Investing in the stock market is a gamble: you can stand to win money, or lose it all. Only 54% of Americans are investing in the stock market in some form, whether through stocks, mutual funds, or retirement plans. Even with the great government-sponsored benefits that come with 401ks and Roth IRAs, Americans are wary of the stock market.
It’s no wonder stock market investing isn’t a favorite pastime of the average American once you take a look back. With the 2008 financial crisis, the 2000 dotcom bubble, and the more recent February 2018 stock market selloff, people are starting to wonder if it’s worth it to invest in the stock market.
But before you decide to keep all of your money in your bank account or stuffed in your sock drawer, there are five important points about stock market investing to understand.
1. You’re losing money if you’re not keeping up with inflation
You may be thinking to yourself, “I’ll just play it safe and keep my money out of the stock market.” This kind of thinking is missing a very key detail: inflation. If you don’t understand inflation and are “playing it safe,” you’re losing money.
Inflation is the reason a loaf of bread cost $0.07 in 1933. It’s the reason why $20 was a lot of money in 1933–a full week’s pay for the average worker. Very slowly over time, the prices of things rise. If you are holding money in cash, that means that money is able to buy less and less over time. As inflation rises, the purchasing power of the dollar decreases.
For instance, let’s say you put $1,000 cash in your sock drawer in January 2015. Because of inflation, what you could buy in January 2015 with $1,000 is going to cost you $1,060 in January 2018. In three years, that $1,000 in cash sitting there has actually lost you $60 since the price of everything around you has inched upwards. In other words: actual money in your hand is worth less and less over time.
To make sure you’re not losing money to inflation, you need to keep your money somewhere where it’s earning at least as much in interest as it’s losing to inflation. In 2016, the average inflation rate was 1.3%. In 2017, the average was 2.1%.
Bank accounts with high interest rates can help keep inflation erosion on your money in check if they’re high enough. Yet, investing in the stock market over the long haul will keep your money earning much more than it’s losing to inflation. Long-term stock market data shows that the average return is around 7%, which will definitely protect your hard earned cash against inflation erosion.
2. The sooner you invest, the more your money will compound
When you’re getting started in stocks, it’s common to choose to use the money you’ve earned to continue investing. If you do this, you’ll be taking advantage of compound interest. Not only will you be earning interest on your original investment, but you’ll also be earning interest on that interest.
For instance, if you invested $1,000 that grew 10% annually and you reinvested the returns, here’s the kind of earnings you’d be looking at:
|Years Invested||Total Money Earned||Money Earned – Last 10 Years|
As you can see, the money earned grows at a faster and faster rate thanks to compound interest. If you invest in the stock market sooner, you’ll be able to take advantage of this growth rate over the long run. With average stock market returns over time at 7%, you can expect money invested now to grow to a healthy size over many years.
3. Invest for the long haul and stay out of the horse race mindset
Even though you understand how inflation erodes the value of your money and the potential gains from investing in the stock market, you’re probably still wondering, “what about all of the stock market crashes?!”
It’s true–there is no guarantee in the stock market. While some investments are FDIC-insured, like money market accounts and bonds, anything in the stock market is not.
However, it’s also important to put things in perspective. As mentioned above, the average stock market return over the long haul is 7%. If you’re looking to invest in the stock market for retirement savings or to earn money over many years, you can take some comfort in this data.
Many news outlets tend to sensationalize stock market changes in the short term to get people to pay attention to them. If you’re investing in the long term, there’s no point in getting caught up in the horse race mindset–watching the market rise and fall in the short term. While it’s wise to check in on your investments, there’s no reason to stress yourself out over every stock market headline.
4. Choose your risk level and invest accordingly
When you're getting started in stocks, the first thing you have to do is choose how risky you want to be. Riskier investments have potentially higher gains, but also a higher risk for losses. Safer investments are more guaranteed to earn you money over time, but the returns will be low.
Investment risk and age
Generally, if you have time on your side, you can afford to be riskier. In past decades, there was an old rule of thumb on how to balance your risk level with your age: simply subtract your age from 100, and that’s the percentage you should have in stocks. The rest can be in safer places with lower returns, like money market accounts and bonds. Since Americans are living longer than they used to, you can update that rule and subtract your age from 110 or 120 instead.
The riskiness of different investment types
Another factor that affects your risk level is the type of investments you get. Money market accounts and bonds have very low yields, but are considered safe since they’re not a part of the potentially volatile stock market.
If you buy shares of stock at an individual company, you’re betting on the success of that company, which can be riskier than something like mutual funds. Mutual funds are great since they wrap many stocks and bonds together, allowing you to put your eggs in multiple baskets. Mutual funds are professionally managed, diverse, and range from riskier mixes to more conservative mixes.
Mutual funds are often described in terms of small-cap, mid-cap, and large-cap, which gives you a sense of the size of the companies that the funds are invested in. Small-cap mutual funds are made of smaller companies, which implies more risk since many of these companies are new, but also high growth potential. Large-cap mutual funds put your money towards large companies–companies with market caps of $8 billion or more–which are more likely to have an established history as a business. Mid-cap funds are a popular middle-ground that are perceived as being less risky than small-cap funds, but have more room for growth than large-cap funds.
The same logic can be applied to stocks: stocks at smaller companies are generally riskier than those bought from larger companies. If you’re going to invest in stocks with individual companies, be sure to do your research and have a stock-picking strategy.
5. Know your best investment options and do the math
When you’re deciding on whether or not to invest in the stock market, it’s wise to compare the interest rates of your current investments and debts first to make sure investing would be worth it for you.
How to balance investments and debt
For instance, let’s say you’re paying off some credit card debt with a 14% interest rate. Credit card debt compounds, meaning your debt will grow larger and larger quickly (like in the chart above, except working against you rather than for you). If you’re growing compounding debt at 14% interest rate and are considering investing, it only makes sense for you to invest your money if you’ll be getting returns higher than 14%.
If you choose to invest your money in the stock market (estimated 7% compounding returns for you) rather than pay off the debt (14% compounding returns for your credit card company), it’s kind of like losing two dollars to your credit card company for every one dollar you make in the stock market.
If you have debts that are below 7%, it’s time to start considering investing. If the market hasn’t been looking good and you want to be on the safer side, don’t start investing until you only have debts with interest rates well below 7%. Take note that mathematically, it’s not the size of the debt that matters, but only the interest rate on the debt and whether it’s compounding against you or not.
Start with retirement accounts for unparalleled tax savings
If you’ve determined it makes sense for you to start investing, a good place to start is your 401k and Roth IRA. These retirement savings accounts have tax incentives that make them an exceptional place to start investing. Plus, the FDIC insures deposits, money market accounts, and CD accounts under your 401k and Roth IRA if you want some of your retirement money playing a more conservative game.
When you invest in the stock market, you’re protecting your money from inflation erosion and can grow a steady nest egg at the very least. From high-risk stock market investments to low-risk money market accounts, there’s a wide range of investment options out there for everyone.