It’s human nature to have a fear of the unknown. And when it comes to money things are no different. One of the main things I see that really holds people back from investing or even opening a retirement account is the fact they really struggle with understanding how the market works. They can’t help shake the feeling that they are “gambling” with their money and livelihood.
The following post is a contribution from The Money Template, a personal finance blog trying to tackle everything about money and how we can save more of it.
As someone who has lost money with their investments, I can completely identify with that fear. I’ve watched my 401k balance get cut in half during the dark days of the Great Recession. I’ve had stocks I own go all the way down to having no value at all. But one thing I can tell you is that it doesn’t always have to be that way. In fact there are quite a few basics that you should get to know that will help you understand that investing is not gambling and to keep your financial faith.
Companies are Businesses, Not Chance:
The first thing you need to understand about stocks and mutual funds is that you’re not putting your money on red or black at the casino. Casino games and most gambling in general is designed to do one thing and one thing only – make the owner rich. There is no skill or craft involved. The wheel spins and dice roll. It’s a game of odds designed to make the patrons think they have a chance when really the house will ultimately win every time. As the old saying goes “a fool and his money are soon parted”. Now compare that scenario to the way the economy works. When it comes to big, legitimate businesses, they don’t merely rely on “luck”. There are business plans, product development, strategic planning sessions, and lots of other things that go into driving a company towards profitability. People go to work every day trying to make that business grow and move forward. Any reputable company wants to survive and they reward their shareholders with growth and earnings.
But Isn’t Investing in Companies Still Risky?
You are always correct to assume that when it comes to investing there is always a risk. It doesn’t matter what you do with your money. There is always a chance that you could lose it. When you invest in stocks, it could go up or it could go down. It just depends on what happens that day. However every day people invest in the market for the chance that their stocks will go up in value. Possibly even double! Take any year between 1970 and 2013. If you had invested in the S&P 500 stock index, you could have lost as much as -37.0% or gained as much as 37.58% for any given single year. That’s a pretty huge spread of possible outcomes. Now consider a relatively safe investment like a bank account. Even things there are not always as safe as they seem. For example if you had a million dollars in the bank and there was suddenly a run on banks (think like the movie It’s a Wonderful Life), then you could potentially lose $750,000 since your account is only FDIC insured for up to $250,000. Now obviously those two examples have vastly different levels of risk. One is far more plausible than the other to happen. So if you accept that all investments carry some level of risk, the only thing you have to do then is ask yourself how much risk are you willing to tolerate for a decent return on your money? Surprisingly the two are not always as linear as you might believe. Especially when you add in one very important ingredient …
Time is a Great Equalizer:
Even though stocks by themselves are relatively risky, there is one very slick way to mitigate how much you’re willing to gamble: By giving it more “time”. Suppose instead of investing in stocks for a single year, you instead give it a little time to mature. Take any five-year period between 1970 and 2013 for the S&P 500 stock market index and the average return will be anywhere between -2.35% and 28.56%. Compare that -2.35% to the -37.0% you were faced with earlier and that’s a WAY less risky strategy to use. Now look at what happens when you keep stretching out the time period longer and longer:
- 15 year period average: 4.47% to 18.93%
- 25 year period average: 9.28%to 17.25%.
As you can see the longer of a period you give yourself to invest, the more it averages itself out. AND more importantly that average gravitates towards a stronger and stronger positive return. What this means is that for people who want to invest intelligently is that as long as they invest in large strong companies over the long haul they should expect all those yearly fluctuations begin to level out and deliver long-term positive results.
Investing is Not Gambling:
Even Warren Buffett himself has said that no one really knows what the market will do tomorrow. It might go up and it might go down. While that is absolutely true, it doesn’t mean that we still can’t become financially independent for the rest of our lives. As investors one of the best things we can do for ourselves is to put our money in market averages or solid, legitimate companies that will help produce well-deserved long-term results. If history is any indicator, you’ll find that out of all the strategies out there this one is simply a great way to minimize your risks and maximize your returns.