In the lesson Stocks 102, 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 stocks can outweigh the risks. We'll examine this risk/reward dynamic in this lesson.
Volatility of single stocks
Individual stocks tend to have highly volatile prices, and the returns you might receive on any single stock may vary wildly. If you invest in the right stock, you could make bundles of money. For instance, Eaton Vance EV, an investment-management company, has had the best-performing stock for the last 25 years. If you had invested $10,000 in 1979 in Eaton Vance, assuming you had reinvested all dividends, your investment would have been worth $10.6 million by December 2004.
On the downside, since the returns on stock investments are not guaranteed, you risk losing everything on any given investment. There are hundreds of recent 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 Kmart 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 stock price. Most stocks won't double in the coming year, nor will many go to zero. But do consider that the average difference between the yearly high and low stock prices of the typical stock on the New York Stock Exchange is nearly 40%.
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In addition to volatility, there is the risk that a single company's stock price may not increase significantly over time. In 1965, you could have purchased General Motors (GM) stock for $50 per share (split adjusted). In the following decades, though, this investment has only spun its wheels. By June 2008, your shares of General Motors would be worth only about $18 each. Though dividends would have provided some ease to the pain, General Motors' return has been terrible. You would have been better off if you had invested your money in a bank savings account instead of General Motors stock.
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.
For example, consider the Dow Jones Industrials Index, a basket of 30 of the most popular, and some of the best, companies in America. If during the last 100 years you had held an investment tracking the Dow, there would have been 10 different occasions when that investment would have lost 40% or more of its value.
The yearly returns in the stock market also fluctuate dramatically. The highest one-year rate of return of 67% occurred in 1933, while the lowest one-year rate of return of negative 53% occurred in 1931. 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, stocks are best
Despite all the short-term risks and volatility, stocks 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. Stocks have outperformed bonds on a total real return (after inflation) basis, on average. This holds true even after market peaks.Rate this Article
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