Stocks

Expected Annual Return (Over 15+ Years)

9.0% - 10.0%**

**6.0%-7.0% after adjusting for inflation¹

Summary

• Stocks can be a good investment to make a bigger return than other investment options like CDs or bonds if you are investing for 15+ years.
• Investing in individual companies is usually a bad idea. It's too risky, and could be compared to gambling with your money.
• Investing only in low-fee, passive index funds is one of the (relatively) safest ways to invest in the stock market, and the simplest too!
• Do not try to "time the market" by buying or selling when you think it is "low" or "high!" You'll be better off investing whatever amount you intend as soon as you have the money available.

What is a Stock?

A stock is a small piece of a company. When you own a stock, you actually own a little bit of that company itself. Companies offer shares of stock in order to generate money they can use to grow the business.

For example, let's say you own a cupcake bakery. Your bakery has been wildly successful, and you're confident that you can replicate the experience in the next town over with a second location, but you don't have the money yet to lease the building and buy the new ovens. So, you offer stock in your bakery to investors. They all purchase "shares" which means you have a pile of cash in your bank account and can open a new location! You can choose to pay out some of your new, higher profits to the shareholders (AKA a "dividend") or you can keep reinvesting the profits into new types of cupcakes, more locations, or advertising to aquire more customers. Your shareholders may be perfectly happy to see you reinvest profits and grow the business even more. This means the company becomes even more valuable, and someday if you do pay dividends they will be bigger, or if your company is purchased by another company, the buyer will have to pay more for that stock the investors hold. If your cupcake business is strong, the stock is also worth more simply because others may want to buy that share of stock on the stock market, because they believe it will continue to grow!

You can buy stocks in all kinds of famous companies, such as Apple (AAPL) or Nike (NKE). If you buy a share of these companies, you own a tiny bit of them. You can then sell the stock to someone else later, and if the price is higher than you paid, you'll make a profit! If it's lower, you'll lose money.

Higher Risk, Higher Reward

By investing in a stock, you're expressing confidence that the company will be successful and grow more valuable. That might happen! Some companies do really well. If you invested $1,000 in Amazon in 2010, you would have over $24,000 today!

But this is far from guaranteed. If the company makes some big mistakes, or if something they can't control happens that hurts its business, the stock value could drop significantly. In the worst case, it could even lose everything. If you invested the same $1,000 in GE in 2010, you would have just $621 today.

However, for taking on this risk, you have the potential, on average, to earn a lot more than holding cash, short term investment products, or bonds.

How to Invest in Stocks

Buy Individual Stocks Directly

You can buy stock of any publicly traded company online using one of many available financial institutions called "brokerages." You could open an account with Fidelity, Schwab, TD Ameritrade, the popular trading app Robinhood, or many others.

For example, if you want to buy a share of Apple, Inc. (technology company of Mac, iPhone, iPad fame), you can type in it's symbol (AAPL) and pay today's price ($106.84 at time of writing) to get one share! Voila!

But how do you know what companies to invest in? Do you know which companies are going to do well in the future, and which ones will do poorly so you can avoid them? In fact, if you actually have true material knowledge about why a company might do well or poorly and you act on it, that's called insider trading, and it's illegal. So, unless you're breaking the law, you really won't know much about how well a company will do at all!

Even beyond specific choices companies can make, what if something big happens that nobody predicted that affects the ones you invested in?

Consider the COVID-19 pandemic that spread rapidly starting in early March 2020 in the United States.

If you invested in American Airlines, you would have suddenly seen the value of your stock plummet when this situation started, as it became clear that many people will not want to travel by airplane.

But look at Zoom Communications, makers of the Zoom videoconferencing software that gained extraordinary popularity after the world needed to slow down or halt in person gatherings due to threat of disease. The stock price increased enormously!

Could you have seen this coming and invested in videoconferencing companies instead of transportation? I know I would not have.

So don't even try.

