mutual funds

Many mutual funds have similar names, so it's best to use ticker symbols when you research and trade mutual funds.

Unlike stocks, where you specify the number of shares you want to buy or sell, for mutual funds, you usually enter the dollar value that you want to trade. If you're using a discount broker, most give you -- on their Web sites -- a way of seeing the minimum purchase requirements and applicable transaction fees when you enter a fund's ticker symbol. (Our Easy Fund Screener has similar information.) When you buy, you must specify whether you want dividends and capital-gain distributions from the fund credited to your account in cash or reinvested in fund shares. Dividends are profits paid by companies to their shareholders, in this case, the fund. A fund realizes capital gains when it sells shares of a stock whose price has gone up. Most investors choose to reinvest the distributions.

Conventional mutual funds (not ETFs) trade only once daily, after the market closes. If you miss the deadline for the day you enter the trade, your transaction will be processed after the market closes on the following day.

When you sell fund shares in a regular brokerage account, your broker will tell you whether you've realized a gain or a loss on the sale. You will have to pay taxes on any gains (unless the shares are held in a tax-deferred account like a 401(k)). Your year-end brokerage statement should show your total gains or losses for the year and how to report them on your tax return. Click here for more information on how to minimize the tax bill on your investments.

Mutual funds are a good way for beginning investors to get into the market. After you've got your feet wet, you may want to move on to individual stocks.

At the time of publication, Harry Domash did not own or control any of the securities mentioned in this article.