An investment is a commitment of resources with the potential for a positive return — a gain. In this guide we'll discuss various reasons for investing, like funding financial independence and retirement. The bottom line is, of course, to become richer. Let's begin with a central arena for creating wealth through investing: the stock market.
Most people are familiar with the practice of buying shares of a company’s stock in order to establish fractional ownership in the company. Ownership is also known as “equity”. Apple is one of the most valuable public companies in the world. Right now you can buy a share of Apple for roughly $180, representing a small portion of equity: about one ten-billionth of the company. The total value of all the shares is about $2.8 trillion, and this total market value is Apple's market capitalization, or market cap. Most large companies are publicly listed, which means members of the public can readily buy shares. Some large private companies like Cargill and Koch Industries are privately owned, but they're not relevant to most people as investments, because they're inaccessible.
Companies sell their stock to the public because they need to raise money; investors are willing to provide money in exchange for the potential benefits of ownership. Once a company publicly issues shares, investors trade shares among one another. The stock price of a company is related to its assets and expected future profits, and owners' rights to those expected profits are why fractional ownership of a company is potentially valuable. There are many companies you could invest in, with the potential for large gains or losses. So what is the best way for the average person to profitably invest in the stock market and achieve long-term compounding growth of their money?
The first improvement beyond a portfolio with a small number of stocks is broad diversification. Compared to a single randomly selected stock (or ten randomly selected stocks), a portfolio with thousands of stocks has the same expected return but far lower risk. The easiest way to diversify a portfolio is to buy shares of a fund, which pools your money with that of many others to purchase an array of stocks that a small amount of money wouldn't be able to buy on its own. But that leaves us with work still ahead of us: there are thousands of funds we could invest in, so how do we choose? Stock funds can be divided into two broad management styles: index and active.
What is an index fund? The term "index" implies that management of the fund’s holdings is not influenced by personal decisions regarding which stocks to trade and when to trade them. Instead, the performance of the fund is intended to reflect its index as closely as possible. An index is like a list of directions for an index fund, showing which stocks it needs to own and in what proportions. Most indices are updated quarterly, and index funds revise their holdings accordingly. So an index fund is an institutionally managed structure which uses money from many participants to build a portfolio of stocks that will match the performance of its benchmark index, without regard for what that performance is.
The index with the most dollars tethered to it is the S&P 500, a group of 500 of the largest companies in the US. Index fund managers purchase shares of all stocks in the index or attempt to purchase shares in a representative sample of stocks. Someone invested in an S&P 500 index fund experiences the aggregate gains and losses associated with that group of companies, weighted by market cap. So a 1% increase in the most valuable company’s share price boosts the fund’s performance far more than a 1% increase in the least valuable company’s share price. Many index funds are market cap-weighted (a phrase often abbreviated to just “cap-weighted”).
The market cap of Costco, another well-known company, is about $330 billion. Because Apple is more valuable, a larger portion of your investment in the S&P 500 is allocated to Apple than Costco (6% vs. 0.7%). But you effectively own the same fraction of each company — perhaps one billionth for a small investor. So another way of conceiving of cap-weighted index funds is that you effectively own the same fraction of each company in the index. Market cap weighting is not the only way funds weight different stocks, but it is the most common because it allocates invested dollars in proportion to the available opportunity set.
To clarify: I'm not recommending an S&P 500 index fund, but it is a simple index — 500 companies weighted by market cap — so it works well as an illustration. The companies are called "large cap" because they have large market capitalizations. S&P Dow Jones, the owner of the S&P 500 index, also creates indices for US mid cap and small cap stocks, called the S&P 400 and the S&P 600, respectively. Most prominent indices are created and maintained by specialized companies. In addition to S&P Dow Jones, the largest index providers are MSCI and FTSE Russell, so you'll often see indices containing those names as well. See this video for more on indices.
