Are stocks safe to invest in? All the disclaimers that you see at the bottom of stockbroker web pages sure makes it sound like they’re not. But the alternatives aren’t necessarily completely safe either. Here’s how to understand how stocks work, and whether you should put your money in them, or elsewhere.
Fear of stocks generally comes from not understanding what they are or how they work. There are ways to make them safe, and with reasonable precautions, their higher yield makes them safer in some ways than traditional “safe” investments.
How I lost a fortune in the stock market
During the dotcom boom, I put all of my savings into stocks. I had a hotshot stockbroker one of my dad’s friends had introduced me to. He normally didn’t deal with the likes of me, but since I had rich friends, he was willing to do me a favor.
He doubled my money in about two years. It was ridiculous. But it took him about two years to lose all of those gains. He called one day and asked for permission to put the money in a safer place. I said yes. I should have asked what he meant by a safer place. He sold all the stock and bought a life insurance policy with the money. And I couldn’t touch it until age 59 1/2 without significant penalty.
Let me interject something here. I didn’t lose money because stocks aren’t safe to invest in. I lost money because my stockbroker was doing it wrong. He was taking unnecessary risks.
When safe investments aren’t safe
The state of Missouri took his license away and he had to sell his practice. When the guy who bought his practice got around to me, he saw my money was significantly underperforming. So he pitched me an idea. He had something safe that would do better. He encouraged me to pay the penalty and try it.
I met him halfway, literally. I withdrew half the money and used it to make a down payment on a rental property. And I let him try out his scheme on the other half. His scheme makes me about 3 percent a year and I can’t touch the money until I’m 59 1/2. I can’t lose money, but the returns he’s getting me project to fund one year of retirement. One. Year.
When your earnings barely outpace inflation, it doesn’t matter that you can’t lose money. To get better returns than that, you have to be willing to accept some risk.
I probably should call him up and ask what the penalty is to get out, while I still have time. That rental property did just fine, at least.
How stocks work
Stock is partial ownership in a company. That’s all. And every paycheck, I buy some stock with a percentage of my earnings. Every paycheck. So, 26 times a year, in my case. You’ll see why soon.
People make money off stock two different ways. If a company does well, its stock gets more valuable. When you spend $100 on a share of stock, it’s with the hope that in a year, that same share of stock will be worth $110. It doesn’t always work out that way but on average, that’s not an unrealistic expectation.
The other way you make money is through dividends. Most large companies pay out a portion of their earnings to their shareholders. If you spend $100 on stock in a large company, you can expect to get about $2 in dividends per year. If you got $2 in cash, you’re willing to live with a slightly lower increase in the share price. That’s one reason large, old, established companies pay dividends. Always reinvest your dividends, by way.
Historically, stocks tend to give about a 10 percent return on investment, on average. That means that your money in the stock market will double about every seven years. When you’re saving for retirement, you’ll be holding that money for decades, so that gives you plenty of time to hit that 10 percent average, or slightly outperform it. If you’re 35 and you invest $20,000 in stocks, you can reasonably expect that investment to be worth $320,000 when you reach your mid-60s. That compares to $48,000 result I expect to get from that “safe” investment scheme.
What about when the stock market crashes?
The stock market has crashed twice in my lifetime. It crashed once on September 29, 2008. It also crashed on October 22, 1987.
There’s something important to remember about crashes. Crashes do not mean your stock lost all value. A crash only means that the most significant stocks lost a large amount of value that day. Large usually means 20-25 percent.
The market always recovers from crashes. The 1987 crash didn’t lead to a recession. We did have a recession after the 2008 crash.
But here’s something important to know. Prior to the 2008 crash, the stock market was already in decline. It had reached its maximum value almost a year before, in October 2007. What would have happened if you had invested $10,000 in the S&P 500 at the very worst possible time, in October 2007?
You didn’t lose all your money.
In October 2017, ten years later, that investment would have been worth $19,530.42. So investing in stocks at the worst possible time in our lifetimes still would have yielded an annual return of almost seven percent.
Tell that to the next person who tries to tell you stocks aren’t safe. And you can check my work with the S&P 500 Periodic Investment Calculator.
The only way you would have lost all your money in the 2008 crash
It would have been possible to lose all your money in the 2008 crash, but it’s fairly unlikely. The way you lose all your money is when a company goes out of business, or reorganizes in bankruptcy in a way that wipes out current shareholders. Some examples of companies who did something like that in the wake of the 2008 crash include Countrywide Financial, Bear Stearns, and General Motors.
