March 11, 2024
It does, indeed, make sense for most people to be stock market investors. According to Jeremy Siegel in his excellent book Stocks for the Long Run, the stock market beat inflation over the period from 1802 to 2021 by 6.9% per year. If you are uncomfortable taking Siegel’s word for it, from March 1957, when the S&P 500 index was started, through December 2023, it beat inflation by 6.5% per year.[1] At that rate the purchasing power of an investment doubles every 11 years.
While stocks are an excellent investment over the long run, bad things can happen in the short run. One of the worst periods for stocks was from October 9, 2007, through March 9, 2009, when the S&P 500 (with dividends reinvested in the index) lost 50.9%. If you had had a significant investment in stocks at that time you would have been sorely tempted to sell out at a loss. You would have done better to stick with it. It took a while for the S&P to recover, but it did get back to its October 9, 2007, level on August 15, 2012. For the ten-year period from October 9, 2007, through October 9, 2017, the S&P 500 index gained 7.3% per year—in spite of the terrible start.
6.5% over the rate of inflation is very good. Down 50.9% is very bad. In order to have the good, you must be prepared for the bad. You have to find the right balance, investing as much as you can in stocks without risking so much that you get scared out at the worst possible time.
Some important considerations in determining how much risk to take:
INCOME
If you have sufficient income to live comfortably without touching your stocks, you can invest a lot in stocks. If you are retired, planning to sell some of your investment for living expenses, then a drop in the market is much more likely to scare you. In this case you should have less invested in the stock market.
YOUR OWN PSYCHOLOGY
Some people are cautious while others are bold. If you are bold, you have to be careful not to be reckless.
YOUR OWN KNOWLEDGE ABOUT YOUR INVESTMENTS
If you have good reasons for owning what you own, you will have a good chance of sticking with your investments if they go down as long as your reasons for owning them hold.
MAJOR EXPENDITURES
If you have major expenditures coming up that will necessitate selling some of your investments, you may not want to wait until the last minute to sell. Suppose you have $500,000 invested and you are planning to use $100,000 of that to buy a new house. If you set aside $100,000 now, leaving $400,000 invested in stocks, and the market drops 25%, you will still have $300,000 invested. If, on the other hand, you wait to sell and the market drops 25%, your investment will shrink to $375,000 before you take your $100,000 out, leaving you with only $275,000. You will have a smaller base to build on.
THE RISKINESS OF YOUR INVESTMENTS
Some investments are riskier than others. In recent history the S&P 500 has dropped some 50%. That could happen again. There are some conservative mutual funds that have never dropped more than 35%. You can invest more money in such a fund than in an S&P 500 fund without risking a greater loss. If the ratio of expected return on the conservative fund to its risk is greater than the corresponding ratio for the S&P 500, then you can get a greater return by investing in the conservative fund than by investing in the S&P 500.
DIVERSIFICATION
It is important to understand the role of diversification. The reason for it is to reduce risk, but when you diversify, you may also be reducing expected return. You want to make sure that you reduce risk by more than you reduce expected return. Suppose you believe you can stand a worst-case loss of $35,000, and you have a choice between two portfolios of stocks. One portfolio may lose up to 50% in a down market. The other portfolio, more diversified, may lose up to 35%. If you want to risk $35,000 but no more, you can invest $70,000 in the first portfolio or $100,000 in the second. If your expected return on the first portfolio is 10%, then you will prefer the second portfolio only if its expected return is over 7%. If diversifying to get to the second portfolio reduces expected return below 7%, you are better off not diversifying. Of course, you can’t know with any precision what is the worst-case risk or the expected return for any investment. These can only be roughly approximated. It won’t be absolutely clear which portfolio to choose. The point, however, is to think in terms of expected return relative to risk and to assess how diversification affects this ratio. Do not diversify solely for the sake of diversification.
Once you have a good appreciation of how much risk you can tolerate, you have to decide which stocks to buy. Analyzing the prospects of a company is complicated, and there are a number of different approaches. You may be wary of trying to choose individual stocks to buy. Fortunately, there is a reasonable way to invest in the stock market without having to evaluate companies. The way to do this is to invest in mutual funds or exchange traded funds (ETFs).
A good starting point is the S&P 500 index. As stated above, the return on the S&P 500 index has exceeded inflation by more than 6% a year over a long period of time, and there are a number of mutual funds and ETFs designed to track this index. Very good stock selection may do better, but the S&P 500 is difficult to beat. Another possibility is to invest in mutual funds or ETFs that have objectives other than matching the S&P 500. Many of these funds have undistinguished records and do not compare favorably to the S&P 500, but there are a few that have done better over long periods of time. To learn more about investing in mutual funds, read our guide to How to Invest in Mutual Funds.
At Northwest Criterion Asset Management, LLC, we have long experience in the stock and bond markets. We take very seriously the process of evaluating both the risk and return of potential investments. Please call us at 609-924-4488 or email us at invest@nwcriterion.com to discuss your investments.
[1] According to Bloomberg, the S&P 500 index with dividends reinvested gained 10.47% per year from the end of March 1957, through the end of December 2023. The Consumer Price Index gained 3.67% per year for the same period.