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This is a continuation of the risk theme we explored in the post titled Winning Personal Finance Coin Flip Risk Assessment. In that post, I presented a hypothetical coin flip as an introspective view of your feelings about risk. Now, we are going to dive into some of the risks involved in investing in stocks and prove that the stock market will always go up over time.
You Can Lose Money Investing in Stocks
Yes. It’s true. You can lose money in stocks. Let’s explore it a bit further.
Individual Company Performance
When you own a stock, you own a share in one company and there are a myriad of reasons your investment could decrease. These include: the company’s competition improving (look-up Blockbuster Video); their costs rising; their reputation changing and causing consumers to stop buying; their product becoming antiquated, and countless other possibilities. This is why it’s not recommended to keep a large percentage of your net worth in one or even a handful of stocks. The associated risk is called concentration risk. With one stock, anything can happen. The risk is even higher if you invest heavily in your employer’s stock because if your company hits a rough patch, you could lose your investment and be out of a job.
Thankfully, there is a better way to invest. You can reduce your concentration risk by holding many investments. You can buy many individual stocks in your portfolio or a mutual fund, which could be invested in stocks, bonds or a combination of both. Avoiding the risk associated with one business by owning many is called diversification. By diversifying your investments, the performance of one company won’t drastically impact your overall performance.
Total Market Index Fund
My favorite mutual fund for investing in stocks is (VTSAX) The Vanguard Total Stock Market Index Fund. (I do not receive any compensation from Vanguard for this recommendation). The prospectus says that this fund “seeks to track the performance of a benchmark index that measures the investment return of the overall stock market.” That’s a fancy way of saying that it invests in essentially all the stocks in the US stock market weighted by the size of the company. If GE makes up 3% of the Total US Stock Market, it should make up that same percentage in VTSAX. The Vanguard fund charges very low costs for the service of managing this fund. The current expense ratio is 0.04%. Paying low costs for your investments is vitally important to the returns you earn. The lower the cost of your investments, the more you keep.
This type of mutual fund – called an index fund – is a fantastic way to invest in stocks. This is because costs are low and having so many stocks in your portfolio mitigates the risk of any one company failing. If Google comes out with a new product that takes market share from the iPhone, Google would likely go up and Apple would likely go down. But the index has both stocks so you are more or less protected.
If you want to read more about an effective yet simple index fund investing strategy, I recommend you read the stock series by Jim Collins.
The Whole Stock Market Can Go Down
Even if you invest in a broad-based stock index, it’s still possible to lose some of your investment. This is called systematic or market risk. The total stock market has had many downturns throughout history. Examples include: The Wall Street Crash of 1929 leading to the Great Depression, and Black Monday in 1987. More recently, there was the dot-com bubble in 2000 and the financial crisis in 2008. If you were invested in stocks during any of these times, it would not have been pretty. However:
Stocks Will Always Go Up Over Time
The important thing to consider is what happened after these downturns. In each and every one of them, the stock market has come back and eventually set new highs. It may have taken a few years but if you stayed invested over the long run, you would not have lost.
Total market returns starting as far back as 1928 were not easily available to me, so I researched some historical returns (with dividends reinvested) of the S&P 500 as a proxy. The S&P 500 is an index of the 500 largest US stocks. It’s holdings make up a majority of the holdings of VTSAX. Also included in VTSAX are the smaller companies not included in the 500. The data I used is from NYU professor Aswath Damodaran and can be found here. Using this data, I analyzed the historical return of investing $100 in the S&P 500 starting on January first of every year beginning with 1927 and continuing for 10 and 20 full years after.
S&P 500 – 10 Year Returns
Let’s say you invested $100 in the S&P 500 on January 1st of any year between 1928 and 2007 and left it in the market for 10 years while reinvesting all dividends. Within this timeframe, there are 80 separate 10 year periods to analyze. In 75 of them, the $100 would have grown! In only 5 of those periods would your investment been worth less than your starting amount. The worst result was the period between 1/1/1929 and 12/31/1938 when your $100 investment would have shrunk to $84.51 losing 15% of your initial investment. That’s not so bad for the worst case scenario. On the high end, a $100 invested in the S&P 500 on 1/1/1949 would have grown to $624.84 by 12/31/1958, a compound annual growth rate (CAGR) of 20.11%. The average result of the 80 scenarios would have grown your $100 to $296.03, a CAGR of 11.46%.
S&P 500 – 20 Year Returns
Alright, so I hear you saying, how can the stock market always go up if your $100 loses money in 5 out of the 80 ten year periods? Now, we will take a look at the 20 year periods. Let’s say you invested $100 in the S&P 500 on January 1st of any year between 1928 and 1997 and left it in the market for 20 years while reinvesting all dividends. Within this range, there are 70 separate 20 year periods to analyze. In ALL OF THEM, the $100 would have grown. The worst result still starts on 1/1/1929 and ends on 12/31/1948 when your $100 investment would have grown to $159.79, a CAGR of 2.37%. See, I told you, the stock market only grows over time. In the best scenario a $100 invested in the S&P 500 on 1/1/1980 would have grown to $2,601.05 by 12/31/1999, a CAGR of 17.69%. The average result of the 70 scenarios would have grown your $100 to $952.08 representing a CAGR of 11.93%.
The Stock Market Goes Up, So What?
Does knowing the historical stock market trend change your thoughts on stock investing? Personally, I have two take-aways from all this:
- If there is a long time before I plan to spend my savings, the stock market has historically produced greater than 11% annual returns over 10 and 20 year periods, while having a very low chance of a loss.
- When I consider spending $100 today, I consider my opportunity cost of investing it in the stock market which has historically grown a $100 to $296.03 in 10 years or $952.08 in 20 years on average.
Think about your natural tendencies. Are you risk averse? Consider how your money is invested. Do you have too much money (that you don’t need in the short term) kept in “safer” investments such as cash or bonds instead of stocks due to fear of loss? Are you avoiding risk and therefore costing yourself expected value in the long run? How much longer will it take you to accomplish your financial goals because you fear losing?