The way you avoid that nightmare scenario is by investing in larger numbers of companies. Lots more. In 1929 there was no easy way to do that, but today there are.
How to make stocks more safe
There are things you can do to make stocks more safe, and I recommend you do so. It’s actually easier than investing in individual stocks, which is the thing that’s most likely to get you in trouble.
The first trick is to diversify. You don’t have to invest in individual stocks, and the majority of people are better off not doing so. A better choice for most people are mutual funds, which are collections of stocks. The fund does whatever the stocks do as a collective. You can buy mutual funds called index funds, which is just the stocks that make up certain indexes that investors and economists use to track the market. These are the most economical way to invest in broad collections of stocks.
A good mix is to dump 30% of your money into a fund that tracks the S&P 500. Dump 20% into a fund that tracks the Wilshire 4500, which is every publicly traded company in the United States that isn’t big enough to make the S&P 500. Put another 20% in an index fund that tracks international stocks. Put another 20% in an aggressive growth fund, something along the lines of American Century Ultra. Then put 10% in a bond mutual fund–not stocks. Every decade that you age, increase your bond holdings by 10%, holding the relative percentage of the others constant.
Then maintain that balance over time. This forces you to periodically buy low and sell high, to help avoid that nightmare scenario of buying high on the worst possible day of 2007. Not every category will have a bad day or even a bad year at the same time. That helps you to buffer against losses and recover more quickly.
Investing in index funds that cover the whole market protects you from the risk of any single stock. If, say, Ford Motor Company is doing badly, some other company is doing well. If you own that one too, you don’t have to care.
Invest regularly, at regular intervals
The way you avoid the nightmare scenario I described above is by not investing all your money at a single time. What would have happened if you bought a year later, in October 2008, after the market had crashed, and held the money for nine years? Your $10,000 investment would have tripled in value–in just nine years. Once again, feel free to check my work with the S&P 500 Periodic Investment Calculator.
That’s why your employer wants you to contribute to your 401(K) every paycheck. Some weeks the market will be up and some weeks it will be down. The 401(K) contribution you hypothetically made in October 2008 more than makes up for the brutal one you made in October 2007. This phenomenon is called dollar cost averaging.
It’s vital that you continue making your 401(K) contributions during a recession, when one happens. During the recession, your balance won’t increase much and may even decrease, but once the recession bottoms out, you make a lot in the recovery. I wasn’t eligible for a 401(K) plan in 2008, but I contributed as much as I could in 2009 and 2010. That made up for every bad investment decision I’ve ever made.
What’s a safe way to handle company stock options?
You may reach a point in your career where you work for a company that gives you stock options. I worked for one such company for about two years.
It’s very tempting to buy the stock at the substantial discount the company offers you, especially if the company is doing well. The problem with that is you can never make an objective decision about how well the company is doing while you work for them. When I worked for Airbus, I couldn’t go to the bathroom without overhearing some conversation about how much better they were than Boeing. When I worked for Qualys, all I heard was how much better they were than Tenable. But I know people who work at those other companies, and they’re hearing the same thing in reverse.
More often than not, you don’t want to tie your financial fate to that of your employer. You’re much better off selling the stock, then reinvesting the proceeds in a diversified fashion, like I described above.
Why stocks may be the safest long-term investment
In spite of the risk, and the horror stories we saw in our high school history books of people losing all their money in the stock market in 1929, stocks may be the safest long-term investment, as long as you use them right.
To understand why, think of why we invest in the first place: to save for a rainy day. We all want to retire someday, and we don’t want to spend our golden years working part-time in a big-box store to make ends meet.
To make the math easy, assume you’ll need $100,000 a year in retirement. Depending on where you live, you may need a little more than that or a lot less, but that’s probably going to be enough to live comfortably. A $20,000 investment at age 35 with average returns in the stock market will be worth $320,000 at retirement. That will fund three years.
Historically, bonds, which are considered the safest investment, yield 2-3 percent. At that rate, that same investment is worth about $48,000 at retirement. The retirement math doesn’t work at those kinds of yields.
The only way to make the math work is to invest in stocks when you’re young, build up a large 401(K) balance, and shift more into bonds gradually as you age. You’ll experience some ups and downs along the way, but you need those ups to get a big enough balance for a 3% annual return to support you in retirement.