Picking individual stocks can be a lot like gambling. You just don't know how they will do, and the risk you will lose money is high. There is a better way (discussed below), to achieve more predictable returns, as long as you invest over a long period of time.

Invest in Stock Mutual Funds or ETFs

What if, instead of investing in just Zoom or just American Airlines, you invested in both, so that when COVID-19 hit, the gains from Zoom would make up for the losses in American Airlines? You could, but we wouldn't know in advance that those two companies would offset each other.

So let's think bigger. If we could invest in a sampling of all companies on the stock market, we can make sure to get some of the good as well as some of the bad in every situation. This will help insulate us from volatile sitations in the market so our money will be more likely to gain value. This is called diversification. Mutual funds and ETFs are goods way to accomplish this.

Mutual Funds

Mutual funds are like a basket full of stocks that you invest in, instead of just one by one. These are offered by many financial institutions and usually have the following qualities:

• They have a theme - A fund will usually invest in something specific, such as large US companies, small US companies, European companies, healthcare companies, technology companies, or something else!
• They charge for their services - These funds usually charge for setting up and managing these funds. This will be shown as the "expense ratio" of a fund, and can vary greatly (more on that below). In many cases, these fees can be worth paying for the diversification they provide.

For one example, check out Vanguard Total Stock Market Index Fund.

It is made up of 3,525 stocks! These are not held evenly, they keep more value of some larger companies. The top 10 as of 8/31/20 are:

1. Apple Inc.
2. Microsoft Corp.
3. Amazon.com Inc.
4. Alphabet Inc.
5. Facebook Inc.
6. Berkshire Hathaway Inc.
7. Johnson & Johnson
8. Tesla Inc.
9. Visa Inc.
10. Procter & Gamble Co.

As you can see, investing in a fund like this is going to help insulate you from the risk of any one company doing poorly. Yet, you can absolutely lose money if the whole category of the fund goes down, which happens frequently. But in the long term, historically many funds have gained significant value (more below).

ETFs (Exchange Traded Funds)

ETFs are a lot like mutual funds, but instead of just investing a dollar amount and adding it to the fund, you have to buy a specific amount of shares as though it were a stock. This is because they trade on the same exchange as stocks (hence the name).

ETFs can be a good option to achieve the same diversification that you can in mutual funds, and sometimes with different options than you have with only mutual funds.

Many of the lowest cost mutual funds, such as VTSAX, linked above, have minimum investment requirements. VTSAX requires you to invest $3,000 minimum. If you don't have that available, you could buy shares of the ETF version, (VTI), for a minimum of $169.09 at time of writing for a single share.

ETFs could come with more fees from the brokerage for making trades, and if you plan to contribute often, you might do better to invest in mutual funds when you can afford the minimum investments! This article from Investopedia is a great resource about the differences between ETFs and Mutual Funds.

Passive vs Active Management and Index Funds

Even within the category of mutual funds and ETFs, strategies that financial institutions take to get the best returns can vary wildly.

The most common distinction is active management vs passive management.

Actively Managed Funds

Actively managed funds are just that, being actively managed by a team of people who are paid to research the market and move the money around to different stocks to try to pick the best ones and get the biggest return that they can. If you're picturing well dressed people in a high rise on Wall St. in New York, well, you're probably right in a lot of cases.

In some cases, these funds do manage to succeed to get even better returns than the overall stock market. But to pay for all this work to manage the money, and the fees they incur doing it, the expense ratio -- what you pay for the privilege of investing -- will be significantly higher.

Yet, if you agree that you probably can't pick the best stocks and that trying to do so is akin to gambling, do you think these people managing funds actively will be able to do better than the overall stock market's performance? It turns out that no, in general, they do not.² In most cases, the overall stock market outperforms actively managed funds, even though they cost more!

These funds can be useful for investors with a large amount of money to invest that are willing to take on more risk, and pay higher fees to try to grow their money even more. But for the average investor, why take on the additional risk for a higher cost?

