WHY SHOULD YOU INVEST IN STOCKS

The big money is not in the buying and selling, but in the waiting.

— Charlie Munger

INTRODUCTION TO STOCKS

I think it is fair to say that most of us have a general sense of what a stock is. Although it is often quite easy to forget this as you are bombarded with the latest daily stock market buzz words from the hoards of financial media outlets vying for your attention. Phrases like “Margin Calls” and “Total Return Swaps” don’t mean much to the average investor, and in many cases, they shouldn’t. 

below, I will look to remove much of the noise that modern media brings to the fore and focus instead on the fundamental principles of stocks. At first, investing may seem intimidating or complicated. That is why it is vital to focus the basics. 

As John Reed writes in his book Succeeding:

When you first start to study a field, it seems like you have to memorise a zillion things. You don’t. What you need is to identify the core principles that govern the field. The million things you thought you had to memorise are simply various combinations of the core principles.

Merely understanding the core principles of investing will allow you to minimise risks and protect your investments into the future.

WHAT IS A STOCK?

A stock represents partial ownership of a company. When you buy a stock, you are purchasing a piece of that company. Once purchased, you have a claim on that company’s assets and future earnings.

When a company needs to raise money, there are two main ways to do so. They can take out a loan, but this will mean taking on debt. Alternatively, they can issue stocks. This allows the company to raise money without going into debt by selling shares of ownership, providing investors with a claim on future earnings.

Stocks tend to be more volatile than other traditional asset classes such as bonds and cash equivalents but with this higher risk comes higher potential reward for investors.

WHY INVEST IN STOCKS?

In today’s market, there are a plethora of investment opportunities across the risk spectrum, ensuring that even the most risk-averse investor can generate positive real returns.

Stocks are generally regarded as one of the riskier investments due to the frequent fluctuation in the price of a given stock over time. This price fluctuation is referred to as volatility.

The cyclical nature of the stock market ensures that there will always be periods of negative returns. If you are willing to accept this volatility as a market function and invest with a longer-term focus, you stand to generate substantial returns in the process.

As you can see from the graph below, the stock market has followed an upward trajectory over time, bouncing back from each downturn in history to go on to record new record highs.

Stocks can be a lucrative tool to help you achieve financial independence. Since 1900, investors have averaged a 7% return on their stock investments per annum.

The power of stock investing has been magnified in the last ten years, with the S&P 500 index returning ~14.0% per annum as savings account slip towards negative rates.

A $100,000 investment in the S&P 500 in 2010 would be worth over $380,000 today, highlighting the need to have your money working for you instead of gathering dust in your savings account.

What gets repeated gets remembered, so let’s focus in on a vital point one more time. In the early ’90s, savings accounts were offering between 7/8%. As recently as 2006, savings accounts for new customers were offering up to 5%. Rates like these were competitive with the long term returns one might expect from the stock market. It actually made sense from a long-term investment standpoint to have some of your money in a risk-free savings account, given the liquidity and positive real returns on offer.

Unfortunately, in today’s market, you are hard-pressed to find a savings account offering you over 1%, meaning that the value of your money is being eroded once inflation is factored in. Now more than ever, you need to be proactive with your earnings. The days of risk-free profits from your savings account are no more. Inaction will not only see you miss out on future profits but guarantee future losses.

As previously mentioned, over short periods, stock movements can be highly unpredictable, which tends to act as a deterrent for many investors. Historically, stocks have been positive on a daily basis 53.0% of the time – little better than a coin toss. However, history also shows the longer the holding period, the greater the probability of positive returns.

On an annualised basis, the S&P 500 has returned positive returns in 70 of its 94 years, producing positive annual return 74% of the time.

The further you extend out this trajectory, the greater the probability of positive performance. Rolling 10-year returns have been positive 94.1% of the time, while rolling 20-year returns have been positive 100% of the time.

Statistically speaking, the long-term probability sits firmly in the investor’s favour.

