Investing in the stock market in any form – stocks, bonds, individual companies – will never give you a guarantee that you’ll make money. When I first started investing, this was one of the scariest things to wrap my head around.
With a savings account, you’re guaranteed that your money you put in will be there tomorrow. Accounts at banks are even insured by the US Government so that even if the entire bank goes out of business, the government will step in and pay you back.
With stocks, there is absolutely no guarantee that the market will go up, or that it will be there tomorrow. In 2008, most people who had put all of their money with Bernie Madoff were left with absolutely nothing.
From 2000 to the end of 2001, Enron was engaged in scandal when it became public that the only reason they were making money was due to accounting fraud which showed massive profits at a time the company was actually losing money. At the time, Enron had earned the coveted “America’s Most Innovative Company” award for years running. The value of the company quickly dropped to $0. If you were invested in the company, your investment was now worth nothing at all.
Companies go out of business all the time. When this happens employees are left looking for new jobs and people who invested in those companies are left with pennies – if they’re lucky.
Even if there isn’t a guarantee that the market will go up, there is a trick that you can use to make sure you don’t lose all your money in the stock market – don’t invest in individual stocks! This goes back to those index funds I mentioned before.
Even if there are no guarantees of returns, there is a way to guarantee that you can get a piece of any total returns from the market as a whole. Let’s look back at the S&P 500 index over time.
We’ll look at the last 15 years for this, since that includes a big downturn (the great recession) and the tremendous bull market since then.
From 1/1/2005 – today, an investment in SPY, the S&P 500 index would have grown from $10,000 to $25,510 or 155%. That’s growth of 6.4% a year on average for that entire period that contains the downturn.
An investment of $10,000 in $VFIAX would have grown from $34,613 or 246% or 8.6% a year! That’s almost an extra 100% grown in the same period. So why?
The difference is that this graph includes dividends received from $VFIAX that are reinvested into $VFIAX and continue to grow, while the $SPY chart doesn’t include that.
A dividend is money paid by a company to it’s shareholders out of its profits or reserves. In the case of the $VFIAX, this dividend is the sum of all dividends received from the 500 companies invested in.
When you invest in an index fund, you won’t receive dividends from every single company that the index fund invests in. Instead, those companies will pay the dividend to the company that runs the mutual fund – in this case Vanguard – and Vanguard will issue you a dividend from that.
The return you’ll get will completely dependent on the index that it’s tracking. The S&P 500 index has been the best performing index during the last 10 years. For the 2000s, international indexes performed better. In the 90s it was technology index funds.
We’ll dig into this chart more later on when we talk about diversification. Of the last 15 years, the mean performance of index funds ranged from about 7.6% to almost 11%. These numbers don’t take into account inflation either, so the actual numbers are closer to 5.5% to 9% for stock market investments.
But will I lose money in the stock market?
It’s impossible to know for sure what markets will do in the future. We can look to the past and see that markets overall in the US have done well when you invest with a low-fee, diversified index fund for the long term, but even that’s no guarantee.
There will be recessions and stock market declines in the future, just like there have been in the past. During these times the people that lose the most money are those who sell during the downturn and then don’t reinvest back into the market until it’s already recovered. If you’re investing rather than speculating, a term we’ll talk more about – but which loosely means you’re trying to time the market rather than invest long-term – you’ll set yourself up for success.
Ok, takeaway time. Here are three things to remember from this section:
#1 – Index funds guarantee you’ll get a return that matches the market. This is one of the few guarantees you’ll ever get when investing.
#2 – Just like individual stocks, index funds fluctuate in value. They have up years and down years. Historically, the longer you hold an index fund, the closer your returns will be to the fund average.
#3 – Dividends are profits from a company distributed to it’s shareholders. Index funds collect all of the dividends from the companies it invests in and distributes them to you. You can choose to take these dividends as cash, which is handy if you’re retired and need the money or reinvest them back into the index fund.
The quote for this lesson is one about holding investments for the long-term.
Only buy something that you’d be perfectly happy to hold if the market shut down for 10 years.
Warren Buffett
This advice holds true for index fund investing. Invest in an index fund that you want to hold onto for 10 years – or even better the rest of your life. Depending on what type of account you’re investing in – a 401k, brokerage account, you may be required to pay taxes for changing funds. Don’t try to time the market – that’s the easiest way to lose money.
In the next lesson we’ll look into one of the biggest concerns people have about investing – the fear that we’re at a market high and there will be a recession any day now.