In contrast to index funds, many funds are actively managed. Managers of these funds have varying degrees of freedom in their investment decisions. Managerial discretion can be expansive in a fund whose holdings are dictated by the personal judgment of a small team, or very limited in a fund that pursues a systematic, quantitative strategy. Letting a professional manage your stock picks may sound appealing, but index funds nearly always outperform comparable active funds in the long run.[1]
Is it possible to select an active fund — or build a portfolio yourself — that outperforms the broad market? Of course it's possible, especially over short periods. But it becomes less and less likely over an investing lifetime of decades, which is the relevant timespan for most investors. Deviating from the broad market by concentrating in smaller pockets of the market can also carry elevated risks that may be difficult to recognize, until they manifest themselves as huge losses. Because financial markets are a competitive environment, there's no assured method of selecting in advance the small fraction of active funds that will outperform a fair benchmark. Broad index funds capture the growth of the stock market driven largely by a small fraction of companies, whose identities are difficult to predict and will shift over time. Click the video here for explanation.
Some funds track an index that is decidedly active in spirit. Invesco, for instance, manages a fund that holds solar energy companies based on an index. Shareholders of this fund are making an active decision to hold a narrow group of companies, so it can't really be placed in the same category as a broad, market cap-weighted index fund. The S&P 500 index invests broadly across sectors and meets some hallmarks of passive investing, but it's concentrated in a single country and, less importantly, in large cap stocks. A completely passive stock fund would track a global, market cap-weighted index. Passive/active is a spectrum, not a dichotomy.
The optimality of broad index funds relies on the idea that financial markets are efficient, which means that prices reflect available information and quickly adapt to new information. No market is perfectly efficient, but the argument underlying index funds is that the market is efficient enough to make it very difficult to continually beat the market through active management, either on your own or by selecting actively managed funds. It follows that the best investments for nearly everyone are tax-efficient funds with low fees that capture broad market returns. The likely result of attempting to outperform the market is long-term underperformance — unless you systematically take more risk, which is discussed in a later section.
The price of a stock is nothing mysterious: it is the last price at which a buyer and seller agreed to trade in public markets. Like anything else, a share is worth what the highest bidder is willing to pay for it. Most stocks trade very frequently — the daily trading volumes of some stocks exceed a billion dollars — so the share price changes continuously when markets are open. There is nothing intrinsically meaningful about the absolute dollar value of a share. A company is not more valuable if its share price is, say, $200 instead of $100. Costco's share price is higher than Apple's, but Apple's market cap is far larger. Price changes are the concern for an investor. Similarly, the share price of a fund has no intrinsic meaning, but changes in the price closely reflect the changes in the share prices of its holdings. The share price of a fund in particular is often referred to as the "net asset value" (NAV). When discussing funds I will use the terms "share price" and "NAV" interchangeably.[2]
Shares of a fund or a company's stock can undergo a split. After a 2:1 split, for instance, all shareholders own twice as many shares and the share price is halved. This is generally conducted to prevent the share price from becoming unreasonably high. Imagine giving four people a quarter of a pizza each. Once they object that a quarter is too big to eat comfortably, you slice everyone's quarter in half to provide normal slices, but of course they still each have a quarter of the pizza in total. A 2:1 stock split is quite like that. Apple stock has undergone five splits, which were 2:1, 2:1, 2:1, 7:1, and 4:1. So without any splits, Apple's stock price would be 2×2×2×7×4 = 224 times its current price of $180. A company called NVR has never split its stock since it went public in 1985, which is why the share price has reached heights over $8,000. In the example above, let’s say you own three shares of XYZ fund each worth $100. After a 2:1 split, you own six shares each worth $50.
You can trade shares of a company or fund in a brokerage account. Two of the largest US brokers are Fidelity and Charles Schwab. Although there are many good brokers, those two are my main recommendations for most US investors, and they will be discussed occasionally throughout the guide.
There are two broad types of fund structures: mutual funds and exchange-traded funds (ETFs). In both cases, shares are not limited as they are when issued by a company, so purchasing shares can be thought of as inserting money into a common pool. Both ETFs and mutual funds can be actively managed or track an index. Thus, there are two broad structures for a fund (ETF vs. mutual fund) and two broad kinds of management (index vs. active).
