Ask most people whether it is more risky to invest in the stock market or to put money in the bank and they’ll instantly say that the stocks are more risky. Obviously you can lose money in the markets, so it is more risky to invest than it is to put your money in the bank, right? Believe it or not, the answer to this question is, “it depends.” To understand why, one needs to look at the different types of risk.
It is absolutely true that if one puts $1,000 in the stock market and withdraws it a few days later he is taking a lot more risk than he would be if he put the money in the bank instead. While he would probably not get any interest over that short a period of time, he could expect with a high degree of likelihood to be able to withdraw his money in a few days from the bank and get back the full amount he deposited (unless there was a fee).
On the other hand, if he put the money in the stock market, the odds are no better than they would be on the roulette table that he would be able to get at least his money back in a few days. In fact, it is likely that he would have less money in a few days because he would need to pay brokerage fees and other expenses when he bought and sold the shares. As soon as he put the money into the market he would have less than he started with.
What if a person puts money in a bank account for twenty years, however. Back in the 1980’s you could get a Coke from a vending machine for 45 cents. A state college might cost $1500 per semester, and even the private colleges cost only about $10,000 per semester. If you put $1000 in the bank in 1980, at 3% interest, you would have about $2000 in the year 2000. The price of a Coke, however, had gone up to a dollar or more. State schools would run $5000 per semester or more, and private colleges were often $25,000 per semester or more. Because the rate of inflation is slightly more than the interest paid by the bank, the person would have more dollars numerically but would be able to buy less with those dollars.
What if that person put the $1000 in the stock market? In 1980 the S&P500 was at $136. In 2000 it was at $1380. It had gone up by more than ten times in the amount of time it took money in a bank account to double.
Granted, the 1980’s were a spectacular time for the stock market. Taxes were lowered and the hyper inflation from the 1970’s was defeated, resulting in a huge expansion of the economy and a big run-up in stock prices. The 1990’s were also spectacular, despite a short recession from 1990-1992, because of the widespread expansion of the Internet in the mid to late 1990’s. Still, even during less spectacular times over long periods the stock market has returned between 7 and 12% per year, while bank accounts have consistently had negative returns of about -0.5%, taking inflation into account.
The reason is that while it is difficult to predict the business cycle, over time the value of businesses increases in numerical terms simply because the fundamental value of a business will increase with inflation. Furthermore, if the business also expands and starts making greater profits, the value of the business, even adjusted for inflation, will increase. On the other hand, banks will pay an interest rate that is slightly less than inflation, and therefore the money left in banks will decrease in value over time.
So, short-term it is more risky to invest and one should be in cash. Over long periods of time, however, it is much safer to be invested than to hold cash. The likelihood of having less if invested in a diversified manner is very low, but you are certain to have less if money is held in the bank.
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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.