Why invest in the stock market?

By Philip Brewer on 27 October 2008 (Updated 18 May 2010) 22 comments
Photo: Philip Brewer

The conventional reason for investing in the stock market--perhaps offered with a bit less confidence now that we're in the midst of a stock market crash--is, "It offers higher returns."  But that gets us ahead of ourselves.  We can learn a lot by taking a couple of steps back and looking first at our financial goals.

Most people have a long list of financial goals, starting with things like paying the rent, putting food on the table, keeping the lights turned on, and so on.  Work your way down the list and you get to things like replacing the old car, buying a house, putting the kids through college, and (sooner or later) retiring.

Most people's wants, if you list them all out like that, will exceed their expected lifetime earnings (even before including the Ferrari, apartment in Paris, yacht, and private jet).  And that's why people so automatically shoot for investments that offer the maximum returns--outsized returns are their only hope of satisfying all their wants.

That thinking, though, leads people to make all sorts of poor choices.

As a thought experiment, imagine someone whose wants could be comfortably satisfied by his or her income.  (Since wants tend to expand without limit, I admit this is a bit tricky, but give it a try.)   Such a person wouldn't need to invest at all (beyond establishing an emergency fund).  In fact, investments would only make sense in the context of some particular goal--leaving a legacy for example.

I'd like to suggest that this is really true of everyone.  You just lead yourself astray if you line up all your wants on one side, and then create an aggressive portfolio on the other, hoping for some big wins to bridge the gap between your income and all the stuff you want.

Note that I'm not suggesting that you target particular investments to specific goals--that's definitely the wrong approach.  Your entire investment portfolio supports all your goals.  Rather, the defect is in letting your wants grow without bound, putting you in a situation where the sum of your income and the return to ordinary saving still doesn't add up to enough to satisfy them.

Now, it's fine to have some out-of-reach desires.  (For example, I'd like to have a private rail car, which although much cheaper than a private jet, is still likely to be forever beyond my means.)  The problem is letting them get out of control in a way that distorts your entire investment strategy.

My suggestion is that you classify your wants into the important ones and the unimportant ones--and that the portion of your portfolio that's going to fund the important ones needs to be conservatively invested.

ARTICLE CONTINUES BELOW

Lots of people have made the point that the stock market is no place for money that you expect to need in the next 5 years.  The events of the past year suggest that maybe an even longer period is in order.  If you're prepared to delay your retirement by 5 or 10 years in order to have a shot at retiring 5 or 10 years early, then an aggressive investment strategy may be in order.  The same sort of thinking is probably not appropriate for your college savings or the down payment on a new car.

Here are some thoughts on some specific categories of investments:

  • Cash isn't much of an investment--but it's what you actually need when you're ready to spend.  Your emergency fund should be in cash (money market fund, high-rate savings account, t-bills, etc.).
  • Short-term bonds rarely yield much more than cash--but they're a good choice for money that you're going to need at some particular time in the near future.  (For example, as your kid approaches high school, it might make sense to start moving his college savings into short-term bonds with maturity dates that match the tuition bills.)
  • Long-term bonds are very vulnerable to inflation, but can be a great investment when the coupon is high enough to provide a good return over whatever inflation turns out to be.
  • Inflation-adjusted bonds are an excellent investment, except when the after-inflation return is very low--which it had been for the past several years.  Happily, the return on TIPS has surged in just the past few weeks, making these an investment well worth considering.  (They are vulnerable in a deflation, which is probably why the return has shot up.)
  • Gold is a store of value.  There's good reason to hope that your investment in gold will maintain its value, but little reason to hope that it will grow in value.  (Although the gold price will go up if there's inflation--and just staying even with inflation can be tough with other investments.  Still, don't expect a return from gold that will fund any of those wants on your list.)
  • Stocks are the classic investment.  Prices are down right now, but the looming recession will probably mean that profits will be low as well.  If you've got a 10-year time horizon, stocks are a good choice.
  • Real estate is another classic investment, but be careful not to delude yourself.  As an investment, your home is worth whatever it lets you avoid paying in rent.  Properties that you rent out are definitely investments--but being a landlord is as much like having a second job as it is like owning an investment like stocks or bonds.

To answer the question I started with, the reason to invest in stocks to earn a higher return is that it lets you satisfy wants that you couldn't otherwise afford.  But those higher returns come with higher risks--risks that mean that maybe those wants won't be satisfied at all.