With an exchange-traded fund (ETF), shares are traded (from an investor’s perspective) just like stocks on an exchange. As with stocks, ETFs trade at varying prices throughout the day and can be bought and sold anytime during market hours (9:30am-4pm ET, Mon-Fri). Also like stocks, they have a bid-ask spread. A spread is one type of transaction cost. It means that the price at which a share can be bought is slightly higher than the price at which it can be sold at any given instant. For example, the price at which shares can be bought might be $116.13 while the price at which they can be sold is $116.11. The share price in this case would be defined as the midpoint between these two prices, which is $116.12. Shares are purchased discretely — you can buy 6, 14, or 23 but not 6½. So if the share price is currently $60, an investor can introduce money into the fund in multiples of $60.
In contrast to stocks and ETFs, whose prices may update every second, mutual funds publish only one price per day and can be transacted only once per day. The NAV is updated after market hours have concluded at 4pm based on the fund’s net gain or loss that day. All orders to buy or sell since 4pm the prior day are executed based on the new NAV. Instead of being traded on an exchange, shares are transacted directly with the fund. There is no bid-ask spread: investors buy or sell at the same price on a given day. You can introduce any amount of money into the fund. If you decided to invest $5,000 and the NAV were $15, you would purchase 333.333 shares. If you decided to sell when the value of the fund's holdings rose by 20%, the NAV would be $18 and selling all shares would yield $6,000.
Mutual funds are relatively old: their modern form originated in the 1920s, whereas the first ETF was launched in 1990 in Canada. The first ETF in the US started trading in 1993. When investing in a taxable account, ETFs are preferable because they generally have a lower tax burden and enable more control over taxes. The specifics are summarized here.[3] ETFs also make it easier to use funds from multiple institutions in a single account. If you want to buy mutual funds in a Fidelity account, there are no fees if the mutual funds are managed by Fidelity. But you'll often pay a transaction fee if the mutual funds are managed by someone else, like Vanguard or Schwab. The situation is similar when using a Vanguard or Schwab account. With any brokerage account, available mutual funds are limited — some are simply not available to purchase. But ETFs are publicly traded securities, and major brokers allow you to buy ETFs with no such fees.
ETFs can be traded frequently, which is convenient but carries little importance for long-term investors. In contrast, by imposing a delay on trading shares, mutual funds encourage a long-term perspective. As we'll discuss in a later section, mutual funds can have various fees that ETFs never have. Beyond the standard fees charged for operating expenses, additional fees from mutual funds are easily avoided in your own brokerage account. But they become relevant in employer-sponsored retirement plans.
For small investors, a drawback of ETFs is the requirement to purchase discrete shares rather than simply investing any amount. How consequential is this issue? ETF share prices usually range from $30 to $250. Those at the higher end are less common and tend to split 2:1 or 4:1 — meaning the price is divided by two or four — so that they don’t become too expensive. A small amount of money will be left uninvested regardless of share prices. If the share price is $120, for example, you may have $50 left in the account that you can't invest unless you purchase a fractional share. See the section on practical information for how to use fractional shares. Overall the issue of precise allocation with ETFs is small.
So the main distinctions are that mutual funds allow easy investment of a precise amount, while ETFs are more tax-efficient, allow frequent trading, never carry additional fees, and are available regardless of which broker you use. We can decide on the following rule: ETFs are preferable for taxable investing while the two types are about equally suitable for tax-advantaged investing (like in a retirement account).
A fund can increase the wealth of its shareholders in two ways: capital gains and distributions. Capital gains correspond to increases in the share price due to an increase in the value of the fund’s holdings. If you buy shares of a fund at $85 and the share price increases to $90, that is a capital gain, because you can sell the shares for a profit if you choose. If your shares rise in value but you haven't yet sold, you have an unrealized capital gain; when you sell the shares, you realize the gain.
