The decision to invest in stocks is one that individuals must take the time to consider carefully, weighing the risks and rewards in the context of their own unique facts and circumstances.
In general, stocks carry far greater risks than other investments, such as bonds and cash. Investors must contend with market volatility based on economic events and trends that are beyond their control. One measure of market risk, or volatility, is measured by standard deviation, or how wide a stock price swings over time. For example, consider the annual swings of two stocks with an average 5 percent simple return over a three-year period:
|Year 1||Year 2||Year 3||Simple Average|
Stock Z is more volatile, with higher highs and lower lows, making the investment ride a lot bumpier and more uncomfortable for the individual investor. It is possible that the Stock Z investor will panic and sell in year one, when the stock is down 10 percent. However, in doing so he or she will miss out on 30 percent returns in year two. By contrast, the investor in Stock X will have a less stressful three-years while ultimately receiving the same average return as the investor in Stock Z.
The equity risk premium (ERP) is the excess returns an investor can expect to receive from investments in stocks over risk-free alternatives, such as short-term US government bonds. While the ERP fluctuates over time, investors can expect to be compensated for taking on the added risk of investing in stocks. In other words, there are opportunities to make a lot of money from stock investments, but there is also a risk of losing a lot of money.
Depending on an investor’s holding period and time horizon, it may not make sense to invest in stocks. Although the equity markets have trended upward over the long-term, an investment of five years or less may be too volatile for the average investor to stomach if they have a deadline; risks of capital losses are very real. For example, consider that during the most recent financial crisis, the S&P 500 peaked in October 2007 and hit the bottom in March of 2009. If an investor bought at the peak and sold at the bottom, they would have taken a loss of more than 50 percent. However, if the investor did not panic and had a longer time horizon to hold onto the stock, he or she could have made back those losses had he or she waited until March 2012 before making a sale. While not making any money over a 4.5-year period is not ideal, you would not have lost any money during one of the largest market crashes in history.
Despite these inherent risks, investments in stocks historically have yielded greater financial returns than bonds and cash. For example, according to data compiled by JP Morgan Asset Management, U.S. stocks have returned an average of 11.2 percent per year between 1950 and 2018, compared to 5.8 percent for bonds. Over any one-year period a stock investor could have made a lot of money (47 percent) or lost a lot of money (39 percent). As the holding period increases, the range of potential outcomes becomes smaller and smaller, with the 20-year rolling results ranging from 7 percent to 17 percent.
The decision of whether to invest in stocks is not a simple one. The guidance of financial advisors can help to mitigate risks based on investor’s individual circumstances. For more information, listen to the Relatable Finance podcast at https://www.provwealth.com.
About the Author: Shane Phillips, CFA, CAIA, CFP ®, is a portfolio manager with Provenance Wealth Advisors (PWA), an Independent Registered Investment advisor affiliated with Berkowitz Pollack Brant Advisors + CPAs and a registered representative with Raymond James Financial Services. He can be reached at the firm’s Fort Lauderdale, Fla., office at (954) 712-8888 or via email at firstname.lastname@example.org.
Provenance Wealth Advisors (PWA), 515 E. Las Olas Blvd., Ft. Lauderdale, FL 33301 (954) 712-8888.
Shane Phillips, CFA, CAIA, CFP ®, is a registered representative of and offers securities through Raymond James Financial Services, Inc., Member FINRA/SIPC.
Raymond James is not affiliated with and does not endorse the opinions or services of Berkowitz Pollack Brant Advisors + CPAs. PWA is not a registered broker/dealer and is independent of Raymond James Financial Services. Investment Advisory and Financial Planning Services offered through Raymond James Financial Services Advisors, Inc., and Provenance Wealth Advisors.
This material is being provided for information purposes only and is not a complete description, nor is it a recommendation. Any opinions are those of the advisors of PWA and not necessarily those of Raymond James. You should discuss any tax or legal matters with the appropriate professional. Prior to making an investment decision, please consult with your financial advisor about your individual situation. The information contained in this report has been obtained from sources considered to be reliable, but we do not guarantee that the foregoing material is accurate or complete. Holding investments for the long term does not ensure a profitable outcome. Though they can help mitigate risk in a portfolio, diversification and asset allocation do not ensure a profit or protect against loss. Investing involves risk, and you may incur a profit or loss regardless of the strategy you select.
The chart above is for illustration purposes only and does not represent an actual investment. Past performance is not indicative of future results. The S&P 500 is an unmanaged index of 500 widely held stocks that is generally considered representative of the U.S. stock market.
* Certified Financial Planner Board of Standards Inc. owns the certification marks CFP®, CERTIFIED FINANCIAL PLANNER™ and federally registered CFP (with flame design) in the U.S., which it awards to individuals who successfully complete CFP Board’s initial and ongoing certification requirements.