The Stock Market: Pros and Cons
After the sub-prime mortgage market collapsed in 2008, the Dow Jones Industrial Average fell more than 30 percent in value in less than a year. The retirement savings of many individuals plummeted, forcing them back to work when they thought they would finally be able to relax. It is a gut-wrenching feeling to check your portfolio every week just to find that you are continually worth less money, especially considering how hard you worked in order to save that money.
That, in a nutshell, if the most negative aspect of investing money in the stock market: its considerable volatility. That is to say, you can lose a lot of money in a short period of time. Indeed, the stock market can take a long time to recover from a significant, negative event. Consider the Great Depression, for instance, when it took the stock market nearly a decade to recover from the crash in 1929.
Therefore, anyone who thinks about investing in the stock market should realize that it is only for those with a long-term horizon. When you only invest in the stock market for a short period of time, like one or two years, you have a very real risk of loss. But when you invest in the stock market over thirty or forty years, the risk of loss is minimized considerably.
This is because the stock market is the highest-returning asset group over long periods of time. Over the past century, the stock market has returned an average of approximately ten percent a year, compared to bond returns that are roughly half of that. Over the long haul, the greater risk of the stock market will be rewarded with greater returns.
And these greater returns are important given the other risk factors investors face. Specifically, the costs of inflation and taxes can have a negative impact on a portfolio's return, making it more difficult to save for retirement. Since inflation costs are fixed across all investors, those costs will eat up a larger proportion of a bond investor's returns. Indeed, the cumulative effect of inflation and taxes could lead to a negative real return for bond investors in low interest environments.
Thankfully, even if you aren't particularly comfortable with the higher risk of the stock market, there are ways to minimize those risks. Perhaps the most important thing you can do is to avoid investing in individual stocks, but rather invest your money in broad-based mutual funds. By diversifying your money over a large number of stocks, you considerably reduce the risk of any one company performing poorly.
Another benefit of investing in mutual funds or various types of financial derivatives is that it significantly reduces the amount of time you have to spend researching your investments. Instead of analyzing and following dozens of individual stocks, which could easily consume all of your free time, you can instead just follow a mutual fund and allow the manager of the fund to run the daily operations of the portfolio. It makes your life a lot easier, so that you can spend time doing the things you truly want to do.
The stock market can be risky. But by taking a long-term time horizon and diversifying your portfolio, you can minimize that risk and increase the likelihood of earning high future returns, making your retirement more secure and enjoyable.