As recent events have made clear, the average return for the stock market may be higher than the average return of most other investments--but that doesn't mean that you can plug the average return into your plans and have any expectation that you'll get that return in any particular year.  Even if you have a long time horizon, stocks may be down right when you're ready to spend the money.

I guess you don't need me to tell you that.

Do some thinking about your wants.  A shot at high returns in the stock market makes good sense for funding some of your wants--especially the less important ones (the sports car) and the longer-term ones (early retirement).   But for the important ones, and the ones with shorter time horizons--arrange to cover those without relying on outsized investment returns.  

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Guest's picture
Debbie M

Interesting, as usual.

I've always used stocks as a way to reduce inflation risk. In other words, by diversifying into stocks, I try to keep myself safer from the risk of losing spending power due to inflation. But you do bring up alternatives to stock investing for that purpose:

1) Inflation-adjusted bonds (when the after-inflation return is above zero)

2) Real estate (with a fixed-rate mortgage, only the taxes, insurance and repairs will increase with inflation, and if you stay long enough, there won't be any additional costs)

I've been annoyed with I-bonds since the fixed part of the rate dropped below 3% (and then 2%), but it seems like TIPS are something I should try.

(I have a house to live in but have very little interest in becoming a landlord. Although, I am sort of tempted to get a duplex and rent the other side out.)

Some people also use dividend stocks this way. They buy from companies who always pay dividends and whose dividends have always increased over time (so far, of course), and they don't have to care what the stock price is so long as the dividend keeps up with inflation. Of course as soon as the dividend drops, I'm sure the stock price also drops and then you're stuck, but it's another thing to add to your basket.

Philip Brewer's picture

To the extent that the companies are out there making things that people want to buy, their stocks do provide some inflation protection.  On average, you'd expect their costs, their prices, and their profits all to rise along with inflation.

It's never that simple, of course.  Some companies will see costs rising faster than inflation and some companies will find that customers won't pay higher prices.  Of course, other companies will having the benefit of opposite trends.  If the companies you own stock in find themselves on the better side of those shifts, you might do very well indeed.

Dividends are, to my mind, the right way to expect a return from stocks.  Rising dividends are one way that stock investments can protect investors from inflation--but, of course, the rising dividends depend on rising profits.

Guest's picture
Greg

Unless you are able to perform due diligence, invest in an index fund. Consistently outperforms managed mutual funds. Also, invest regularly to minimize the effect of cycles.

Guest's picture

I don't know this: it sounds like you're discouraging investing in stocks, which I'm a little wary about. I think I see your point—people are greedy and want the greatest possible return for their investment. But without investing in stocks, I can't see how most people could possibly afford to retire unless they make tons of money.
Don't you agree?

Guest's picture

Investing in the stock market gives you a variety of ways to invest your money in every industry. Now a days you can invest in various ETF's that feature companies throughout the world that don't trade in United States.

Philip Brewer's picture

As long as your goal is 10, 20, or 30 years out--retirement, for example--then stocks are a fine investment.

The problem is that stocks did so well from about 1980 until the dotcom crash, that it was easy to imagine that stocks did well all the time.  Even the 1987 crash didn't change that perception, because the market recovered so quickly.  People started suggesting that most of your assets should go into stocks (for maximum returns).  A few even suggested that you could get by without a cash reserve--using credit to bridge the gap, on the off chance that the market was down when you needed some cash.

I think that your short-term and medium-term goal should be funded with income, savings, and investments such as bonds of an appropriate maturity.

Retirement is an appropriate goal to be funded with stocks.  In fact, a retired person should go on holding a substantial portfolio of stocks, because his goals--such as a comfortable standard of living--still have a time horizon of many years.

Guest's picture

I placed most of my investments in Credit Union term deposits a while back. They pay 4-4.5% - approximately 1% more than banks. (Canada)

A lot of the interest in stocks and mutual funds has been the enthusiasm of financial planners. Some are quite young and inexperienced. Then there are the commissions.

Up to that point I found the bank representatives to be quite pushy and I often came away with something I didn't really want.

Guest's picture
Guest

You said, "Gold is a store of value". This is a perfect reason in these unprecedented times of financial distress to buy gold.

Yes, gold will do very well in inflationary times. That should be coming down the pike very soon at us - especially in light of the billions upon billions of dollars being manufactured and thrown into the system.

But, are you aware how well Gold did in the Great Depression? The metal was confiscated by the government (safe deposit boxes were actually broken into.) FDR ordered this so he could print dollars without limit. Gold held it's value, even rising through the depression. Lucky for those who defied the government edict. The mining stocks did very well. Homestake, the largest gold miner had a 10 fold increase in price during the depression and, I believe, was the best performer for those years.

