Investing classroom: Investing for the long run

Lesson 1.3: The third in our series of investment lessons considers the risk/reward dynamic of equities investing

Morningstar 12.10.2009

In the last lesson, we noticed that the difference of only a few percentage points in investment returns or interest rates can have a huge impact on your future wealth. Therefore, in the long run, the rewards of investing in equities can outweigh the risks. We'll examine this risk/reward dynamic in this lesson.

Volatility of single stocks
Individual equities tend to have highly volatile prices, and the returns you might receive on any single equity may vary wildly. If you invest in the right equity, you could make bundles of money. On the downside, since the returns on equity investments are not guaranteed, you risk losing everything on any given investment. There are hundreds of examples of dot-com investments that went bankrupt or are trading for a fraction of their former highs. Even established, well-known companies such as Enron, WorldCom, and K-mart filed for bankruptcy, and investors in these companies lost everything.

Between these two extremes is the daily, weekly, monthly and yearly fluctuation of any given company's share price. Most equities won't double in the coming year, nor will many go to zero. But do consider that there will inevitably be a considerable difference between the yearly high and low share prices of the typical equity on the London Stock Exchange.

In addition to being volatile, there is the risk that a single company's share price may not increase significantly over time. Clearly, if you put all of your eggs in a single basket, sometimes that basket may fail, breaking all the eggs. Other times, that basket will hold the equivalent of a winning lottery ticket.

Volatility of the stock market
One way of reducing the risk of investing in individual stocks is by holding a larger number of stocks in a portfolio. However, even a portfolio of stocks containing a wide variety of companies can fluctuate wildly. You may experience large losses over short periods. Market dips, sometimes significant, are simply part of investing in stocks.

The yearly returns in the stock market also fluctuate dramatically. It should be obvious by now that stocks are volatile, and there is a significant risk if you cannot ride out market losses in the short term. But don't worry; there is a bright side to this story.

Over the long term, equities are best
Despite all the short-term risks and volatility, equities as a group have had the highest long-term returns of any investment type. This is an incredibly important fact When the stock market has crashed, the market has always rebounded and gone on to new highs. On average, equities have outperformed bonds on a total real return (after inflation) basis. This holds true even after market peaks. In other words, stocks have been the best-performing asset class over the long term, while government bonds, in these cases, merely kept up with inflation.

This is the whole reason to go through the effort of investing in equities. Again, even if you had invested in equities at the highest peak in the market, your total after-inflation returns after 10 years would have been higher for equities than either bonds or cash. Had you invested a little at a time, not just when stocks were expensive but also when they were cheap, your returns would have been much greater.

Time is on your side
Just as compound interest can dramatically grow your wealth over time, the longer you invest in equities, the better off you will be. With time, your chances of making money increase, and the volatility of your returns decreases.

Equity returns easily surpass those you can get from any of the other major types of investments. Again, as your holding period increases, the expected return variation decreases, and the likelihood for a positive return increases. This is why it is important to have a long-term investment horizon when getting started in equities.

Why equities perform the best
While historical results certainly offer insight into the types of returns to expect in the future, it is still important to ask the following questions: Why, exactly, have equities been the best-performing asset class? And why should we expect those types of returns to continue? In other words, why should we expect history to repeat?

Quite simply, equities allow investors to own companies that have the ability to create enormous economic value. Equity investors have full exposure to this upside. For instance, in 1985, would you have rather lent Microsoft money at a 6% interest rate, or would you have rather been an owner, seeing the value of your investment grow several-hundred fold?

Because of the risk, equity investors also require the largest return compared with other types of investors before they will give their money to companies to grow their businesses. More often than not, companies are able to generate enough value to cover this return demanded by their owners.

Meanwhile, bond investors do not reap the benefit of economic expansion to nearly as large a degree. When you buy a bond, the interest rate on the original investment will never increase. Your theoretical loan to Microsoft yielding 6% would have never yielded more than 6%, no matter how well the company did. Being an owner certainly exposes you to greater risk and volatility, but the sky is also the limit on the potential return.

The bottom line
While equities make an attractive investment in the long run, equity returns are not guaranteed and tend to be volatile in the short term. Therefore, we do not recommend that you invest in equities to achieve your short-term goals. To be effective, you should invest in equities only to meet long-term objectives that are at least five years away. And the longer you invest, the greater your chances of achieving the types of returns that make investing in equities worthwhile.

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