Why invest in the stock market?
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.
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.