One type of distribution is a capital gains distribution. These are chiefly carried out by mutual funds, and represent the taxable, realized net gains that the fund is required to pass on to its shareholders. The primary reason that stock ETFs are more tax-efficient is that they almost never have to distribute capital gains. The default response to capital gains distributions should be to immediately reinvest them. You don't have to do this manually: you can change your account settings so that it happens automatically.
The most common distribution is a cash dividend, in which shareholders are paid by their company. A cash dividend means that owners of a company — including its cash and other assets — are transferring money from the company to themselves, and reducing the value of the company by an equivalent amount. Some companies distribute earnings by paying cash to stockholders, but others do not, including some of the most valuable companies in the world like Amazon, Meta, and Berkshire Hathaway. Stock funds pass this cash on to you. For example, at the end of a given quarter, a fund may announce a dividend of $0.65 per share. If you own 100 shares, you would receive a $65 dividend on the payment date.[4] Note that stockholders, shareholders, and owners of a company are all synonymous here. As a fund shareholder, you don't directly own stocks — the fund does — so you don't have the voting rights conferred by stock ownership.
While a concrete cash payment may be appealing, a payment to shareholders implies an equivalent reduction in the value of each share. By definition, each share is worth $0.65 less after the dividend, and there is no reason to prefer a $0.65 per share dividend payment to a $0.65 increase in the share price.[5] The advisable response to dividend payments is to pretend they never happened and immediately reinvest them, unless you happen to need the cash. If you need to generate income at any time, you can simply sell shares. The drawback of dividends is that they compel you to withdraw money from the investment, thereby creating a taxable event, even if you don't have a present need for income.
The combination of a fund's capital gains plus all distributions (assuming immediate reinvestment of distributions) is an important performance characteristic of the fund called its total return, which can be easily viewed on its webpage. It is generally illustrated by showing how an initial investment of $10,000 would have changed in value over time. See the chart for this cap-weighted US stock ETF called "Growth of Hypothetical $10,000".
Index funds have the advantage of low fees. To see the annual fees charged by a fund for operating expenses, look for its expense ratio. All funds suggested in this guide were selected partly for low expense ratios. A .10% expense ratio means you'll be charged ten cents annually for every $100 invested in the fund. Expense ratios are important, but small differences — like .05% vs. .11% — should not be the sole determinant of choosing one fund over another. (Some people become overly preoccupied with tiny differences in fees.) These fees are automatically withdrawn from the fund, so a fund's returns are always presented after fees; you don't need to mentally subtract any fees when viewing performance. The term "basis point" is a convenient way to express a hundredth of a percentage point. An expense ratio of .25% can be expressed as 25 basis points. If Fund A returned 7.6% in a given year and Fund B returned 7.0%, we can say that Fund A beat Fund B by 60 basis points. Basis points are abbreviated as bps, pronounced like "bips".
Although this section focused on stock funds, funds can hold securities other than stocks (like bonds). Every fund has a descriptive name as well as a ticker symbol, which serves as a short but unambiguous label for the fund. The "Avantis US Small Cap Value ETF" has the ticker symbol AVUV. ETF tickers have two to four letters, and mutual fund tickers have five letters ending in an X like SWAGX. An individual company's stock also has a ticker symbol with one to five letters: Apple's ticker is AAPL and Costco's ticker is COST.
There are many asset managers that provide ETFs and mutual funds. Some of them also offer brokerage services — like Fidelity, Schwab, and Vanguard — and many asset managers do not, like BlackRock, State Street, and Invesco. You could buy shares of a BlackRock ETF in a Schwab brokerage account, or shares of a Vanguard ETF in a Fidelity account. These asset managers and others will be discussed in a later section. Some brokerage firms don't manage their own funds, but offer access to mutual funds managed by other companies; E*Trade, for instance, offers access to some Vanguard mutual funds (and others) with no transaction fees. Remember, you can buy any ETF in any brokerage account.
