Should you invest in stocks? Unfortunately the answer isn’t a simple “yes” or “no” for several reasons, not the least of which may be your tolerance of financial risk. [For definitions of any italicized terms I use that you don’t know, see glossary at the end of this article.]
Over the many years that I’ve been investing in the stock market, the best-known U.S. market indices (Dow, S&P, NASDAQ) have all gone up – eventually. But they are not up all the time. I’m fine with that, but I also know many people who are not fine with it.
Are you risk averse?
Some folks who are risk averse would rather make less money and sleep well at night. I’ve found that this often applies to their careers as well as their investment strategies. And even if you tell them things will be ok when they see markets plunging crazily downward, they get really nervous.
Thing is, markets will do that. They aren’t CDs or bank savings accounts designed to protect your money (while offering you almost no interest). Should people with low tolerance for risk really put themselves through all the ups and downs of the stock market?
Maybe. Keep reading. I’ll do my best to explain.
First … what exactly is the stock market?
It’s basically a a place where all public companies have their stocks traded (offering people the chance to buy or sell shares) on a number of stock exchanges. The shares of stock themselves are a company’s way of getting investors to fund their business by offering them a percentage of the company, albeit a very small percentage if you only own one share.
The value of the stock, at any given time, is determined by how many people want to buy versus sell. Like anything — it’s supply and demand. More buyers (demand), the higher the price. Less buyers, as when bad news hits, and stocks can start tumbling.
How high buyers are willing to pay depends partly on things like the industry the stock is part of, ratings, and real numbers like earnings and business growth (or lack there of). But there is also the psychology of a stock’s appeal to potential buyers, which can be a major player.
A stock with no earnings can become a market favorite anyway, especially a relatively young company in aggressive growth industries like tech and bio pharmaceuticals, although not limited to them. Buyers trade security today (low risk) for potential high earnings in the future (high risk).
Losers can turn into winners
Let’s look at Tesla, for example. Their earnings are NEGATIVE as of this date – losing almost $8 per share. And yet, even with some warnings from savvy analysts, people are still buying it. Why? It’s a sexy company owned by a visionary who may one day bring it to glory — or failure.
Did I mention the stock market involves gambling at times? Well it does. But the trick is to match the risk of what you own to your own risk preference. And sometimes that means at least some part of your portfolio has stocks that are priced higher than current earnings reflect.
Wait. Am I really saying that we might want to put hard-earned money into stocks that might be making nothing using some strange calculation of what their stock price should be based on potential alone? With no reliable earnings to back them up?
Maybe. Amazon had many years with mostly negative earnings. But as its business grew, even without earnings, the stock price also grew. Sure would have been great to own that stock from the beginning, when the price was a fraction of what it is now.
But I don’t want to lose ANY money!
I don’t blame you. Me neither. No one wants to lose money — unless you are selling to get losses which can be deducted on your income taxes. But that’s for another day and a future post!
And a Tesla may not be the right investment for you, especially at about $200 per share as I type this. Maybe AT&T is more your speed — steady growth over the years and a dividend way higher than any bank is paying for savings.
Of course, even AT&T can and will go down. It’s up to you to decide if you can stomach the twists and turns with a belief that 10 years from now, a solid stock like this should probably be doing well for you. Then again, markets will dip in the future also; you never know when a dip is coming.
To help keep their money a little less subject to the whims of market volatility, people can dollar cost average their buying. Or the can make sure to own enough stocks (often with the help of mutual funds) so no one individual stock can wipe them out. (Portfolio theory.) But again, I’ll go into that more in future posts.
Here’s the thing … you ARE losing money
I used the phrase “protect your money” in relationship to those low-paying bank savings accounts or money market funds. And while your basic investment principal is safe, as the years go on and inflation (even low inflation) eats away at the value of money, those “safe” investments are no longer worth what you initially invested.
Does that surprise you? The number looks the same, but the amount you can buy with it has shrunk. While your bank has been making money on what you gave them, you have been effectively losing money in real terms.
=> EXAMPLE: $100 today invested at 1% gives you $110.46 in 10 years. Not bad, huh? Well, if inflation is 2% during that same time, you’ve actually lost money – a little over $10 in real terms. Not good!
That’s why, even if you are risk averse, once you learn about investing and feel more comfortable, you might consider investing at least some of your money in stock mutual funds or even index funds to not only keep up with inflation, but to also get the growth that has averaged well above 5% a year over the long run. Imagine if banks paid that! (They once did.)
