Why Should You Invest In Stocks? by Chris Gilbert
So you want to invest your hard-earned money? You want your money to work for you. Great! So which investment vehicle do you want to start with? Since you’re here, I’ll assume it’s the stock market. But what are stocks? How do you not lose money? These are excellent questions and ones I want to answer today. We’ll discuss stocks and other investments, and how they compare historically. I will show you why stocks are the best option to grow your investment and the quickest route to financial independence.
Here’s a round up of hedge funds’ May returns
“The stock market is filled with individuals who know the price of everything, but the value of nothing.” — Phillip Fisher
- What is a stock?
- What other investment options are out there?
- How do stocks compare vs. other investment options?
What Is A Stock?
Let’s start with the basics. Many people, including investors, believe stocks (shares, equity) are pieces of paper that can be bought and sold on a whim. If you read the post on value investing, then you know that to be false. A stock is a share in the ownership of a company. Holding stock in a business means you are one of many owners, or shareholders, that make up the entire company. This means you have a part ownership interest in the company and the stock represents your claim (no matter how small) to the company’s assets and earnings.
“If you are not willing to own a stock for 10 years, do not even think about owning it for 10 minutes.” — Warren Buffett
Shares are created when a business or company reaches a certain size and wants to go "public". When they do this they decide to sell a chunk of itself to you, me, or whoever else would like to invest in them. So when you purchase stock, you become a business owner. And the better the business does, the better your investment does.
Another way to earn money through stocks is with dividends. These are a portion of profits distributed to a company's shareholders. These can be in the form of cash, shares, or other assets and can be reinvested or allocated elsewhere at your discretion.
Other Investment Options
Before you decide to invest in stocks, you should be aware of the other options out there. these include bonds, mutual funds (index funds), savings accounts (CDs), and other vehicles such as gold, real estate, and cash.
- Bonds -Bonds are essentially loans. When you purchase one, you are lending out money to either a business or government, called corporate or government bonds (T-bills or Treasuries), respectively. In return, they pay interest on your money and eventually pay back the principal (as long as they don't go bankrupt), but no more. The main attraction to bonds, particularly if you're buying from stable companies or governments, is their relatively low risk. This relative safety also comes with lower expected returns than stocks when investing for the long-term. That being said, there can be times when bonds should be considered in your portfolios. If interest rates on a 30-yr T-bill were 10-15% it would certainly be something to look into.
- Mutual Funds - A mutual fund is a collection of stocks, or bonds, usually managed by a group of individuals who try to earn a return by buying and selling securities (stocks/bonds). When you invest in a mutual fund, your money will be pooled with many other investors enabling the managers to charge a fee for their work. The primary advantage of a mutual fund is it requires almost no effort. You can invest your money while spending little time and effort into managing which stocks you should own. Theoretically, mutual funds should offer better returns since "experts" are managing your stock selections. In reality however, they often fall short for several reasons I'll discuss in a later post.
- Stocks and Bond Indexes - These vehicles are very similar to a mutual fund except for they try to mirror the components of the index, such as the S&P 500.
- Savings Accounts - The upside to savings accounts is there is almost no risk. Your principal will be protected, interest is guaranteed, and you have no worries. The downside is those interest rates are tiny, not even consistent with inflation. For example, if your interest rate is 2% and inflation is 3%, your real return will be negative. These should really only be used for emergency funds, not as a long-term investment option.
- Alternative Vehicles (Gold, Cash, Real Estate, etc.) - There are times when I favor keeping the majority of a portfolio in cash. The stock market ebbs and flows and can become overvalued just as easily as undervalued. Just look at recent history with the dot-com bubble or the financial crisis. If you can't find any wonderful companies for good prices, then there is no reason to buy. It can be hard to do, but sometimes cash is the best option. As for gold, silver, and other metals; I don't own any, but I am not completely against it as well. When it comes to portfolio allocation, I see no reason to invest more than 5% in any of these options. I won't pretend to know much about real estate. I own a house, which is usually a solid investment, but after that I'd be lying if I told you much more. There are many people who invest in real estate and do well, but I do offer caution. Real estate can fluctuate just like stocks, you deal with a lot of taxes, put in time and maintenance, and also must take the time to sell.
Stocks Vs. Other Options
But how do stocks compare, historically, to the other aforementioned options? That's a good question because stocks oftentimes get a bad reputation for offering nothing but risk. As history shows however, as long as you stay in the stock market for a decent amount of time you are bound to have a better return rate.
As you can see from the graphic below, stocks have not only performed admirably since 1926, they have destroyed every other investment vehicle along the way. If you would have chosen stocks to invest your $1,000 in, you would be the proud owner of $364,782.42 averaging 6.8%, inflation-adjusted, annual compounded returns. Compare that to 0.5% for T-Bills, 1.8% for Gold, and 2.9% for corporate bonds and you see an astronomical gap. Corporate bonds and gold actually displayed more volatility than stocks as well. That tiny, little purple dot next to the original $1,000 is what your investment would've become if you had just left it as cash. Inflation averaged 2.8% since 1926, eating away at your $1,000 over time to a measly $75.07.
Average Compounded Annual Real Return on Investment (Inflation-adjusted)
So why not just keep all your money in mutual funds or stock indexes and let the professionals worry about the market? A couple of reasons. First, not all fund managers are the experts they claim to be. In fact, very few are. Fortune magazine reported since 1985 only 4% of all fund managers beat the S&P 500. The few who did, only managed to best the index by small margins.
Secondly, stocks as a whole do not consistently earn 6-7% year in, year out. If you were to invest in every stock in the Dow Jones (a key index) from 1906-1942 then you would have earned $0. Not a penny. For 36 years. You would've lost money due to inflation. In 1965, the Dow hit 1,000 and never went over for the next 18 years. My point is the stock market has years, decades even, where it stays flat or decreases. If you would've put all your money in a mutual fund or a stock index during these time-frames, you would be right back where you started, decades later.
This is why I recommend you invest in stocks, but not on a whim and not with a service. Follow a value investing philosophy, invest for the long-term, and, as history shows, you will be much more successful than if you didn't.
- A stock is a piece of a business. It should be viewed as owning a small slice of the company. Your investment returns will depend on the success/failure of the company
- There are many options to invest your money in -- bonds, mutual funds, savings accounts, gold, real estate -- but stocks beat them all
- History shows stocks average close to 7% real compounded annual returns, turning a $1,000 investment to $364,782.42 from 1926-2013. Beating the next best investment vehicle (corporate bonds) by more than $350,000
- Stocks do not increase in value consistently. There are decades where returns are flat or negative. This means you shouldn't trust your money in mutual funds or stock indexes. Follow a value investing philosophy and invest for yourself
About Chris Gilbert
I am a full-time pharmacist as well as an avid investor. I discovered the art of value investing by reading the works of Benjamin Graham. After that I began to drift towards Peter Lynch, Warren Buffett, and Charlie Munger. My investing philosophy now is simply to find great companies at a discount while using a common sense, value oriented strategy, and maintaining a long-term outlook. I am determined to educate the individual investor that investing is not hard, not time consuming, and not expensive. Through the use of value investing and the (Y)OURPORTFOLIO Spreadsheet, my goal is to help you obtain better results in a fraction of the time.
Website and Blog - yourportfoliospreadsheet.com