Introduction
The difference of only a few
percentage points in investment returns
or interest rates can have a huge impact on your future wealth.
Therefore, in the long run, the rewards of investing in stocks can
outweigh the risks. We'll examine this risk/reward dynamic in this
lesson.
Volatility of Single Stocks
Individual stocks tend to have highly volatile prices, and the returns
you might receive on any single stock may vary wildly. If you invest
in the right stock, you could make bundles of money. For instance,
Eaton Vance EV, an investment-management company, has had the
best-performing stock for the last 25 years. If you had invested
$10,000 in 1979 in Eaton Vance, assuming you had reinvested all
dividends, your investment would have been worth $10.6 million by
December 2004.
On the downside, since the returns on stock investments are not
guaranteed, you risk losing everything on any given investment.
There are hundreds of recent examples of dot-com investments that
went bankrupt or are trading for a fraction of their former highs.
Even established, well-known companies such as Enron, WorldCom,
and Kmart filed for bankruptcy, and investors in these companies
lost everything.
Between these two extremes is the daily, weekly, monthly, and
yearly fluctuation of any given company's stock price. Most stocks
won't double in the coming year, nor will many go to zero.
But do
consider that the average difference between the yearly high and
low stock prices of the typical stock on the New York Stock
Exchange is nearly 40%.
In addition to being volatile,
there is the risk that a single company's
stock price may not increase significantly over time. In 1965, you
could have purchased General Motors GM stock for $50 per share
(split adjusted). In the following decades, though, this investment
has only spun its wheels. By June 2008, your shares of General
Motors would be worth only about $18 each. Though dividends
would have provided some ease to the pain, General Motors' return
has been terrible.
You would have been better off if you had
invested your money in a bank savings account instead of General
Motors stock.
Clearly, if you put all of your eggs in a single basket, sometimes that
basket may fail, breaking all the eggs. Other times, that basket will
hold the equivalent of a winning lottery ticket.
Volatility of the Stock Market
One way of reducing the risk of investing in individual stocks is by
holding a larger number of stocks in a portfolio.
However, even a
portfolio of stocks containing a wide variety of companies can
fluctuate wildly. You may experience large losses over short periods.
Market dips, sometimes significant, are simply part of investing in
stocks.
For example, consider the Dow Jones Industrials Index, a basket of
30 of the most popular, and some of the best, companies in America.
If during the last 100 years you had held an investment tracking the
Dow, there would have been 10 different occasions when that
investment would have lost 40% or more of its value.
The yearly returns in the stock market also fluctuate dramatically.
The highest one-year rate of return of 67% occurred in 1933, while
the lowest one-year rate of return of negative 53% occurred in 1931.
It should be obvious by now that stocks are volatile, and there is a
significant risk if you cannot ride out market losses in the short
term. But don't worry; there is a bright side to this story.
Over the Long Term, Stocks Are Best
Despite all the short-term risks and volatility, stocks as a group have
had the highest long-term returns of any investment type. This is an
incredibly important fact! When the stock market has crashed, the
market has always rebounded and gone on to new highs. Stocks have
outperformed bonds on a total real return (after inflation) basis, on
average. This holds true even after market peaks.
If you had deplorable timing and invested $100 into the stock market
during any of the seven major market peaks in the 20th century,
that investment, over the next 10 years, would have been worth
$125 after inflation, but it would have been worth only $107 had you
invested in bonds, and $99 if you had purchased government
Treasury bills. In other words, stocks have been the best-performing
asset class over the long term, while government bonds, in these
cases, merely kept up with inflation.
This is the whole reason to go through the effort of investing in
stocks. Again, even if you had invested in stocks at the highest peak
in the market, your total after-inflation returns after 10 years would
have been higher for stocks than either bonds or cash.
Had you
invested a little at a time, not just when stocks were expensive but
also when they were cheap, your returns would have been much
greater.
Time Is on Your Side
Just as compound interest can dramatically grow your wealth over
time, the longer you invest in stocks, the better off you will be.
With time, your chances of making money increase, and the volatility
of your returns decreases.
The average annual return for the S&P 500 stock index for a single
year has ranged from negative 39% to positive 61%, while averaging
13.2%. After holding stocks for five years, average annualized returns
have ranged from negative 4% to positive 30%, while averaging 11.9%.
These returns easily surpass those you can get from any of the other
major types of investments.
Again, as your holding period increases,
the expected return variation decreases, and the likelihood for a
positive return increases. This is why it is important to have a long term
investment horizon when getting started in stocks.
Why Stocks Perform the Best
While historical results certainly offer insight into the types of
returns to expect in the future, it is still important to ask the
following questions:
Why, exactly, have stocks been the best
performing asset class? And why should we expect those types of
returns to continue? In other words, why should we expect history
to repeat?
Quite simply, stocks allow investors to own companies that have the
ability to create enormous economic value. Stock investors have full
exposure to this upside. For instance, in 1985, would you have
rather lent Microsoft money at a 6% interest rate, or would you have
rather been an owner, seeing the value of your investment grow
several-hundred fold?
Because of the risk, stock investors also require the largest return
compared with other types of investors before they will give their
money to companies to grow their businesses. More often than not,
companies are able to generate enough value to cover this return
demanded by their owners.
Meanwhile, bond investors do not reap the benefit of economic
expansion to nearly as large a degree. When you buy a bond, the
interest rate on the original investment will never increase. Your
theoretical loan to Microsoft yielding 6% would have never yielded
more than 6%, no matter how well the company did.
Being an owner
certainly exposes you to greater risk and volatility, but the sky is also
the limit on the potential return.
The Bottom Line
While stocks make an attractive investment in the long run,
stock
returns are not guaranteed and tend to be volatile in the short term.
Therefore, we do not recommend that you invest in stocks to
achieve your short-term goals.
To be effective, you should invest in
stocks only to meet long-term objectives that are at least five years
away. And the longer you invest, the greater your chances of
achieving the types of returns that make investing in stocks
worthwhile.
Quiz
There is only one correct answer to each question.
1 The average yearly difference between the high and low of the
typical stock is between:
a. 30% and 50%.
b. 10% and 30%.
c. 50% and 70%.
2 If you were saving to buy a car in three years, what percentage of
your savings for the car should you invest in the stock market?
a. 50%.
b. 70%.
c. 0%.
3 If you were investing for your retirement, which is more than 10
years away, based on historical returns in the 20th century, what
percentage of the time would you have been better off by
investing only in stocks versus a combination of stocks, bonds,
and cash?
a. 50%.
b. 100%.
c. 0%.
4 Well known stocks like General Motors:
a. Always outperform the stock market.
b. Are too highly priced for the average investor.
c. Can underperform the stock market.
5 Which of the following is true?
a. After adjusting for inflation, bonds outperform stocks.
b. When you invest in stocks, you will earn 12% interest on your
money.
c. Stock investments should be part of your long-term
investment portfolio.
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1. Hindsight error.