Some final thoughts
Over time, 10 / 20 / 30 years or more, markets on average have always gone up, and (depending on your age) should go up in the future way more than the piddly percentage banks are now paying you. But that said, there are no guarantees about the future. None.
So in the end, you have to decide if you can stand the ups and downs, knowing if you balance your portfolio of stocks and bonds well (more to come on that topic also), eventually there should be more ups than downs for you. While money that sits in a low-paying bank or money market account is for sure losing you money in terms of what you can actually buy.
But if you the ups and downs would drive you crazy, no matter how much you’ve learned about investing and no matter how tempting, then that’s important too. The choice is yours. And it has to be something you can live with. Money cannot buy peace of mind!
FINANCIAL TERMS GLOSSARY
Financial risk – To what extent you can count on your money growing or shrinking. Often stocks that have high growth potential and are considered exciting will have a hefty price premium built in. But on just a whiff of bad news that same stock can tumble out of bed. (My first broker used to say that.) That’s high financial risk. Low risk is a fully-insured savings account.
Market indices – These are the averages of a certain group of stocks, such as the Dow Jones Industrial Average. The DJIA is made up of 30 well-known companies, although there have been different stocks in that basket over the years as some fall out of favor or even vanish.
There are many such indices (plural of index) all over the world, but the ones we hear about most in this country are the Dow Jones, S&P (Standard % Poor’s), and NASDAQ. Each index has its own set of stocks, and the real time averages of those at any given time are used to give a picture of how stocks are doing on that day.
Investment strategy – Your investment strategy is the logic / formula you use to invest. A little each month. Big spending when the market falls. Finding investments you believe in and holding long term no matter what. Using some mix of bonds and stocks to help level the volatility. Even hedging (minimizing risks by what you choose to own at the same time), which has not always been the dirty word it is now.
Stock exchange – A formal marketplace, organized with tons of strict rules, where stocks are bought and sold. The New York Stock Exchange (NYSE), for example, still has an actual trading floor and lots of excitement, although a good deal of trading happens now electronically. You probably saw the NYSE in the film Trading Places.
CDs – Certificates of deposit. These are investments, usually offered by banks and investment firms, where you can earn a specific amount of interest on your money for a fixed amount of time. They pay very low now, but your principal is protected and, as with other bank deposit investments, you are insured up to $250,000 by the FDIC (Federal Deposit Insurance Company).
Public companies – Some companies stay private, to keep tight controls and/or to not be subject to public scrutiny of their operations. But other companies, who want to widen the number of people who might invest, go public … meaning their stock is now traded on one of the exchanges and available for anyone to buy.
But they also must file public statements about their finances and are subject to protective federal regulations, since they are owned by their shareholders now. (Many company execs make sure they have a huge number of their own shares, so don’t feel too sorry for them.)
Supply and demand – A core economic principle that tells us the price of something is influenced by how easy it is to get and how in demand it is. The more in demand and the less available or limited the supply, the higher the price goes. (Like Hamilton tickets on Broadway now going for as high as $1,000 for a single ideally-located, hard-to-get seat!!)
Dollar cost averaging – Similar to not putting all your eggs in one basket. Instead of buying all your shares of a stock or mutual fund at once, you slowly purchase the same number of shares over time, getting some at a higher and some at a lower price. This way you minimize the risk of buying all your shares at an especially high price, and then cringing on those lower days when you wish you could have bought at a better price.
Portfolio theory – Again, similar to not putting all your eggs in one basket. The idea is that if you own one stock, if anything bad happens to that company, you can wind up losing a bundle. But if you own enough stocks (or bonds or funds), they will balance out. A mutual fund, which is made of of many stocks, does that for you.
But, since many mutual funds have a segment they specialize in, you might want a few different types of funds to help balance that out. Another possibility is something called index funds which are a type of mutual fund that is based on one of the many indices, such as one that contains the stocks within the S&P index.
Investment principal – The initial amount you invest, separate from any interest or dividends you might earn or any drops in the initial price. A savings account guarantees that you will at least get the principal, plus any yearly interest they offer added to your investment’s worth at regular intervals according to the terms.
Market volatility – Like a roller coaster, markets go up and down, bringing different prices rather than a steady price every day. High volatility means the ups and downs can be really big. Low volatility means the new price at any given point stays closer to the initial price.
More on this topic (links coming soon)