Playing the Stock Market

One of the great American dreams is to get rich quick, and many people try to do that on Wall Street. Between 1982 and 1997, the Dow Jones Industrial Average has gone from below 800 to over 8000. This represents a compounded annual return of over 14 percent -- very good, but certainly not the get-rich scheme the media would have us believe. And you would have had to have guessed the exact times of the market peaks and bottoms to earn that return -- something almost no one can do. In fact, had you bought a five-year or longer certificate of deposit at your local bank in 1982, you also would have earned solid double-digit returns -- at a fraction of the risk.

Investing in stocks need not be mysterious. As in all investments, there are risks and corresponding expected rewards. Anyone considering investing in the stock market must first do a bit of homework on those risks and rewards. The most likely way to lose money in stocks, as in any investment, is through ignorance.

Historically, stocks have outperformed both short- and long-term bonds by a wide margin. Over the past sixty-five years, the average real return on stocks has been about 7 percent per year over inflation, and government long-term bonds have returned between 1 and 2 percent on average per year. Corporate long-term bonds have had only a slightly higher average real return. For the "safest" investments -- U.S. Treasury bills -- the real rate of return has been about zero. Apparently, rates of return on the safest, shortest-term bond investments are only adequate to compensate for inflation, but not large enough to provide an after-inflation rate of return. It's important to understand that when we say stocks earn on average 7 percent above inflation, we do not mean to imply that stocks will have a return 7 percent above inflation every year. Quite the contrary; rates of return on stocks vary considerably from year to year. In some years stocks return much more than inflation; in other years they decrease in value considerably. That's why stocks are a risky means to save for short-term goals.

In the past, the up years in the stock market have been sufficiently good to compensate for the down years and to provide a rate of return about 7 percent higher than inflation. Unfortunately, there is no riskless way to earn a rate of return substantially above the rate of inflation over the long term. Investors have to accept some risk to earn positive real returns. For uninformed investors, investing in the stock market approaches the mystical. The odd vocabulary, the need to go through a broker, the sense that it is not an "even" playing field, well-publicized abuses -- all seem to work against the individual investor. However, the average investor can -- with careful homework, a tolerance for risk, and patience -- earn greater returns in the stock market over time than in most other investment vehicles. This is not to say that small investors should invest directly in individual stocks. It's usually recommended that small investors start with mutual funds, a way to pool your investment with others.

Next: What Is Stock?

Show Full Article

Related Topics

Personal Finance