Why Stocks Should Be A Part Of Your Investment Portfolio
I'm going to start by saying something that I truly believe. "Stocks should be a part of every investors portfolio". What level of exposure you should have will depend on your risk profile and willingness to experience volatility,
There are a lot of misconceptions about the stock market. I’m sure you have heard at least one of the following:
- The Stock Market is a giant scam
- Stocks are really risky
- My friend/relative lost a lot of money in the stock market
- No one knows what the stock market is going to do
Before I address the above, lets break what a stock is to its simplest form. A stock or a share is an ownership in a business. No different than the local plumber or fish and chip shop.
Even when you own a share in a global giant like BHP or Rio Tinto, you become a small owner in that business. Shares = Businesses.
But how do you make money from shares?
Generally, there are two ways in which an investor or owner is able to make money in the stock market. The first, which happens to be a favourite of a lot of investors, is via dividends. In essence, when a business makes a profit, they have to decide what to do with the profit.
Businesses will either reinvest this into the business (new equipment, expansion, etc) or pay part of this cash back to the owners via a dividend. So, a dividend, is just the investors share of the businesses profit. Makes sense, right?
For example, ANZ paid a dividend of $1.80 per share to shareholders last year. Many investors like to invest in businesses that have a solid history of increasing their dividends over time.
The second way that you can make money in the stock market is through capital growth. That is simply that the sale price of the share is worth more. A great example of this is look at CSL shares. Over the past 20 years as the business has continued to grow, increase revenues and profits, the share price has grown accordingly.
Now that we have established the two ways that you can make money in the stock market lets address the misconceptions that I mentioned above.
The Stock Market Is A Giant Scam
Everyone knows someone who has been burnt in the stock market. From famous scandals like Enron to local collapses like Slater and Gordon, there have been many cases of stocks that have resulted in investors losing money.
However, the Australian market and regulators do a world class job in ensuring that our stock market is as honest and transparent to investors as possible.
Stocks Are Really Risky
There is no denying it, stocks do contain an element of risk. Even great businesses may find that their core products or services are no longer relevant. There are ways to minimize your risk in the stock market. You could use strategies such as dollar cost averaging (regular investment) or, my preferred option, holding a diversified portfolio to help reduce risk and make sure that all your eggs are not in one basket.
Another great way to minimise your investment risk is through understanding the stocks you are holding. For example, if you own shares in Coles and the share price wasn’t doing too well but every time you went to a shopping centre the Coles was packed, it is generally a good sign that the business is doing well and the share price is likely to recover over time.
My Friend/Relative Lost Money In The Stock Market
Now this one happens for a variety of reasons. Paying too much for a growing company, the business surprised with disappointing earnings, putting all their eggs in one basket or pulling their money out of the market at the worst possible time. Unfortunately, humans are programmed to avoid pain and losing money hurts a lot more than making money makes us feel good.
For example, investors in a simple index fund would have suffered large losses during the GFC (almost all investors did except the likes of John Paulson). However, over time the investors have more than recovered their money as the market recovered. There are always going to be boom and bust cycles in markets, it is normally a great idea to ignore today’s headlines and focus on your 20 year plan.
No One Knows What The Stock Market Is Going To Do
This one I can’t dispute. No one, is able to consistently predict all the fluctuations of a market of the short term. The stock market is a car that runs on all the information available in the world and updates by the microsecond while it is open. Economic data, political data, currency movements, commodity movement, human emotions, mass psychology, expectations and even the weather all affect how a market is going to perform. That’s before we even start to consider the individual company and how it is performing.
What I can say confidently is that over a long enough time horizon stocks are very likely to increase in a manner greater than cash, bonds or defensive investments (although with a lot more bumps along the way). The reason for this is simple, businesses have the potential to grow to revenues and profits near to infinity.
The simplest reason I can give for you to invest in shares is that historically shares have been a great way to build your wealth over a long period of time. Research by Vanguard shows that the Australian stock market grows at an average of 9.4% per annum, at this growth rate combined with enough time it is amazing how quickly your investments can grow.
The information contained on this article has been provided as general advice only. The contents have been prepared without taking account of your personal objectives, financial situation or needs. You should, before you make any decision regarding any information, strategies or products mentioned in this article, consult your own financial advisor to consider whether that is appropriate having regard to your own objectives, financial situation and needs.