There's a better option!

Index Funds

A stock index is a list of specific stocks compiled to keep track of the performance of that group over time. Creators of an index decide ahead of time what the rules will be that determine which stocks will be in the list. For example, an index could be expressed as "the top 500 largest companies in the United States" (S&P 500 Index), and it will be very clear at all times which companies should be in the top 500 or out -- you just look at their market capitalization to find out how "large" they are and compare them to everyone else. Another example might be the NASDAQ Biotechnology Index. This index tracks US companies that meet some criteria to show they are large enough, and that they are categorized as being part of the biotechnology industry or the pharmaceutical industry.

An index fund is a mutual fund or ETF that follows the same rules as a stock index. So when the index goes up, so does the fund. And when it goes down, the fund does too. What is so useful about index funds is that they are much cheaper to manage. You don't have to pay a team of people to research all day to decide which stocks to buy or sell in the fund; you just follow the rules of the index. The criteria for what should be included in the index is simple enough that you don't need to make as many trades either, which also saves money. The result is that most index funds will have lower expense ratios, which will mean that you make more money over time from your investment in these funds!

As discussed above, actively managed funds don't usually seem to outperform the stock market as a whole, and they cost more, which eats away at your investment returns. This is why we only recommend investing in index funds to make a higher return on average.

Invest For the Long Term

Even if you invest in index funds that are well diversified and have low fees, these funds can fluctuate wildly in the span of a week, a month, or even a few years. Between 1995 and 2000, the dotcom bubble was expanding and stock market value rose immensely, only to crash between 2000 and 2002 when the "bubble burst." In 2008, the great recession caused largely by the subprime mortgage crisis resulted in a collapse of stock market value that took several years to recover from. In March 2020, amid growing fears about the worsening COVID-19 pandemic, stock prices globally dropped as much as 30%, only to recover completely in the US by May, two months later³. However, these are just the extremes. There are smaller drops and gains nearly each and every day.

How can the stock market, even a diversified index fund, possibly be a good investment if the price swings so unpredictably? Because if you are able to wait long enough, historically, it always has recovered from each downturn and continued to grow.

Holding Longer is Better

If we look back at the time period from 1973-2016, we can actually test what would have happened if you had invested in the S&P 500 (a list of the 500 largest US companies, and a common index to invest in) for different lengths of time.⁴

** Approximate because my source⁴ does not report the exact values, only charts

Looking at these extremes is interesting because these are the best and worst possible outcomes, if you had invested for every time period of that length from 1973-2016. You can see that investing for 1 year could be amazing (60%) or a total disaster for you (-42%). Investing even 10 years is much better, but there's still a 10 year period where you would have lost money at the end (an average of -3% per year). But after 15 years, there was not a single 15 year period of time where you would have lost money! In the worst case, you would have gained approximately 4% per year. At 20 years, the worst case was +8% per year!

Where Does the 9%-10% Annual Return Figure Come From?

Looking historically at the S&P 500**, back as far as 1871 where we have data, we can actually just calculate that the average annual return is about 10%, or 7%, adjusted for inflation.⁵. You can try it for yourself here. Warren Buffet is even quoted as having arrived at this same 6%-7% figure (after adjusting for inflation) as a long term average for annual returns of the overall market.⁶ While, this is the average of the entire run of the stock market, in almost any 30 year period of time, returns are similar to this 9%-10% range. If you invest for a long period of time and keep your money invested, we have strong reason to believe these returns may continue to happen.

**Before 1957, the index tracked fewer than 500 companies, but can still be considered a strong proxy for the overall US stock market's performance.

🚨IMPORTANT!!🚨 -- This absolutely does not mean 10% average annual returns are GUARANTEED in the future if you invest at least 15 years. However, it is a bet that I, and many people feel comfortable taking, given that it has always worked out historically in the past so far. We don't know what will happen in the future, but we can hope that what has happened before will happen again, and feel confident there is a better chance than not that it will.

