Stock Investing Basics - Part III

Time Is on Your Side

To help put this into context, let's look at how various types of investments have performed historically. Bonds and stocks are the two major asset classes that have been used by investors over the past century. Knowing the total returns on each of these, and their associated volatility, is crucial to deciding where you should put your money.

Putting your money into cash reserves - U.S. Treasury bills, or more recently, money market funds - has yielded roughly 4.2% per year during this century, according to Global Financial Data. While this may not seem like a lot today, it is important to remember that for most of this century, inflation was nonexistent, making a 4.2% average annual return attractive until the 1960s. Though it is interesting that cash reserves have outperformed bonds this century, if one expands the time frame back to 1802, cash returns trail the return of bonds, and during the 1980s and 1990s, cash reserves have consistently trailed bond returns.

Long-term government bonds have returned around 4.0% per year since 1900; surprisingly, they're not that superior to short-term bonds. The best decade for bonds in the past century was the 1980s, when bonds returned 13.81% annually. The worst was the 1950s, when bonds lost -3.75%. Had you invested $1 in long-term bonds in 1900, you would have about $50 today.

Stocks have also been very good to investors. Overall, stocks have returned an average of 9.8% per year since 1900 - quite a bit higher than bonds. Surprisingly, the range of the returns for stocks is not that much larger than the range for bonds over the same period. According to Global Financial Data, the worst return in one decade was the 1930s, when stocks declined 0.17% per year, including dividends. The best decades have been the 1950s, when stocks increased by 18.23% annually; the 1980s, when stocks increased by 16.64% annually; and the 1990s, during which stocks have increased by 17.3% annually. Had you put $1 into stocks in 1900, you would have over $10,000 today.

Determining Your Investment Style

What kind of investor are you? Are you a swing-for-the-fences type, or are you content hitting singles and doubles, racking up slow and steady gains? Or do you prefer to sit in the stands, chatting with your companions and occasionally cheering your home team on?

Before you start investing, you should determine your investment style. There are two major variables in figuring out your investment style - your risk tolerance and the amount of time you can dedicate to investing.

Risk. How comfortable will you be if you invest in something in which the price changes every day - sometimes not the way you want it to change? There are various degrees of risk across the investment spectrum, from government bonds, which are considered risk-free as they are guaranteed by the government, to commodities and options, where you can and often do lose all of your money.

You need to consider how comfortable you will be seeing your investment decrease in the near term while you wait for it to increase over the long term. Although stocks have historically increased in price over the past two centuries, there have been some pretty bad periods. Without counting dividends, your equity investments could have lost almost 80% of their value had you bought stocks at the high in 1929 before the crash. You could have lost 40% had you bought at the high in 1972. Heck, in October of 1987 the Dow decreased 25% - in just one day! The important thing to remember about stocks, though, is that you don't lose anything until you sell them. For example, if you didn't panic and sell your stocks in October of 1987, you did quite nicely as the market rebounded in subsequent years. That's why, when you're investing in the stock market, you need to think long-term. Don't invest any money in stocks that you'll need in the short term.

Government bonds provide guaranteed returns, and bank savings accounts are insured by the Federal Deposit Insurance Corporation (FDIC). For stock investing, there is no similar guarantee or insurance that the ride will be smooth or that every investment will make you money, but if you buy good businesses and hold for the long term, the odds are in your favor. Just remember that the safest road isn't always the best one. At the Motley Fool we believe that the biggest risk is not taking enough risk, meaning not investing enough in stocks.

It should also be said that you can learn to increase your risk tolerance for investing in stocks. Once you see the kind of returns you can generate over time, you'll come to realize that it really doesn't matter if your stock drops or rises over the course of a few hours or days or weeks or even months. It may be fun to check your stock prices (and it's so easy on the Internet!) but it doesn't mean much over the long term.

Time. Speaking of the long term, time is another important element of your investing profile. How much time do you want to spend on investing? How active do you want to be in the management of your money? Do you want to spend 15 minutes a year on it? Then maybe you should consider using the Passive Strategies detailed below. Or maybe you have eight hours a week, in which case you might enjoy researching companies and poring over financial statements to pick individual stocks.

Another time factor is: When do you need the money? Whether you need the money next week or in a hundred years will dramatically affect what investment vehicle you decide to use. Although stocks have great long-term returns, the returns over periods of three years or less can be downright scary. Luckily for you, as you have now determined your goals and how much money you will need to get there, you also know how soon you will need the money and will be able to make the appropriate choices when you are ready to invest.

Active and Passive Strategies

The two main methods of investing in stocks are called active and passive management. No, active investors aren't the ones who exercise and eat leafy greens while passive investors watch too much TV and eat junk food. Instead, the distinction between active and passive investing is whether you (or whoever manages your money) actively choose the companies in which you invest or whether your investments are determined by some index created by a third party.

Active investing is what most people mean when they talk about stock investing. Whether they do it, their broker does it, or a mutual fund manager does it, the money is managed "actively." The hardest part about making the case for passive investing is convincing people that active investing may not always be all that it is cracked up to be. According to Lipper Analytical Services, over the five years ended in June 1998, 90% of "general equity" mutual funds, meaning garden variety stock funds, under performed the Standard and Poor's 500 Index - the major benchmark for stock mutual funds.

With 9 out of 10 equity mutual funds failing to beat the market average over five years, you can understand why some people want an alternative to "active" management. Many people who just want a return equal to that of a major stock index use passive investing as a way to do this. The most famous passive investment strategy is investing in the Standard and Poor's 500 Index, also known as the S&P 500, although the Russell 2000, the Wilshire 5000, and various international indexes are also used for passive investment options.

Summary

Now you have figured out your goals, set your investment horizon, thought about your investment style, and considered whether or not to use active or passive investment strategies.

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Article Souce: The Motley Fool.