THE PURCHASE OF STOCKS PROVIDES RETURNS IN TWO WAYS

Stock Appreciation

In strict theoretical terms, the current price of a stock is the present value of future cash flows, so as a company’s earnings increase, so too should its stock price. In reality, however, there are far more variables at play with company earnings and stock price rarely moving in unison. Multiple market forces result in daily price movements for stocks depending on the supply/demand relationship in the market at any given time. As demand for a given stock increases, so too will the current market price. This increase in stock price above your original purchase price will provide profits to you as an investor in the form of stock appreciation once sold.

Dividends

You can think of dividends as profit-sharing. If a company does well, it wants to reward its investors with some of those profits. The company will provide periodic cash distributions directly to investors based on the number of shares held. Bear in mind, not all companies pay dividends, opting instead to re-invest company profits into further growth.

INVESTING TERMS

Stock Exchange

Stock exchanges are simply where stocks are bought and sold. These exchanges allow investors to buy and sell shares of a company among each other in a regulated physical or electronic space.

The exchange works like an auction with a buyer and a corresponding seller. Traders who believe a company will do well, bid the price up, while those who believe it will do poorly, bid it down.

The better known listed stock exchanges in the United States are the New York Stock Exchange (NYSE) and the Nasdaq, but there are numerous stock exchanges worldwide. Across the top 3 American exchanges, over 6,000 different company stocks are listed, and in aggregate, they represent over $30 Trillion’ worth of value.

An Index

A market index tracks the performance of a group of stocks, representing the market as a whole or a specific sector of the market, like technology or retail companies. You have likely heard of the S&P 500 or the Nasdaq Composite Index. The S&P 500, for example, is an index showing how 500 of the largest companies in the U.S. have performed over time.

The more popular Indexes are often used as proxies for overall market performance, which is why we hear so much about them in financial media. You can also invest in an entire index such as the S&P 500 through index funds. These Index Funds work by mirroring the holdings of the specific index in question.

INVESTMENT STYLE

In today’s market, there is an infinite number of potential investment combinations to choose from. Any attempt to go through every possible stock and investment line by line would be an exercise in futility. A far more productive means of determining your optimal investment portfolio is to understand the investment styles available.

If you’re like most investors, you probably haven’t given much thought to your preferred “style”. In essence, if a group of stocks have similar characteristics and performance patterns, they are said to fit within an investment “style”. The performance of stocks within a particular style are positively correlated, while the returns between styles are typically uncorrelated.

For example, if we take “size” as a basis for categorising style, some investors became drawn to large-cap companies. In contrast, others focus on the future vision and growth potential of smaller companies.

The major equity investment styles are:

• Active vs. Passive Investing

• Developed vs, Emerging Markets

• Growth vs. Value Investing

• Small-Cap vs. Large-Cap Companies

Walking through each one and assessing your preferences will give you a quick idea of what investment styles work for you.

For example, if we take “size” as a basis for categorising style, some investors became drawn to large-cap companies. In contrast, others focus on the future vision and the growth potential of smaller companies.

If you want to learn more about the various investment styles available and which approach is best for you, simply download my FREE e-book here

Walking through each one and assessing your preferences will give you a quick idea of what investment styles work for you.

Remember, there is no one size fits all approach to investing.

The Bottom Line

It’s pretty much impossible to predict the exact movement of the stock market, but amidst the unpredictability, the benefits of investing in stocks remain unchanged. What needs to change is investors’ perception of the stock market and its associated risks.

Focusing on the day-to-day volatility can result in complete inaction, choosing instead to ‘play it safe’ with your savings account’s negative real returns. Better the devil you know and all that.

In reality, re-scripting the narrative to focus solely on your long-term investing goals will allow you to participate in the rising tides of markets over time without being all-consumed by any short-term market uncertainty.

There are several ways to construct your equity portfolio to allow for more stable returns, ensuring you persist in the market despite any misgivings you may have towards the short-term volatility.

By spreading out your investments across various regions and investment styles such as those just mentioned, you can balance higher-risk equity investments with more steady and predictable returns.

Further diversification across different investment types, such as bonds and alternative investments, will mitigate your investment risk further while still offering the potential for significant returns in the long run.

Next up. HOW TO CREATE YOUR INVESTMENT PORTFOLIO