Gold is a currency and insurance. It will rise in price dramatically only because the public will lose their faith in paper currency.

Guest's picture
Rich

Gold is a horrible investment. Historically it's had a terrible rate of return compared to the market with only a very few sprints in between that were quickly crushed. The only thing gold is guaranteed to collect is dust. Gold doesn't produce anything. It doesn't grow. It locks away your cash from the market further stagnating it much like we see people flooding out of the market in a panic.

The smart investor right now is completely drooling over himself since the entire market is on a 50% sale. Gold might be up right now but unless you purchased a year ago then you're making a costly error. If you want to invest into a mining company, which actually produces something, then I'd say go for it but hoarding gold away as an investment is unwise advice.

Oh and as far as gold being a currency you're sadly off base. If the world got so bad to the point where the entire economy has imploded and the country was in complete chaos you could have truck loads of gold and you'd be no better off. Why? You can't eat gold and those with any food, medicine or shelter will be hoarding it for themselves no matter how much gold you have.

It IS pretty stuff though.

Guest's picture
John Truong

My current focus these days is profiting off the backs of those who are profiting off of mine. I'm enrolled in some dividend reinvestment plans and dividends are driven by profits. Who's making profits? Big, evil corporations!

I'm currently enrolled with an oil company, an urban-sprawling commercial real-estate developer, and a (Canadian) bank. In the near future, I want to get a pharmaceuticals company and an insurance company. All of these companies have proven methods for screwing people out of money and putting profits ahead of human decency.

As the profits roll in, they feed the dividends, and the dividends are reinvested without fees into new shares. The new shares result in more dividends. Compounding!

It's another way to invest in the stock market, anyway. Some people might find it suits them, but it does require a lot of setup and patience.

Philip Brewer's picture

Check out my post How to get rich by being evil.

As for getting rich by investing in evil corporations, I think you may have missed the boat--that's so last administration.

Guest's picture
Debbie M

One thing about investing in evil is you win either way. Either you get lots of money, or evil-doers are sinking!

Guest's picture
Lynn

I found back in 1978 that I did not have the time to properly research individual stocks.I could not bring myself to pay an investment advisor so I began investing in different types of mutual funds. I have been investing twice a month or dollar cost averaging now for the last thirty years.
As I have gotten older I have invested in the money market or short term bond funds for liquidity and safety reasons and less in the more agressive growth funds. My appetite for risk has changed over the years and I have continued to adjust my portfolio as I get closer to my retirement.
If you have a long term investment horizon this investment strategy, although a little old fashioned compared to the newer types of investments available today, has worked very well for me.

Guest's picture
Flash

As a 20 year old Economics major, and a father who is an exrtemely successful financial advisor, I'm fairly biased with respect to stocks. Historically, and in the long run, stocks have outgrown all other means of investment. Now is the time to invest at the current lows. The Dow Jones Industrial Average seemed to increase exponentially from the 1930s to about 2000. The last time we saw numbers this low was the beginning of 1998 and between mid 2002 and mid 2003. Investing now will yield tremendous returns in the long run. My grandmother once told me that you have to look at the stock market like a little boy walking up a hill with a yo-yo. The yo-yo goes up and down but he's still walking up the hill. Until the 21st century this seemed very true. However, our day in age is more complicated. Now it looks more like a football game, with each player on the offensive lines either eating dirt or standing tall with each play. Personally, I think it's time to take the punt and let our defense do their thing and we'll try again.

What's important is that stocks have historically been premier. The valleys in the market allow for greater growth so invest at these points. Stocks avoid inflation and, in my opinion, the exchange rate that belittles our American dollar. Also, as mentioned in the article, expecting high rates of return in the short run exposes the investor to extremely high risk. Unless your going to quit your job and become a day trader, avoid all of this by diversifying in quality national and international mutual funds. By quality I mean 4s and 5s.

I'd love to continue but I got to go to class!!! Please critique me if you do not agree, I believe I still have much to learn.

Philip Brewer's picture

@Flash:

Probably true.  But we now are reminded of the fact that, even if the stockmarket is on a perpetual uptrend, we can get periods of a decade or two during which the overall trend is flat or even down.

During the long uptrend from the early 1980s through 2000, it was easy to forget that, and to imagine that stocks were a fine place to put your money even for short and medium term goals.  But suppose someone who hoped to retire early had started pouring money into the stockmarket in 1997?  There were a couple of points (in 2000 and again in 2007) when he probably felt like an investing genius.  Today, though, he's probably behind where he'd have been if he'd have just left the money in cash--and that's no way to fund an early retirement.

