“Should I invest in stocks” is one of the top investing-related searches on Google. If that’s how you got here, I’m happy you decided to stop at WELLth. Today, we’re going to discuss some basic characteristics of stocks, bonds, and other investments and how they can add value to a well-diversified investment portfolio.
Stocks – The Wealth Builder
The primary reason to own stocks is for capital appreciation – that is for your account to grow. Historically, stocks of companies domiciled in the United States have returned 10% a year on average, which means that an account invested in only stocks and earning average returns will double in value every 7.2 years. That means after 40 years, a $100,000 portfolio would grow to $4,525,926. Pronounced exponential growth is one of the most appealing characteristics of owning stocks.
When you own a stock, you are an owner of a portion of a company. That means that you are buying the right to share in the profits and losses of a company. Ideally, you are owning companies which are profitable, but a bad economy can make companies lose money on occasion. Why are stocks such an excellent investment? It’s because they are risky – read below.
Owning Stocks Sometimes Sucks – And at The Worst Times Too
Pardon my vernacular above, but the real reason why stocks make people money over the long run is because of something called “risk premium.” Risk premium is money you earn by owning an investment which can lose money. The higher that premium (i.e. earning potential), the higher the risk of losing money. Leaving your money in your checking account earns you no risk premium, which means you earn close to nothing. Investing in stocks earns you a high-risk premium over the long term, but that is because stocks often lose money over the short term.
We have seen countless examples of how investments in stocks lose money. Normally once or twice a decade, we experience a “bear market” which is a decline in stock prices, as measured by the S&P 500 Index, of 20% or more. Quite often, these declines exceed 30% and sometimes 40% in magnitude.
- In 2020, stocks fell by over 30%
- From 2007-2009, stocks fell 56%
- From March 2000 to 2003, they fell 49%
- In 1990, stocks fell 20%
- In 1987, they fell 34%
- During the Great Depression, they fell over 83%. This is an obvious outlier
It’s easy to brush off the potential losses of a bear market as bearable (pun not intended) when you’re not enduring one, but losses occur at the worst times. For instance, during the coronavirus pandemic of 2020, millions lost their jobs and needed money to fund their living expenses. They turned to their investment portfolios, which had lost over 30% of their values, and were forced to sell their stocks at losses to cover their expenses.
Similarly, in 2008 and 2009, as the global financial system appeared on the verge of collapse, the millions of newly unemployed individuals and struggling business owners needed cash. They were forced into selling their stocks at over 50% losses, missing out on the gains and wealth building opportunities the stock market offered over the following decade. I personally know several people who had to delay retirement because of this exact situation.
This is why I suggest those of us who place a significant portion of our savings into stocks (most people under 60 years old) keep an emergency bank account which could fund six months of expenses if need be. Yes, this money won’t grow when the stock market is climbing, but it will act as your safety net for when the economy, and our respective life situations, turn ugly.
In summary, stocks are fantastic wealth building tools, but you need to be prepared for high anxiety and periods of significant loss once every few years.
Bonds – The Zig to Stocks’ Zag
Stocks are the fun part of the portfolio that multiply your money over the long run. Bonds are, as the fictional character Jared Vennett from The Big Short says,
“. . .comatose. We all know about bonds. You give your snot-nosed kid one when he’s fifteen and by the time he’s thirty he makes one-hundred bucks”
They’re important though, as these relatively safe types of investments (e.g. U.S. Treasury bonds) generally increase in value when everything else is falling. Government bonds are the ultimate diversifier of a stock portfolio – when stocks do poorly, these often perform well. That’s why bonds are an important part of a portfolio – they can protect your portfolio from losing money while paying interest. Remember how I just mentioned above that a stock portfolio lost 56% of its value between 2007 and 2009? If you invested 60% of your money in stocks and 40% in high-quality bonds that loss would have been trimmed to 15.72%.
If bonds are so great and they often perform well during bad times, what are their risks? For government bonds, there are two main risks. The first is interest rate risk. If you own a bond that pays 3% in interest per year and suddenly similar bonds are available that pay 5% a year, nobody will want your bond that only pays 3%. The second risk is purchasing power risk. If your bond pays you 3% in interest each year and inflation jumps from 2% to 10%, you are guaranteed to lose 7% a year in purchasing power by holding that bond. Stocks, on the contrary, usually hold up well during periods of inflation, as long as it remains relatively low (somewhere below 5% annually is ideal).
Bonds are an excellent complement to stocks in a well-diversified portfolio. When stocks fall, bonds often climb, and when bonds fall, stocks often climb. Over time, diversifying a stock portfolio with bonds reduces a portfolio’s risk and increases risk-adjusted return.
Thoughts on Bitcoin, Commodities, and Currencies
These types of investments are usually less appropriate to invest versus instruments like stocks or bonds (and perhaps real estate). The reason why is that investments such as Bitcoin, commodities, and currencies don’t produce cash flow. When you own stocks, you have ownership in a company which is working to create profits. Similarly, if you own bonds, you own an instrument which will pay you interest. Conversely, when you own a currency or a commodity, you own an object which is worth something. It produces neither profits nor interest.
That said, these instruments store value well, so they may perform well if significant inflation, or a general rise in prices, occurs. Each type of instrument is sensitive to various and specific economic and political variables. Even so, these types of assets usually only merit a small portion of an individual’s investment portfolio.
Whatever You Decide to Invest In, Stick to The Plan
Investing is an anxiety-laden task. In most cases, doing what feels right will leave you worse off. Because of emotional decision-making and veering off course from a financial plan, most investors perform quite poorly, regardless of whether they decide to invest in stocks, bonds, or something else. Below is a chart using data from Dalbar’s Quantitative Analysis of Investor Behavior, showing how poorly stock investors perform because of emotional and flawed decision making.
Do You Have a Disciplined Investment Process?
Your homework from this post then is to evaluate your own investment philosophy. If you’re a do-it-yourselfer, determine if your investment process is consistent, evidence-based, and repeatable. If you work with an advisor, hold them to a high-standard and ask them for documentation on how your money is managed and the evidence that supports their methods. Phrases indicating an emotionally driven process “I like to own companies I think are good,” or “after XX number of years doing this, you just get a feeling” are clear red flags.
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