Why You Should Invest in the Stock Market

We think it is great you are considering investing some of your money in an asset rather than spending it on something that offers no return. 

Before we get into the risks of investing, we will start with a happier tone and review some of the most powerful arguments in favor of investing in the stock market, starting with compound interest and the high return potential of equities.

Power of Compounding Interest

Albert Einstein once said, “Compound interest is the eighth wonder of the world. He who understands it, earns it ... he who doesn't ... pays it.” 

By investing in the stock market, you are giving yourself the opportunity to experience the magic he is talking about. 

Compound interest is the interest an investor earns on his original investment, plus the interest earned on the total interest that has accumulated thus far. This creates a snowball effect over time.

Essentially, compound interest is a “wonder of the world” because we are really bad at understanding exponential growth. For example, if a penny were to double in value each day, how much do you think it would be worth after 30 days? 

For the first three days, the value would be: 1c, 2c, 4c… Make a guess.

If you estimated anything less than $5 million, you were wrong. Here is how the compounding plays out:

Highest Return Potential

Unfortunately, our search for an investment that will double our money each day with minimal risk continues. 

However, the stock market has provided exceptional returns over long periods of time and, in our opinion, is the best way for a saver to compound wealth over the long haul. 

Over the past 80 years, the S&P 500 has compounded at a rate of more than 10% annually. As seen below, this performance far surpassed the returns from government bonds and cash over the same time period:

                     Source: NYU 

What does a 10% annualized return mean? Well, if you had invested $1,000 in the S&P 500 in 1930, did not make any additional contributions, and never sold, your portfolio’s value would have increased from $1,000 to over $3 million at the end of 2014. 

While inflation would reduce your real return by 2-4% per year, this is still incredible growth to witness in a single lifetime. Here is another look at the stock market relative to other asset classes, provided by Fidelity:

                                                     Source: Ibbotson Associates, Fidelity

Simply put, with a long enough time horizon (e.g. 10+ years), the stock market provides you with the highest potential return compared to practically any other asset class. 

Finally, J.P. Morgan provides a great chart highlighting the power of compound interest as it relates to saving for retirement (below). Check out additional analysis by Business Insider: 

Liquidity and Data Availability

Relative to most other asset classes, stocks are incredibly easy to buy and sell. While this can create problems by making it easy to rack up unnecessary trading costs or trade on our emotions, it provides opportunity for practically anyone to invest immediately and with minimal costs. 

Unlike real estate, there are no closing costs, you do not have to worry about physical repairs and maintenance, and you can exit your investment at any time. We are fortunate to have this privilege.

Additionally, financial data has never been more accessible to individual investors. Between electronic SEC filings, advanced company websites, and online providers of historical financial data, getting up to speed on a stock is easy if you are willing to put in the time.

Time Commitment

One of the common myths used to discourage individual investors from taking control of their own financial destiny is that there is no way they can compete with the “professionals” who analyze stocks full-time for a living.

Having met with dozens of full-time stock analysts and portfolio managers, we estimate that the average professional spends less than four hours per quarter researching any single stock they hold or cover. Many will not even open a 10-K.

So how can you be competitive? Stick to businesses you can understand very well, and invest at least several hours every quarter to continue getting to know them better. More on this in a future post.

Advantages of an Individual Investor

As an individual investor, you have several noteworthy advantages over institutional investors. 

No one is screaming at you to cover more stocks or bring forward an actionable idea, so you have the luxury of looking deeply only at companies you understand, at your own pace. Do not force anything outside of your comfort zone or swing at pitches you are not sure you can hit.

Another advantage is your ability to invest in small cap stocks that have little sell side coverage or institutional ownership. Large funds have a much smaller presence in stocks with market caps less than $1 billion because their average investment size would force them to own 5-10%+ of the stock, a risk they cannot take. This means you have a better chance of trading against less informed parties and discovering an idea before it receives broad institutional support. 

Finally, you can afford to exercise far greater patience in your investment strategy - time horizon arbitrage. Many institutional investors have little patience for underperforming stocks. Clients want quarterly, if not monthly, performance updates. This can pressure even long-term oriented investors to sell stocks during periods of near-term weakness, placing much less value on the companies’ long-term prospects. If you are willing to look beyond the next one or two quarters, you improve your chances of outperforming over time.

We will go deeper into some of these issues in a future post.

Coming Soon…

Stay tuned for our next post covering some of the pitfalls of investing. We will take a look at how to make market volatility work for you, a handful of the most common behavioral traps investors fall into, and strategies to protect yourself from the emotional urges caused by the market.