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The Short Answer

What Is a Stock?

This type of investment is the backbone of many investor portfolios.

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Friend: “Are you in the stock market?”

Me: “Yeah, kind of?”

That’s my response when people ask if I’m invested in the stock market. The question implies owning individual stocks, which isn’t the case for me. (It’s in my "too hard" pile.) But I do own hundreds of stock shares indirectly through mutual funds and exchange-traded funds--a safer bet for me and my investing goals.

The same generally applies for most investors as funds offer more diversification and convenience. What are stocks, and how should you invest in them?

Why Does a Company Issue Stock?

The average company doesn’t start as a publicly traded corporation. Most companies are privately held at first, meaning funding comes from the founders--or their friends and families. A growing company will eventually need more funding sources, which is where stock comes into play.

A company can issue public shares of stock through an initial public offering, or IPO. Once the IPO is complete, the stock debuts on a market exchange like the New York Stock Exchange. Investors can then buy shares, making them part owners of the business. This gives money to the company, so it can hire new employees or develop new products.

What Are the Benefits of Owning Stock?

The primary benefit of owning stocks is seeing the stock's price increase or “appreciate.” Stock price appreciation isn’t guaranteed, so investors who make wise bets can see eye-popping returns. The downside is that investors are also exposed to stock failures, which can hit pretty hard.

Because of the potential upside, stocks are one of the best investments to maximize your wealth. But you want to protect from individual blowups, which is why diversified exposure to stocks is a less-risky way to meet your investing goals.

Another benefit some shareholders receive is a dividend, or a cash payment from the company to stockholders. It’s like a “thank-you” payment for owning stocks, and most companies that distribute one do so every three months.

Not all companies offer dividends. Fast-growing companies often put cash to work by reinvesting in their business rather than distributing it to investors. Generally, older, more-established companies have room to offer dividends.

Proxy voting is another right stockholders enjoy. It allows them to choose the board of directors, vote on shareholder resolutions, and even have a say on CEO pay.

Because I don’t own individual stocks, I don’t have these rights. The investment company that manages my mutual funds and ETFs has these rights and exercises them on my behalf.

Should You Start with Stocks or Stock Funds?

The main reason I have stock funds rather than individual stocks is diversification. I prefer to have exposure to dozens if not hundreds of stocks than make active bets on a few individual companies.

Another reason is that many stock fund managers are experienced investors. I don’t have the time nor the energy to keep up with markets and make tactical portfolio decisions. Fund managers are paid to make these choices, so I stay out of my own way and let them do the stock-picking for me.

Excellent stock funds come in many shapes and sizes. Some, like Oakmark Investor (OAKMX), hold less than 100 stocks, while Vanguard Total Stock Market ETF (VTI) holds well over 3,000 stocks. Others like iShares Core S&P 500 ETF (IVV) own primarily U.S. stocks while some almost exclusively focus on international stocks like Dodge & Cox International Stock (DODFX).

Here are the best core stock funds and the best foreign-stock funds worth considering, according to Morningstar’s Susan Dziubinski.

Morningstar’s Guide to Stock Investing

If you’re passionate about investing, and want to try picking stocks, here are a few ideas to keep in mind.

  1. Allocate a small portion of your portfolio. When picking stocks, you shouldn’t put all your savings into a few names. Instead, put away 5%-10% of your savings into this "mad money" bucket. This prevents you from losing too much in case one of your bets goes wrong.
  2. Look for stocks with strong businesses. Companies with strong businesses are likely to outperform their competitors over the long term. The Morningstar Economic Moat Rating helps you understand a firm’s competitive advantages and how likely it is that the company will remain profitable and fend off competition.

    A company whose competitive advantages can last more than 20 years receives a wide moat rating. One that can fend off their rivals for 10 years has a narrow moat. A company with either no advantage or one that is temporary has no moat.
  3. Consider stocks trading below their fair values. There are many factors to consider when picking stocks, but one of the most important is valuation. The Morningstar Rating for Stocks helps you find those stocks that are trading below their intrinsic value and avoid those with less upside potential. Stocks that receive 4- or 5-star ratings are the most attractive buying opportunities.

Sachin Nagarajan does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.