Investing in the stock market, over the long run, has been a winning strategy, Stocks have returned an average of 9.5% since 1928. Compare that with a 5% return for long term government bonds and a 3.5% return for cash. This 100 chart of the S&P 500 over the last 90 years, illustrates the path taken to that return.
You can see that there are long periods in which the stock market goes down in value. Specifically, from 1929 to 1932 , 1937 to 1942, 1946 to 1949, 1968 to 1982, 2000 to 2002 and 2007 to 2009. Though, riding those periods out, would have resulted in gains, in the long run.
The owners of a companies stock are referred to as shareholders. A company may pay a portion of its earnings to shareholders, in the form of a dividend, or it may not. If the company has a good year, the dividend may be higher. If has a bad year, it could be lower. If the company goes out of business, the shareholders get what is left, after the company pays all its debts.
Compare that with other forms of investment, such as CDs or government and corporate bonds. Those investments provide guaranteed interest rate payments, as far as the issuer is good for. Bond owners also are ahead shareholders as far as receiving payments, if a company should happen to go out of business. As noted above, shareholders of a company are only entitled to what is left over, after the company pays its debts.
The fact that a stock’s payment stream is less certain, will make its price more volatile. On the other hand, its return will be higher over the long run, to compensate for that volatility.
Since stocks compensate you for the risk you are taking, it makes sense to own them. But how much should the average investor put in stocks?
Warren Buffet advocates putting 90% of your money in a S&P 500 index fund. But we know that the stock market has had long periods where it has gone down in value. We also know there are risks to owning stocks. Having 90% invested in stocks, may make sense when you are young and have time to ride out any potential pitfalls, but not as you get older. Some financial advisors advocate taking 110 minus your age, to determine what percent you should have in the stock market. So, someone 40 years old, would invest 70% in stocks and 30% in bonds.
Of course, these rules make everything simple, but what about someone who does their research and finds undervalued and overvalued stocks. There is nothing wrong with having more or less money in stocks, depending on where you think the market will go. Investing actively can be lucrative. But be cautious. As many seasoned investors know, not every trade is a winner, and you could very well underperform the overall market.
I have written in the past about how I think emerging markets will do better than developed ones, over the next several years. Regardless, investing internationally is a good way to diversify.
Adding international stocks has proven to limit a portfolios overall volatility, while maintaining the same return. Over the last 46 years a portfolio of international and U.S. stocks has had the same return as a portfolio of just U.S. stocks, 10.2%. However, the volatility was lower for the International plus U.S. stock portfolio during the same time frame.
Owning stocks over the long run will build wealth. Keep in mind that you will have to whether some periods of negative return. You will come out ahead, in the end.