When reading business news in outlets like The Wall Street Journal, you'll often read about changes in different indices. The most widely reported in the US are the S&P 500, the Dow Jones Industrial Average (DJIA), and the Nasdaq Composite (often shortened to the Nasdaq). The S&P 500 is a decent representation of large cap US stocks, but for a more comprehensive view, you could observe the movements of an ETF like VTI, Vanguard's total US stock ETF. The easiest way to view price changes is with a third-party website or app like Yahoo! Finance.
The Nasdaq Composite and the Dow Jones Industrial Average, sometimes called the Dow, are not good representations of the US market or any meaningful subset of it. The Nasdaq Composite was created in 1971 to index the returns of stocks on the new Nasdaq stock exchange. The Nasdaq index is often noted for being heavy on tech, but you could query the movements of tech stocks more directly by checking a tech ETF like VGT. The Dow was first published in 1896, and its historical significance is the only reason to care about it. The 30 companies in the Dow are weighted by share price even though, as we discussed above, share price is a meaningless indicator. The WSJ, CNBC, and other outlets still choose to report the Dow's movements. A few well-known indices in other countries are the FTSE 100 in the UK, the DAX in Germany, and the Nikkei in Japan.
It's impractical for a typical investor to invest in a different fund for each country. So there are broader indices, such as the FTSE Global All Cap Index. This index is tracked by VT, Vanguard's total world stock ETF. You can check VT anytime on Yahoo! Finance to see how the global cap-weighted stock market is moving. Currently, the ten most valuable public companies in the world are:
- Microsoft
- Apple
- Nvidia
- Alphabet (parent of Google)
- Amazon
- Meta
- Berkshire Hathaway
- Taiwan Semiconductor Manufacturing Company
- Tesla
- Visa
If you check the holdings of an S&P 500 index fund like VOO or IVV, you'll find that the funds hold slightly more than 500 stocks. What gives? The S&P 500 is a collection of 500 companies, and a few companies have multiple share classes. Alphabet, the parent company of Google, has class A shares (GOOGL) with voting power and class C shares (GOOG) without. Berkshire Hathaway has class B shares (BRK-B) with less voting power and class A shares (BRK-A) with more voting power and a six-figure share price. S&P 500 index funds naturally hold both share classes of each stock in proportion to their market caps. In order to calculate a company's allocation in a fund, you must add the weights of all share classes.
Investing in the stock market used to mean accepting a heavy burden of fees. Many mutual funds had a large fee upon purchasing or selling shares, called a load. In the 1990s, a load of 8% was typical for active mutual funds: you would pay 8% of your investment for the privilege of investing the other 92%. Expense ratios used to be much higher, at least 1%. Commissions for purchasing individual stocks were high: it was common decades ago to pay your broker 1% of the value of the shares you were purchasing (or an expensive flat fee). And you had to buy shares in multiples of 100, or face even higher commissions. The need to buy at least 100 shares of each company meant that building a diversified portfolio of stocks on your own required already having a lot of money.
The first index funds launched in the 1970s, but didn't pick up significant assets for many years. With the advent of online trading, commissions eventually fell to less than $10. In October 2019, Charles Schwab dropped their trade commissions from $4.95 to zero, prompting all other major US brokers to quickly do the same and completing the move toward zero commissions that others in the industry had set in motion. So you no longer pay fees for purchasing or selling shares. You can buy shares of VT for about $100 each and invest in the cap-weighted global stock market — over 9,000 stocks in more than 40 countries. It's a tax-efficient ETF with an expense ratio of .07%. This is a product even the wealthiest people couldn't imagine in 1970: owning the global market for seven basis points, while paying nothing to trade. Investors today are extremely fortunate compared to those in the past.
