**DOUBLE POST DAY! Click the link at the bottom of this article to go directly to the next one: "What is the difference between stocks and bonds?"**
One of the biggest arguments I’ve heard against investing is: “How do you know that the stocks you buy will go up in price?” That is a perfectly warranted question, and it is a topic that I thought would be important to share my thoughts on. This one question is probably what keeps most people from investing their money in the first place, so breaking it down might be helpful for you!
One critical thing to understand is that potential profit (and loss!) are directly correlated with the amount of risk you take. The more risky the situation, the more you would want to get paid to put yourself in such a situation. So what is the absolute safest investment in the world? Well, we would like to think that would be taking no investment risk at all. In theory, doing nothing would have a return of 0%. No risk, no return, no loss.
But that’s when a nasty thing called “inflation” comes into play. All healthy economies have some sort of inflation, and it is a very simple thing to understand. Over time, the US dollar will depreciate versus the price of goods in the economy. This means that one dollar tomorrow will be able to purchase fewer goods/services than one dollar today. Over just a few days, the effect of inflation is inconceivable. Over years, it is potentially painful. And over generations, it is massive. If you gave your son/daughter a $1 per week allowance back in 1950, they would be very happy. What could you buy with just $1 today?
So now we know that inflation eats away at your idle cash, slowly but surely, over your lifetime. Generally, inflation will erode 1-3% of your purchasing power every single year. THIS is how you are putting your money at risk by not doing anything at all! Investing is a critical skill that is necessary to both maintain and increase your wealth.
If you invest in the world’s safest security for the long term, the 30 Year US Government Treasury Bond, you will receive an interest payment of about 3% per year in addition to receiving all of your capital back. (These Government Treasuries are what people are referencing when they speak of our national debt)
Now, I am not here to bash investing in the US Government, but that payout is minuscule because the risk of loss is so low! And when you account for inflation (1-3%/Year on average), you may not make much money in profit at the end of the day. Take it up a notch in risk by investing in private US Corporate debt, and a high quality corporate bond could bring you in 4%+/Year for 30 Years as of today. The difference between the return on these investments is called the “spread” against the US Treasury. So in this case, by investing in High Quality Corporations with consistently positive cash flow/profit, you would make an extra 1%/Year spread on your investments.
The “spread” widens as you go from less risky investments to more risky ones. In general, stocks are considered to hold “more risk” than bonds. The "risk" in this scenario is the probability that the company’s stock falls in price, at which point your money invested would be worth less.
A seemingly infinite number of things have an effect on the price of a company’s stock, and stocks go up and down every single day. But on average, the general stock market (commonly measured by the Standard & Poor’s 500, or S&P500, Index) pumps out a return of 7% per year net of inflation. This astronomical difference in return comes with very little extra risk, if you invest properly.
Notice how I didn’t say the stock of Apple, or Amazon, or Coca-Cola. I mentioned the general stock market. This is a huge distinction to make because investing in just one company holds more risk than investing in 500 of them at once. Investing in all 500 of the largest companies in the United States (the S&P 500) gives your portfolio a massive amount of diversification. Your Coca-Cola stock that is having a bad day could be completely offset by your Amazon investment that is shooting up in price.
All of this to say that we can invest in the worlds largest companies, receive that potential for profit, and minimize our risk of one company blowing up our portfolio.
This WILL NOT protect you from the event where all stocks go down at once, like we saw happen in 2007-2009. In a scenario like that, the only thing you can do is stick to your guns and continue to invest in the country’s largest companies. If all 500 of the S&P’s components went out of business, there would be MUCH larger problems going on than how much your investment portfolio is worth.
Please note: I recommend always keeping 6-12 months of expenses in cash on hand, and always having a positive cash flow (total monthly income - total monthly expenses). This is a 100% prerequisite before you start investing. By doing this, you will have the dry powder necessary to buy high quality stock at rock bottom prices when everyone else is too scared to do so.
“But MDAS, you said cash has a negative return because of inflation, why should I hold so much at one time?”
We need cash to live. We need cash on hand to cover emergencies that need immediate attention. While this amount is losing 1-3% of its purchasing power every year, a much larger amount in investments is bringing in 7%+ to offset the losses of inflation and net you some profits.
If you’re interested in a step by step guide on how to get started investing for the long haul, check out my article on that HERE! If you are looking for some reading material on investing, check out J.L. Collins' book, The Simple Path to Wealth. It is a great book on getting started and maintaining your investing momentum throughout your life.
If you thought this was helpful, terrible, or somewhere in the middle, please leave me feedback in the form of a Direct Message on instagram @MakeDollarsAndSense, or feel free to send me an e-mail/text to the information on my Home Page. I truly appreciate constructive criticism and opposing views, so bring em on!
P.S. New blog posts coming your way every Monday!
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