My main point was simply that you need to keep your timeframes properly in mind.  Just because the average return in the stockmarket is higher than the average return from bonds or cash, is not a reason to put money that you're going to need in a year or two into the stockmarket.  For a few years, though, it sure felt like it.

Guest's picture
Flash

Mr. Brewer,

I thank you very much for your comment. What prompted me to visit this site is because I'm preparing a speech on IRAs and 401(k)s. With that said, I didn't mean to come across as an individual who would pursue the market over a one to two year period with the intention of liquidating soon after. I think when you look at the market you must be willing to invest over a 10 to 15 year period at the minimum. I plan on investing in my 401(k) over the next 40 years. Who knows where the Dow will be at then. But I do believe over the next 20 years our nation and the world will be faced with new problems that will require technological advances and innovation. For instance, one of these will be renewable energy and means of transit that emit zero emissions. I'm waiting for the day Congress passes some bill that will push our nation into a fossil fuel free nation where wind, water, and the sun powers all. General Electric stock is so-so, but can you imagine what would happen to share prices over night after legislation such as that? I'm very excited to continue my education in economics, psychology, and modern history (with respect to business and how certain events affect "people").

Guest's picture
TELEMA S.D LAWSON JACK

PLZ I AM A STUDENT'WHO WANTS TO INVEST BUT I AM IN NIGERIA.I LOVE INVESTING INTO STOCKS.RIGHT NOW I HAVE MANY STOCKS OVER HERE.PLZ TEACH ME HOW TO INVEST OVER THERE.THANKZ.TELEMA

Guest's picture
Guest

For my assignment i want to choose skocks as a good investement could u please give some good points about stocks and what type of stocks eg. natural reserouse what eles...... enough to write a good essay please.

Question is as follow:

You have recently inherited $25,000 from your Grandmother. You plan to buy a house or condominium some time within 10 years of graduating from Humber. Using only the financial assets we studied in ECON004, design and present and investment strategy/plan to accumulate a big enough down payment to acquire the property.

Guest's picture

I think it is a very good time to invest in stocks, because the valuation are so low now. And the stock market usually quickly forgets its past.

Keep a close eye on the composition of your portfolio though: I have written a free online tool for monitoring separate risk categories inside a portfolio.

The URL is:
http://www.numericalexample.com/content/view/85/27/

You can also find the tool by searching on the following:
"Trading Simulator" numericalexample

Users can enter almost any number of transactions, dividends, an initial cash balance, interest rates, costs and dividends.

The Trading Simulator computes the value of your portfolio, the costs, the interest received or paid and the ROI.

In addition the Trading Simulator produces two time graphs. The top graph shows the value of the portfolio, the cash part and the investments. The second graph shows the value of each (risk) category of your investments.

Guest's picture
Paulson

I LOVE INVESTMENT SO MUCH. BUT MY PROBLEM IS WHAT DO I INVEST IN. I WAS THINKING OF INVESTING INTO LANDED PROPERTY, UNTIL THE ISSUE OF STOCK EXCHANGE CAME ACROSS MY MIND. PLEASE MR MODERATOR, I WILL APPRECIATE A REPLY FROM YOU. HOW DO I GET INTO THE NIGERIA STOCK EXCHANGE?, WHAT ARE THE GUIDELINES TO BE SUCCESSFUL IN THEIR MARKET?, WHAT ARE THE LANGUAGES INVOLVED?, WHAT ARE THE CRITERIA FOR BEING ADMITED?, WHAT BOOKS DO I READ TO ENHANCE MY KNOWLEDGE?, OTHER MEMBERS WHO HAS ANSWERS TO THESE QUESTIONS SHOULD PLS REPLY OR REACH ME THROUGH MY MAIL ON Jonify2005@yahoo.com. Or 07038178349. Thanks a lot

Guest's picture
Paulson

Mr moderator, please as a student how do i become rich in order to satisfy my material needs like good clothing, good perfumes, good manicure etc. Please i need your reply

Guest's picture
Guest

If a stock is not paying a dividend, then why purchase it? The broccoli analogy makes sense, but it is different in that the broccoli you are purchasing is not an investment, it is a need...for nutrition...that is the reason a person buys food. With stock, yes demand drives the price, but why does the person or people wanting the stock, thus driving up the price, want it as well? This is circular reasoning. If there were no other buyers for an equity, and it does not pay dividends, then tell me, why would I buy a stock?? thank you.