The stock market is a means of buying and selling fractional ownership in publicly traded companies. "Equity" in a company is another term that expresses ownership, so stocks are also called equities. For nearly everyone, the most effective method of benefiting from the stock market is to purchase shares of a fund, which owns a diversified portfolio of stocks. The portfolio should be directed by a broad index, rather than by the choices of an active manager. ETFs and mutual funds are the two broad structures of these funds. A fund has the potential to increase the wealth of its shareholders through increases in the value of its holdings — the many individual stocks — and through distributions, particularly cash dividends. When a fund pays any kind of distribution, each share falls in value by that amount, so the share price naturally falls. A fund charges fees expressed as an expense ratio, and low fees are one important criterion for selecting funds.
The book Why Does the Stock Market Go Up? is a brief explainer on many common questions about the stock market. Various books are recommended throughout the guide; they're all rounded up in the vocabulary and further resources section.
We will eventually explore potential portfolios of stock funds, but first we should consider how to navigate risk. And because most people cannot keep all their money in stocks, we’ll cover how to grow a portion of your assets with bonds, which carry a spectrum of risk that the stock market cannot provide.
Click here for the next section — Thinking about risk
All sections:
- Cover page
- Introduction to index funds
- Thinking about risk
- Tax-advantaged accounts
- Your psychology
- Investing for retirement
- Guidelines for personal finance
- Building a stock portfolio
- Fund proposals
- Advice
- Practical information for execution
- Taxes
- Vocabulary and further resources
- Advanced topics
Footnotes:
1 The SPIVA reports are a great illustration of how poorly actively managed funds perform in the long run. In the most recent report, we find that over the last 20 years, 93% of small cap funds, 92% of mid cap funds, and 94% of large cap funds have underperformed their benchmark. Someone might reasonably ask: if we select funds that performed well in the recent past, are we likely to invest in funds that continue to produce high returns? The SPIVA persistence scorecard shows that most funds with recent performance in the top 25% do not remain in the top 25%. And as the first document shows, even those in the top 25% are likely to fall behind their benchmark over longer periods. The evidence indicates that picking an actively managed fund that outperforms its benchmark in the long run is largely a matter of luck, and you would have to be very lucky to do so. You are overwhelmingly likely to underperform the index by picking active funds, regardless of their recent performance. The gap between index and active funds widens after taxes.
But why? Why are there so few actively managed funds that consistently outperform a fair benchmark? I think there are several reasons. (1) A great deal of temporary outperformance is due to luck, and luck rarely persists for periods as long as 20 years. (2) The most successful funds over short periods of time tend to be those that embrace an investing style or sector that happens to perform well. Fortune eventually stops smiling on such funds when that style's favorable time passes. This is a form of luck, but it's worth identifying. (3) Fees are higher in actively managed funds, putting any active manager at a disadvantage compared to low-fee index funds. (4) Active managers are mainly competing against and trading with other institutional investors. What matters is not whether the active managers are highly skilled and equipped with deep resources — many are — but whether they can continually outcompete other active managers. (5) Managers who show any signs of skill are quickly buried in money. If you're managing a $20 million fund, you can use a small number of your best ideas. But success brings excited new investors. Once you're managing billions of dollars, you have to spread the money across an increasing number of companies, and your best 500 investment ideas simply can't be as good as your best 50. (5) Some managers with exceptional track records make a ton of money and decide to retire young, leaving someone else to manage the fund.
In this Rational Reminder interview, two researchers explain that: funds can be undervalued or overvalued like stocks, where a manager can be undervalued if their fund is small, allowing that manager to outperform until their fund becomes too big; and the skill of a fund manager is correctly measured by their value added, a combination of their fund size (harder to outperform with more money) and their gross alpha (relative performance before fees). ↩
2 The NAV and the share price are not actually synonymous, although they're often used interchangeably. This is a technical point that need not be understood to be a successful investor. Net asset value (NAV) is a fund's net assets (assets minus liabilities) divided by the number of shares. A party called the authorized participant does its best to keep an ETF's share price very close to the NAV, by creating or redeeming ETF shares to meet current demand for shares. This must be done so that shareholders experience capital gains or losses that correspond closely to the gains or losses of the fund's holdings.
