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How investing in stocks can make you rich

May 21, 2009 14:43 IST
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Stocks are volatile, which is another way of saying they're likely to experience wide swings in value. However, over long periods of time, there's good reason and evidence to believe stocks also will appreciate dramatically faster than any other type of asset. That makes it easier to attain your long-term wealth goals.

When you buy a share, or stock, you are buying a piece of the issuing company. Admittedly, it's probably a small piece, but that share you purchase gives you the right to participate in the company's wealth (or fiscal decline) and vote on matters of some importance - directors, company auditors, and some shifts in cor­porate policy.

In some cases, you are also entitled to dividends - payments of cash or stock to shareholders. Some companies also provide their shareholders with perquisites, such as tickets to the company's theme parks or discounts on its merchandise.

Why share prices go up

Because companies tend to grow and prosper over time - and because a share of stock allows you to participate in the prosperity - stock prices, in the aggregate, tend to appreciate over long periods of time. However, individually, some companies prosper; others fail.

If you buy a share in a loser, you could lose all, or a significant portion, of your initial investment. In other words, when you invest in stocks, you risk losing your initial investment, but because you are taking a bigger risk, you get the opportunity to earn far bigger rewards.

How big a reward? In the case of the US, for example, the Chicago-based research company Ibbotson Associates has tracked the performance of US stocks from 1926 onwards. The period till the turn of the century included the Great Depression, the New Deal, World War II, the Korean conflict, the Vietnam War, the Kennedy assassination, Reaganomics, and the Gulf War, not to mention the lunar landing, the break-up of Ma Bell, the Watergate scandal, and the dismantling of the Iron Curtain.

In other words, it is a fairly diverse period that has had its share of ups and downs, just like any period in history. During that time, the average annual return on small-company US stocks was about 12.4 per cent. The average annual return on big-company stocks was 11.2 per cent. Over the same period, inflation rose 3.1 per cent per year, and the return on U.S. Treasury bills was 3.77 per cent.

To put it another way: If you had a diversified portfolio of large-company stocks during that period, the value of your investment portfolio rose 8.1 percentage points faster than the rate of inflation. For every $100 you put in the market, you hiked your buying power by $8.10 each year. At the end of twenty years, your real (inflation-adjusted) buying power increased fivefold, to $503 from $100, without any additional payments from you.

Although investing is as much an art as a science, it's reasonable to expect that future investment returns will mirror historic returns over long periods. In other words, it's reasonable to assume that stocks will continue to appreciate faster than the rate of inflation and other types of traditional investments.

The downside: it is also reasonable to assume that stocks could repeat their short-term historic performance over shorter periods, too. And that's been far less illustrious than the long-term performance. To be specific: the market crash of 1929 so depressed stock prices that investors who put $100 in the market then saw the value of their securities fall to less than $20 at the market's nadir in 1932.

It took roughly eight years before securities prices rose back to ground zero, where $ 100 invested in 1929 was worth $100 again. And then the market took another sickening slide, from which it didn't recover until after World War II had ended. From start to finish, it was a full fifteen years of pain for stock market investors.

The market also took a sharp, decade-long dive in 1969. And it experienced short-term 'crashes' in 1987, 1989, and 1990. But its performance in 1995 was enough to make an investor beam. Stock values as measured by the Standard and Poor's 500 index were up more than 37 per cent.

The following years till 2000 were almost as impressive. Big-company stocks posted a 23 per cent gain in 1996, a 33 per cent gain in 1997, a 28 per cent gain in 1998, and a 21 percent gain in 1999.

Incidentally, although investors in small companies have done better than investors in large companies over the long haul (average annual returns of 12.4 per cent versus 11.2 per cent, respectively), at various points in time, small-company stocks do worse than big-company stocks. They fall farther and faster, and they stay depressed longer.

How to deal with price yo-yos

These heady climbs and sickening slumps are called volatility. When an investment is as volatile as the stock market, it is unwise to invest unless you have a fairly long time horizon that allows you to wait out the price swings and go for the long-term price appreciation.

How long is a 'fairly long' time horizon? That depends on you and why you are investing. Let's say you want to buy a house in five years, and you're trying to determine where to invest the down-payment money.

The stock market would be a good place for all or part of that money if you wouldn't be crushed if your home-buying plans had to be put off because of a market slump that depressed the value of your investment portfolio and thus reduced the amount you had saved for the down payment.

What if you would be crushed if you couldn't buy the home as planned? Then put the down payment money in bonds that mature (or pay back their principal) at the same time as your plans do.

Stocks are also ideal to have in your retirement portfolio. The younger and farther from retirement you are, the more stocks you can handle. And they're a good choice for college funds for young children.

However, if you are investing in individual stocks rather than mutual funds, you must diversify your portfolio by buying stocks in several different companies that do business in several different industries. That ensures that your net worth won't crash if one industry, whether it's oil, technology, or retailing, hits a slump.

Experts suggest you own shares in at least eight to ten different companies. Ideally, those companies should be operating in substantially different industries.

Do it the equity mutual fund way

Mutual funds are investment companies that pool the money of many investors and buy securities in bulk. The securities that a fund buys are determined by the fund's investment objectives. These investment objectives are spelled out in the prospectus and by the fund manager, who makes the investment decisions.

So-called equity funds - also known as growth or aggressive growth funds - buy stock in companies. When you buy a share in an equity fund, you're actually buying an interest in all of the different stocks held by that fund.

That gives you the ben­efit of broad diversification, which reduces the risk that your investment portfolio will be savaged by a single bad stock. In essence, if you buy the right mutual fund, you may not need to diversify the stock portion of your portfolio further. One fund could do it all.

There are lots of other benefits and tricks to buying mutual funds. However, let it suffice to say that investing in equity mutual funds is an alternative to investing in individual stocks. It is a particularly good alternative for those who don't want to spend a lot of time picking individual shares or for those who are starting out and don't have a lot of money.

(Excerpt from Investing for Beginners by Kathy Kristoff. Published by Vision Books.)

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