The stock market offers greater growth potential than many other savings and investment options, but it also presents a variety of risks that can limit returns. Taxes, trading fees and unpredictable stock prices are just a few of the hazards that can cause losses in the stock market. Following a few basic stock investing principles that limit risk and out-of-pocket costs can reduce the chances that you'll incur large losses and increase the chances of steady returns.
Any particular stock has the potential to lose most or all of its value if the company that issued the stock performs poorly. If you put too much of your wealth into a single company, you could lose a large percentage of your net worth if that company fails. Diversification describes spreading your wealth across many different investments to limit risk. Buying stocks in a variety of different industries and countries to diversify stock holdings can reduce the impact of a few bad investments.
Buy and Hold
Stock prices fluctuate up and down over time based on investor demand for shares. In the long term, stock prices tend to follow corporate earnings, but in the short term, prices can fluctuate due to all kinds of factors that affect investor sentiment, including politics, economic conditions and natural disasters. Buying stocks and holding them for the long term lets you take advantage of positive trends that unfold over several years or decades while avoiding the impact of short-term market unpredictability. Professional stock traders sometimes trade stocks in the short term to make quick profits, but frequent trading is a risky practice that typically results in large losses for new investors.
Federal taxes can take a significant bite out of stock gains, especially if you don't invest for the long term. Gains you realize on stock investments held a year or less are taxed at your normal income tax rate, while gains on stocks you hold longer than a year are taxed at a top rate of 15 percent. Holding investments in a tax-deferred retirement account like a 401(k) plan or individual retirement account can also limit taxation. You don't pay taxes on any investment gains in tax-deferred accounts, although you usually owe income tax on withdrawals during retirement.
When you buy and sell stocks, you have to make trades through a broker who typically charges a fee for each trade. Avoiding frequent trading can limit transaction fees. You can also invest in mutual funds -- a type of professionally managed investment that can hold dozens of underlying assets like stocks, bonds and commodities -- that doesn't charge a "load" or transaction fee. Even no-load mutual funds, however, include an annual percentage fee called the "expense ratio."
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