buyupside.com Stock Investing Primer
Step 2: Own a Diversified Portfolio of Stocks

The U.S. stock market includes thousands of individual stocks and stock funds (collections of stocks). With all these choices available, how do you getting started buying stocks? One option is to buy a stock fund that tracks the 500 largest publicly traded companies in the U.S. Collectively, these 500 companies are known as the S&P 500. Why is owning the the S&P 500 make sense? It is a diverse mix of all types of companies like IBM, General Electric, Microsoft and Colgate that provide goods and services to the U.S. and the world. With the S&P 500, you don't have to attempt to pick a few stocks that may or may not do well. You can sleep well knowing that your diversified portfolio of 500 companies will protect you from a few bad apples.

For many investors it is very difficult to pick stocks and mutual funds that have a better long-term performance (makes you more money) than the S&P 500. Most professionally managed mutual funds do less well than the S&P 500 in the long run. Of course some funds do better but it takes lots of time and study to pick the winners. The same is true with individual stocks. If you pick a winner, you can make huge amounts of money in a short time. But you can also lose a lot of money very quickly if you pick a loser.

As a shareholder of the S&P 500 you are entitled to benefit from the good fortune of these companies. As they grow their businesses and profits, their stock prices will increase and you'll make money from this price appreciation. Some of the companies will generate excess cash and distribute it to shareholders in the form of cash dividends. You may take the dividends in cash or you may reinvest them and buy more shares of stock. I recommend that you reinvest the dividends.

The combination of dividends and stock price appreciation ensures that your long run returns will be greater than most other types of investments. Of course there will be periods when the stock market is doing well and some years when it's doing poorly. But over the long run you can expect the S&P 500 to rise in price.

Index Fund
You can buy the S&P 500 through a special type of mutual fund called an index fund that mirrors the return of the Standard & Poor’s 500 stock index. The index fund is not managed by a professional manager so it is very inexpensive to run compared to a managed mutual fund that require hands on buying and selling of stock.

Two low fee index funds that tracks the S&P 500 are the Vanguard 500 Index Fund Investor Shares (VFINX) and the Spartan 500 Index Fund - Investor Class (FSMKX). Each fund owns the 500 companies that comprise the S&P 500. So when you own either of these funds, you have exposure to the broad U.S. market. When the market goes up, the value of your investments rise. But when the market goes down, the value of your investments falls.

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Posted May 30, 2008.

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