Many investors, perhaps you included, are conflicted about investing in stocks.
What makes these investments attractive is that stocks, as a group — though not every individual stock — have provided stronger returns over time than bonds or cash. Stronger returns mean that an investment portfolio that includes stocks can gain more value than one that doesn’t, improving the likelihood of your reaching your investment goals.
But stocks can be volatile, which means their prices can change quickly and sharply. In one dramatic example, the S&P 500 index, which tracks the performance of large-company US stocks, had a positive total return of 5.49% in 2007, a negative return of -37% in 2008, and then positive returns of 26.46% in 2009 and 15.06% in 2010. It’s hardly surprising that the prospect of a 37% loss keeps people out of the stock market despite gains in other years.
A matter of time
While it’s possible to lose money on a portfolio of stocks in any one year, or —more rarely — for two, or even three, years in a row during a major market downturn, the potential for losing money on stocks over extended holding periods is rare. Since 1926, when modern recordkeeping began, there have been only four 10-year holding periods (the 10 years beginning in 1929, 1930, 1999, and 2000) when stocks lost value. What’s more, in every 20-year holding period since 1926, returns have been positive.
In other words, if you treat stocks as a long-term investment, volatility poses a relatively small threat to your bottom line, provided your stock portfolio includes a diversified assortment of investments. That’s easy to achieve at a modest cost by selecting a number of broad-market index funds that track different segments of the overall market.
The trick is to stay invested even when the market is moving against you. One sure way of losing money in the stock market is to pull your money out — and lock in your losses — at every downturn, only to buy your way into the market again after it's already bounced back.
And while 20 years or more may seem like a very long time, it really isn't when you consider that the life expectancy for women at age 65 is more than 21 years and for men is more than 19 years. Indeed, it's not uncommon for people who begin investing in their 30s to remain invested for over 45 years. And even people who begin investing in their 40s or 50s may stay invested for 20 or 30 years, or more.
There have always been speculative bubbles — periods when stock prices have risen to unsustainable levels based on investor optimism, or what Alan Greenspan termed “irrational exuberance.” The late 90s was one such period, as were the bull markets of 1970 to 1972 and 1982 to 1987.
Usually, a period of very high stock prices is followed by a period of depressed prices. Stocks become undervalued — or fall lower in price than a company's prospects would seem to warrant — when investors overreact to negative news, such as a company profit warning, rising interest rates, or political or economic upheaval at home or abroad.
Historical evidence demonstrates that stock prices eventually readjust to levels that are more in line with their actual value — and more in line with past historical performance. While the ups and downs can be unsettling, they may actually reward the patient, long-term investor who takes advantage of the opportunity that a downturn presents to purchase high quality, undervalued stocks at discounted prices.
Once you accept the ups and downs of investing in the stock market as normal, and understand that even sound, high-quality investments can fluctuate in value, you may wonder how you can gauge how well your investments are doing.
This is where benchmarks can help. A benchmark is an index, average, or other measure, whose changing value serves as a standard, or basis of comparison, for evaluating the performance of your portfolio against the overall market. For example, the S&P 500 and the Dow Jones Industrial Average (the DJIA or the Dow) both track the performance of large-company stocks and are the most widely followed benchmarks of the US stock market. The Russell 2000, as another example, is the benchmark for small-company stocks.
You’ll want to avoid measuring the performance of one type of asset against the benchmark of another. For example, let's say that one year the Russell 2000 gained 12% but the large company stocks that make up most of your portfolio gained an average of just 2%.
While the Russell 2000 can tell you something about the overall performance of small-caps, it can tell you very little about the performance of your portfolio in comparison to the rest of the large-company market. To get an accurate sense of how well your portfolio is performing, you would have to measure it against the S&P 500 or the Dow.
Hindsight is 20/20
To be a successful long-term investor is easy in principle, but more difficult in practice. The difficulty occurs when tales of speculators who have achieved great wealth quickly encourage others to make big bets on questionable products or to buy and sell rapidly to capture market gains.
In most cases, trying to beat the market leads to disastrous results. People take far too many risks, pay too much in transaction costs, and find themselves giving in to the emotions of the moment — pessimism when the market is down and optimism when the market is high. Their actions lead to substantially lower returns than they could have obtained by just staying in the market.
A better approach is to pursue long-term returns using fundamental strategies, such as asset allocation and diversification, that may help you increase your returns while minimizing your investment risk.
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