Why Invest in Stocks? 

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Why Invest in Stocks?



Investment Snapshot

In November 2001, Enron filed for bankruptcy. Investors who bought the stock of this high-profile company at $60 per share at the beginning of that year saw their investments wiped out.
For the three-year period from March 2000 through 2003, the stock market was in a steep decline. The Nasdaq Index was down 71 percent. To put this in historical perspective, the stock market has not seen such a decline since the Depression of 1929.
The stock price of Boeing Company was $33.50 a share on November1, 2001, and rose to $85 per share on May 3, 2006, a 155 percent increase over the four-and-a-half-year period. The preceding Investment Snapshot illustrates the ease with which you can lose money investing in stocks. Yet more than half the households in the United States own stocks either directly or indirectly through retirement accounts. Understanding what stocks are and how stock markets work can help you to avoid the costly mistakes when investing in stocks and to build a portfolio of stocks that include winners such as the Boeing Company example.

WHY YOU SHOULD INVEST IN STOCKS

The Investment Snapshot poses the question: Why invest in stocks when you can lose part of your investment? The answer to this question can be obtained from Figure 1–1, which illustrates why stocks are so compelling an investment.

Over the 19-year period from 1986 through 2004, both largecompany and small-company stocks outperformed bonds and Treasury bills and kept well ahead of inflation. In 5 of the 19 years stocks underperformed bonds and Treasury bills. However, an investor with a long time horizon should not be bogged down by a small number of negative yearly returns because the focus should be on accumulating long-term wealth.

FIGURE 1-1
Annual Returns of Stocks, Bonds, and Treasury Bills, 1986–2004

Annual Returns of Stocks, Bonds, and Treasury Bills, 1986–2004

FIGURE 1-2
Total Real Returns from Investing $1 from 1926 to 2000

Total Real Returns from Investing $1 from 1926 to 2000

Figure 1–2 illustrates how the total real returns of stocks outperformed significantly returns of bonds and Treasury bills over the time period from 1926 through 2000. One dollar invested in each of the aforementioned investments had markedly different returns when adjusted for inflation. For a one-dollar investment in small-company stocks, the total accumulated value would have increased to over $500, whereas a similar investment in large-company stocks would have returned $150 over the period. Real returns on Treasury bills, long-term Treasury bonds, and corporate bonds were $1.50, $3.79, and $5.50, respectively. These returns illustrate how compelling stock investments are over long time periods.

You can draw the following inferences:
For stock investors, a long time horizon is needed to reduce the risk of loss.
In order to earn greater returns over a long time horizon, stock investors should not focus on the volatility of annual returns, which may be thought of as bumps in the road to larger overall returns.
Losses in the stock market are hardly noticeable over long periods of time.
Small-company stocks earn larger returns than largecompany stocks over long periods of time.
For short time horizons, bonds and Treasury bills might outperform stocks.
Bonds earn larger returns than Treasury bills (money market securities).
Investing in common stocks offers federal tax benefits not available to bond and money market investors. Dividends from common stocks are taxed at preferential federal rates (lower than marginal tax bracket rates), whereas interest from bonds and money market securities are taxed at the holder’s marginal tax bracket rates.

Table 1–1 lists some of the reasons why you should consider investing your long-term money in stocks to earn larger returns than those of bonds, Treasury bills, certificates of deposit (CDs), and money market mutual funds.

Investors with a long time horizon (more than five years) who can withstand the risk of loss owing to down markets should invest in stocks. Investors with shorter time horizons who need to earn current steady streams of income from their investments and who are risk-averse should invest in bonds. The types of securities that you invest in are determined by your financial objectives and your personal characteristics.

Table 1-1
Major Reasons to Save More and Invest Wisely

* People are living longer and need more money to fund retirement.
* Health care, education, and insurance costs are rising.
* Real estate and housing prices have risen steadily.
* There is a need to get ahead of inflation and improve standards of living.
* People want to accumulate wealth to pass on to heirs.
* The more you save and invest now, the greater is your purchasing power owing to compounding.
* Investing wisely increases your wealth.

KEY CONCEPTS

Why you should invest in stocks
Developing your financial plan
What investing in stocks can do for you




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