Of Stocks and Risks

Finally! After years and years of searching for the magic pill (read: simplified explanation in stock market investing), I read this entry of a well-known money blog post I just can help but quote it down...Alternatively, you can read this same entry at the link below. Read on with GUSTO!

http://www.mymoneyblog.com/archives/2006/12/a-better-way-to-view-stock-market-risk.html#more-1106

"The prospect of losing your hard-earned money is scary. You know that if you invest with $1000 in stocks, in a year you could be left with either a huge gain or a huge loss. People (including me in the past) tend to look at the stock market like a slot machine:

This is good in that, yes, for the short-term the stock market is risky. Don’t put money you may need right away into stocks. However, when young people tell me that they are putting their Roth IRAs in a bank CD because they are afraid of the stock market, that is bad. Roth IRAs are long-term investments. We’re talking 30, 40, 60 years for some people! The way you should be looking at the stock market is this:

As you can see, as your time-horizon lengthens, your risk of losing money decreases significantly. When looking back and taking any 25-year period between 1950 and 1994, the worse case still gave you a 7.9% annualized return. Note that the average for all of these time periods is still the same, 10% per year. So what you’re really looking at is something more like:

Although we may not get that same 10% average in the future, I think it’s clear that you need to make your horizon as long as possible by starting now. Remember, most of you are not going to touch your Roth IRA for decades, so it doesn’t matter what happens next year. What matters is that you were “in the game” for that year, extending your time period in the market, rocky or not. Also, this is just stocks - We are not even taking into the account the additional tempering effect of incorporating bonds to your portfolio.

Finally, consider this. Right now, bank CDs paying 6% in some cases may seem nice. But after inflation, the long-term return of cash-equivalents like bank accounts or Treasury Bills is… zero. By not investing in stocks (again, for long periods), you are giving yourself a 100% chance of making nothing. IRAs, 401ks, 403bs, TSPs, they are all for the long-run.

Get in the game!

* The graph is adapted from one in A Random Walk Down Wall Street by Malkiel, one of my recommended investing books. Common stocks are defined as a diversified stock portfolio, such as the S&P 500 Index.