Do You Need Stocks?
With the discussion up to now, you may have seen no compelling reason why you should invest in stocks rather than simply putting your money somewhere safe, such as a high interest savings account. Certainly, with a savings account you don’t have to pour over different companies’ accounts to try and figure which ones will perform best. There is an element of risk in investing in the stock market, but good luck finding a high interest savings account nowadays! Overall, most people should put at least some of their savings into the stock market. If you only use secure and safe investments, then you’re likely to miss out on the best returns.
In fact shares have returned about 7% annually over the past 50 years on average. This is taken as a whole, covering the different market sectors and sizes of companies. Obviously, sometimes different sectors lead in gains. Going back to the dot-com boom at the turn-of-the-century, Internet related companies’ shares were zooming up in value. They obviously gained more than 7% per year during the good times, and equally obviously crashed to virtually nothing just a couple of years later, with few exceptions. The 7% return applies to a portfolio that is diversified across the market.
If you are considering the stock market as a place to put a proportion of your savings, you need to be thinking in terms of being able to leave it there for at least 5 to 7 years, so that if the prices fall they have a chance to rebound. Just as many people advise investing in stocks of different types of companies, or diversifying your shareholding, you should also diversify outside of the stock market, with other investments such as real estate, gold, etc. Putting all your money in the market is not wise when there is the slight chance of a crash such as the global economic crisis of 2007/2008.
So one reason that you should include stocks in your investment portfolio is that they are capable of giving you the best return on your money, provided you know what you’re doing when you select them, and know how to keep an eye on them to guard against any surprises. Obviously an average return of 7% per year has been more than enough to stay ahead of inflation, and if you had done better than average by careful stock selection you would be even more ahead.
Taking the idea of the riskiness of share investment a little further, unless you are a gambler you probably want to stick with the larger companies. Some people try to peddle the idea of “penny stocks” as a way to make a fortune, but this is highly risky and not a good way to invest your life savings. The small stocks may have a place for the trader who is evaluating risk versus return and keeping an active eye on his account, but they are really not for the longer-term investor.
Small, untested and growing firms have great potential for profits, but historically also have a high risk of failure. It is easy to find the success stories, where a few thousand pounds a few years ago would have become millions today, but that is because the multitude of failures have disappeared from public view. You should not be fooled by the hype which many of these stocks receive, particularly where the enthusiastic mailing points out how other similar companies have done in the past. With the luxury of hindsight, anyone can find remarkable success stories for penny stocks.
On the other hand, you must always be careful where you invest, even if you avoid small cap stocks. Simply investing in large companies is not guaranteed to work, as there always exceptions such as Marconi, a one-time FTSE 100 company that was worth £35 billion that collapsed after misjudging the technological markets.
It’s worth mentioning here that if you don’t want to decide on individual stocks, you can take a different course for your investment. Many financial companies are set up to put the investor’s money into a pool, which is then invested in bulk by “experts”. The most common form of this is called the mutual fund, though anything called a fund has a similar idea. You can also see exchange traded funds (ETF’s), hedge funds, funds of funds, etc.
I will talk further about funds later. I guess they work for some people, particularly the lazy ones, but there are drawbacks and I don’t think they are the best choice.