The ETF issuer State Street has a useful plot of the degree to which a fund's NAV deviates from its share price over time. The greatest deviations occur due to large, tumultuous price movements during and after market crashes. See, for example, SPDW and look for the section called "Premium Discount to NAV Graph and Summary". On some days shares trade at a premium — the share price is higher than the NAV — while on others they trade at a discount. The deviation is expressed in basis points, abbreviated bps. Some funds (like SPTM) deviate much less than others (like SPEM). Schwab's fund webpages also have this feature under the "Performance" tab (e.g., FNDX), and Vanguard's webpages display it in the "Price" section (e.g., VT). ↩
3 Low-turnover, broad market mutual funds can be tax-efficient, and their tax burden often differs very little from their ETF counterparts. This is especially true of many Vanguard mutual funds due to a patent they hold. Here is a related interesting article from Bloomberg on how heartbeat trades allow ETFs to avoid distributing capital gains to shareholders. ↩
4 The payment date is easy to understand: it's the date on which the cash lands in your account. This may occur early in the day, or as late as the evening after the market has closed. The other important date is the "ex-dividend date", which may also be called the "ex-date". Those who own shares at the end of the business day before the ex-dividend date will receive the upcoming dividend payment, regardless of whether they sell some or all of their shares before the payment. Those who buy shares on or after the ex-dividend date will not receive it. (This implies that, all else equal, the value of each share falls by the amount of the dividend on the ex-dividend date.) You may want to understand another date called the record date, which is always the business day after the ex-dividend date. However, this is a formality and in practice, all you need to know is that (1) those who buy shares before the ex-date receive the dividend on the payment date and (2) all else equal, the share price falls by the dividend amount on the ex-date. Of course, all else is never equal, so in the same way you don't expect a share price to be the same on two consecutive days, don't expect a share price to fall by exactly the dividend amount.
How do you know what these dates will be? You can check any fund's webpage (like this one or this one) and under "distributions", it will show the fund's past distributions and possibly an upcoming set of dates. Distributions include dividends (which may be labeled "income" instead) as well as capital gains distributions. ↩
5 There are three broad ways for public companies to use profits: (1) reinvest into company growth; (2) strengthen the balance sheet (e.g., pay down debt); and (3) directly return value to shareholders. A company can return value to shareholders through (a) dividends, usually a simple cash payment, or (b) stock buybacks, also called share buybacks. The company buys shares and eliminates them, which benefits all remaining shareholders because each share corresponds to a larger fraction of ownership. A company should generally buy their own shares only if they believe the shares are undervalued.
Younger companies with high growth potential don't tend to pay dividends or buy back shares, because that cash is important fuel for their growth. A company may distribute dividends or buy back shares instead of reinvesting the cash because it's relatively mature and believes that the best use of some of its cash is to directly benefit shareholders. Stock buybacks have an effect on the shareholder which is similar to the effect of dividends, except that buybacks are more tax-efficient because they don't compel the stockholder to experience a taxable event.
Many people, who are generally not the most informed about financial markets, castigate dividends as "free money" for the elite stockholders of society — just another way the rich get richer. As I've hopefully made clear, comments like these reflect multiple layers of misunderstanding. A cash dividend is when owners of a company receive cash from the company whose assets (including cash) they already own. Not only does each dividend payment cause the share price to fall — eliminating the benefit of the dividend per se — but every day someone holds a stock or stock fund, they are bearing a great deal of risk. Stock buybacks have very similar benefits for shareholders but, as far as I can tell, the dividend critics don't tend to criticize buybacks. The reverse is also true: buybacks have their own outspoken critics, who often don't justify their contempt with informed arguments, and notably don't seem to understand the similarities of buybacks and dividends. (One real difference is that buybacks are better for executives and others who hold stock options.)
A 1% tax on stock buybacks was introduced in the Inflation Reduction Act, and beginning in 2023 this will slightly reduce the favorability of stock buybacks relative to other uses of cash. The tax will be paid by companies, and has no effect on tax returns for individuals. ↩