One of the more difficult concepts to grasp for new investors is what to expect in the way of investment return when investing in equities. Those who are extremely cautious may get discouraged when they have been investing for a year or two and see the value of their investments decline. They are used to the steady growth of a savings account.
Likewise, other investors sell stocks when they have achieved a small return – say when a stock goes up by 10% – because they figure a 10% return is good, once again compared to what they would get in a bank account, and they should lock in the profit. While a 10% gain may seem like a good return when compared to a bank CD, it is a small gain for a stock position that can easily return a thousand percent or more over a period of several years. If you are constantly selling stocks when you get gains of only 10%, regardless of the underlying fundamentals of the company, you’ll sell off all of your winners and end up with a portfolio of losers.
The concept of return from equities is very different from that from a bank CD. Buying CDs is saving – putting money away and trying to preserve its value. You know that the money will be there when you need it and you receive a small but predictable amount of interest to help keep up with inflation. Because CD rates never actually keep up with inflation, you could also choose to buy something like gold if you wanted to preserve the value of your savings for a long period of time. For example, if you wanted to bury wealth for your great-grandchildren to dig up some day in the backyard, there are few better ways to store the wealth than in a bar of gold.
Saving is like putting a stick in a pond. It just sits there, perhaps being blown around now and then but it never really goes anywhere. It is predictable and boring, but it is safe.
Investing, on the other hand, is not predictable, at least for short periods of time. You can never really predict what the value of your investment will be on any given day, week, or month. One day you may be up a few percent, the next you may be down a bit. Unlike the bank CD where you can calculate out the interest you’ll receive to the penny, the best you can do with equity investing is predict your return over long periods of time based on what returns have been in the past.
Investing is like throwing a stick into a river. Some rivers are more docile like the Mississippi, where your stick will travel slowly but fairly steadily downstream. Others are like the Colorado coursing through canyon land, filled with rapids and eddies. At times your stick will shoot lightning fast through a jetty between the rocks, and other times it will drift slowly through a deep pool.
All rivers have eddies, and sometimes your stick will actually drift upstream for a ways. If you were to throw your stick into the stream near one of those eddies and then pull it out again quickly, you might think that the river flows upstream and you would be better off leaving your stick in a pond where at least it would not lose ground.
While you cannot predict where your stick will be at any given time, you can do a fairly good job at predicting how far it will travel over long periods of time. This is because while there are various eddies and rapids in the river, such that the speed changes frequently if you focus in, if you move far away from the river you’ll see that the water is always being pushed downstream at a fairly regular rate.
Likewise, if you purchase a stock or a mutual fund and watch it from day-to-day, you’ll see all kinds of fluctuations. Sometimes it will even decline in value – sometimes by quite a bit. If you back away and look over long periods of time, however, you’ll find that the value always tends to go up and by rates that far exceed what you can get through saving. This is because while businesses have good and bad periods, and while the price people are willing to pay you for a share of stock fluctuates depending on the mood of the buyers, businesses that survive always tend to grow and expand. If you buy a mutual fund, some companies will fail and be removed from the fund, but the others that survive will grow and drive the value of the fund as a whole up.
The other way in which the market is like a river is that most of the progress is made during very short periods of time. In a river like the Colorado there are deep pools that may stretch for miles in which you would think you are not moving at all if you were floating in a raft. Every so often, however, there are short stretches in which the river becomes shallow and, because the flow rate of water is constant, you speed up to several miles per hour and shoot between the rocks.
Likewise, stocks tend to trade within a narrow range for a long period of time and then suddenly shoot up by several points. This is the reason you don’t want to try to time the market and jump in and out. If you miss one of these rises your return can drop from 15% to five percent or less. Big gains are made quickly.
So stop looking at returns like bank returns. Even looking at percentages is not really appropriate. Instead, watch the flow of the river and realize if you get stuck briefly in an eddy, the water will all make it downstream at some point. Just stay your course and hold on for the ride.
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Disclaimer: This blog is not meant to give financial planning or tax advice. It gives general information on investment strategy, picking stocks, and generally managing money to build wealth. It is not a solicitation to buy or sell stocks or any security. Financial planning advice should be sought from a certified financial planner, which the author is not. Tax advice should be sought from a CPA. All investments involve risk and the reader as urged to consider risks carefully and seek the advice of experts if needed before investing.
Photo by Mihai Tamasila Website http://mihaitamasila.blogspot.com/