When saving for your goals, investing in the stock market is just one of your options. But it’s a confusing and sometimes scary option, so you might wonder if it even makes sense to invest in stocks.
Should you Invest in Stocks? Why?
As with any financial topic, the only responsible way to answer the question is that it depends. There are a few “easy” situations, such as:
- If you’re young and strictly talking about saving for a retirement that will come in over 40 years, you should probably invest in the markets (assuming you’re comfortable with the risk – see below)
- If you’re building up a down payment that you expect to use in two years, stocks probably aren’t the best place for your money – a savings account (and maybe a few CDs) is more appropriate
Beyond that, again, it depends on your goals. So when does it make the most sense to use stocks as opposed to much safer investments?
Going for Growth
The main reason to invest in stocks is that you believe your money will grow faster (compared to other investments) in the stock markets. When you look at all of the options available for your money, stocks are on the higher end of the risk/reward spectrum: they historically have been riskier investments with relatively higher long-term returns.
For a chart showing historical growth, see the classic Stocks, Bonds, Bills, and Inflation.
Building assets: why does growth matter? When you’re growing assets, there are several factors that determine how much money you’ll have in the future:
- The amount of money you put in
- How much growth you get from your investments (including losses you might suffer)
- The length of time you earn those returns
If you need one million dollars in 20 years, there are several ways to reach that goal. The simplest way (and the most difficult) is to actually put away one million of your own dollars without any growth. In other words, your deposits over time add up to one million – no interest earnings, no dividends, and no capital gains. For example, you’d save $50,000 per year for 20 years (assuming a 0% return), which adds up to the one million needed.
Another way to build up your savings, which is more realistic for most of us, is to get some help from your investments. Your earnings will add to your account – and you still need to add money too – so that you don’t have to do all of the work. For example, to build up one million dollars in 20 years:
- At 4% growth, you’d need to save about $35,000 per year
- At 8% growth, you’d need to save about $21,000 per year
As you can see, the higher your returns, the less you need to contribute to your account. That’s why you might invest in stocks. To play with the numbers yourself, try this calculator.
So how much might you earn in the stock market? There’s no way to predict, and choosing a number is tricky: if you choose too high, you’ll fall short of your goals. If you choose too low, you’ll save more than you need to and fund your goal early (which is better than the alternative). In the past, financial commentators used to talk about 10% average annual returns for an extremely aggressive investor. Going forward, experts suggest slower growth, so it would be prudent to use a number lower than that. Of course, taxes and fees also reduce the amount you get to keep.
Past performance: there are no guarantees in life, and that certainly applies to investing. Although stocks have historically delivered higher long-term returns than safer assets, it might not be that way going forward. Or, it might not work out that way during the timespan that’s important to you (when you decide to withdraw the money and spend it, for example).
Time horizon: it’s important to stress the phrase “long-term” in this discussion. Over the short-term, the stock market is extremely risky: you might earn a lot, you might lose a lot, or you might end up in more or less the same place – there’s no way to know. For details, see Section 6, Part 2. How short is short-term? There’s no set definition, but many say that you’d want to stay invested for a minimum of seven to ten years. Others would argue you could go shorter, but the shorter you go, the more risk you’re taking.
Inflation: one of the main reasons to invest in stocks is the goal of outpacing inflation. Things get more expensive over time, so a dollar that you save today probably won’t buy as much in 20 years. However, over the long term, stock have historically moved faster than inflation, so your dollar in the stock market might (hopefully) buy even more in 20 years than it does today.
Risk: don’t forget that stocks are high on the risk/reward spectrum. They have tended to deliver higher rewards, but that comes at a price – you have to put up with the risk. What’s the risk? You might lose money (the value of your investments could drop quickly). Those losses might be temporary, but they might be unbearable for you emotionally, or they might come at a bad time – when you need to sell and use the money. To manage the risk, it’s best to invest for the long-term and diversify your investments. Once you get close to needing the money, evaluate whether or not you should take some risk off the table. Scroll down for more discussion on losses.
All or none? Investing in stocks isn’t a black-or-white thing. Any good investor will use a blend of investments, typically including bonds (and other investments) as diversifiers. You don’t need to invest 100% in stocks, although you can if you want to. Whatever you do, it’s often prudent to diversify among different stocks (and different types of stocks). Again, we’re talking risk/reward: you might win big if you just buy one or two stocks, but it could work against you.
Individual stocks vs. stocks in general. When you choose investments, you can put your money in individual stocks that you select, or you can invest in numerous stocks – without really caring which particular stocks are included. Picking individual stocks is a pain, requires research, often means with more risk, and can sometimes come with high transaction costs. A better alternative might be to invest in mutual funds or ETFs that spread your money among numerous different stocks. You’re still investing in “stocks” with the hope of getting stock-like returns.
Do you Need to Take Risks?
Knowing your needs is an important part of saving and investing. You don’t need to invest in the stock market if you’ve got plenty of money already – why take the risk? However, if you want or need the potential for growth, that’s when you’d consider stocks.
Do some rough calculations to figure out whether or not it makes sense to invest in the markets. What do you need the money for, and when will you need it? How much will you need, and how willing are you to adjust in case things don’t work out well for you? For some ideas and examples, see How to Plan for Retirement (other goals, such education funding or buying a house, use more or less the same process).
The most important thing is to do some planning. It doesn’t need to be 100% accurate – it won’t be because you can’t predict the future. But knowing where you’re headed will certainly help you get there.
What About Losses?
If you’re going to invest in stocks, bonds, or other non-cash investments, you need to be comfortable with losses. There will come a time when you lose money – at least temporarily. Your account balance will drop, and it will not feel good. Hopefully you’ve set up your investments at a risk level that is appropriate for you.
When things go bad, don’t keep checking your account balance. The media will make you think that you need to do something right now. Maybe that’s accurate, but it’s usually not (again, assuming you’re a long-term investor with a decent mix of investments). You’ll want to train yourself to think long-term and say “this too shall pass.” There have been countless days of losses in the stock market, and no shortage of very scary crashes. Yet the markets have (so far) recovered over time.
When you Shouldn’t Invest in Stocks
It might also help to discuss situations in which the stock market is probably not the best place for your money. Note that it’s impossible to know the ins-and-outs of every situation – so you need to use your own judgment and consult with professionals who know the details of your life and the world you live in. There will be exceptions to every rule, and your situation might or might not be that exception. Plus, markets are unpredictable and you could always get lucky (or not).
In the late 1990’s, when the markets didn’t do anything except go up, people with no investing experience took out student loans and invested in the markets, getting excellent returns. It happens occasionally. But the markets are risky, and you can just as easily lose money.
Here are some times when you might not want to invest in stocks:
- You plan to use the money within a few years and you aren’t willing (or able) to lose any of that money
- An FDIC-insured bank account might be a better option
- You know that you’ll react badly if there are losses in your account, and you’ll sell when the markets are down (locking in your losses and eliminating the possibility of recovering)
- Can you train yourself to only look at your accounts at regular intervals, or can you have somebody else handle the investment decisions for you?
Of course, when you pass on the stocks, you’re taking other types of risks – those risks just aren’t in your face as much as stock market volatility that gets reported in the news every day. Especially if you’re investing for long-term goals, you’re taking the risk that inflation will eat away at the money you save, and that’ll make it more difficult to reach your goals.