Don't Try to Time the Market; Invest Early and Often

So, if you are convinced that investing in diversified index funds for at least 15 years is a good idea to get a relatively safe return, and the price in any given day, month or year is fluctuating wildly, when do you invest in the stock market?

If you buy when the price is high, and the next day the value sinks lower, you'll have lost a bunch of value right away. Yet, if you buy when the price is low, and the next day the price rises, you could make significant gains immediately. Surely, this is worth considering, right? But what if you wait too long for the price to fall and suddenly it goes even higher due to some unforseen event? Or the price falls, so you buy in, only for it to fall even lower the next week!

Just like above, we can actually just look back at historical data and replay every possible scenario to find out! Schwab performed this fascinating study where they invented fictional people with $2,000 a year to invest over the 20 years from 1992-2012. They pitted someone with impossibly perfect timing who bought at the very bottom of every year (Peter Pefect) with someone with terrible luck who bought at the very top of every year (Rosie Rotten) and someone who simply invested the $2,000 as soon as she could, without question, each year (Ashley Action).

What they found out might surprise you:

1. Having perfect timing did win, but not by much - Peter Perfect did the impossible, and he beat out Ashley and Rosie.
2. Investing ASAP each year came in a close second place! - Ashley Action's strategy was simple, and she ended up with nearly as much money as Peter Perfect. Since, unless you have a crystal ball to see the future, you will never be able to have perfect timing, this is who we should try to emulate!
3. Even having the worst timing in the world wasn't so bad - Despite investing at the worst possible time every year, something extremely unlikely to happen by chance, Rosie Rotten still ended up with way more money than if she just invested in cash investments. So, you can feel assured, that even having the worst possible timing wasn't the end of the world, and you will almost surely do better than that, just by chance.

This has also been replicated in numerous other studies in other time periods.⁷ The evidence seems clear, that "timing the market" just doesn't pay off. Trying to do so will actually make you less money. When you have extra money to invest, just invest it all right away and move on with your life!

How Much You Could Make in Returns?

Let's test out what it might look like to invest in three different index funds! Keep in mind we will use the average annual return since the fund existed. You won't have gotten exactly this return by investing in just any time period, and you won't in the future. Invest long term and we hope (with high confidence!) the return will be somewhat similar in the future.

1. Vanguard Total Stock Market Index Fund (VTSAX) - 7.41% (since 11/13/2000)
2. Vanguard Small-Cap Index Fund (VSMAX) - 8.68% (since 11/13/2000)
3. Vanguard Total International Stock Index Fund (VTIAX) - 4.53% (since 11/29/2010)

Plug in a set number of years and a dollar amount to see how much you would earn over time.

Why Invest in the Stock Market?

• You have money to invest and not touch for at minimum 5 years, ideally 10 or 15 or more, such as in a retirement account.
• You want to make a better return than CDs or bonds, and to outpace inflation (average of 2% annually alone). If you don't try to get a better return, your money may even lose value over time.

Why Not to Invest in the Stock Market?

• You need the money for something like a down payment on a house, or a car purchase, or other expenses in the next 5 years.

References

1. What Stock Market Return Should You Expect In The Future?. Wall Street Physician. Accessed 9/23/20.
2. SPIVA U.S. Year End 2019 Report. S&P Dow Jones Indices. Accessed 9/20/20.
3. 2020 Stock Market Crash. Wikipedia. Accessed 9/20/20.
4. The Best And Worst Rolling Index Returns 1973-2016. The Balance. Accessed 9/20/20.
5. What’s REALLY the average stock market return? (And what return should you plan for?) Mr. Money Wizard. Accessed 9/20/20.
6. Buffett: Expect 6%-7% Returns From the Market. TheStreet. Accessed 9/20/20.
7. Dollar Cost Averaging Just Means Taking Risk Later. Vanguard. Accessed 9/21/20.

• © 2020 Explore Personal Finance
• About
• Contact
• Disclaimer