Investing 101: Buy your first stock or fund

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 the following one), 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 more 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. My follow-up to this column describes 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 own only 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.

Continued: Managed funds vs. indexed funds

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