Monday, October 06, 2008

Why Invest?

With all my cautionary tales about the stock market, it's a wonder that anyone even bothers to invest, much less in the stock market. Why bother, when a long term savings or FD is practically riskless and gives a steady return?

Here's the reason: you invest because over time, all other things being equal, your money is worth less.

We've all heard about inflation, that 3-5% per annum force of economic nature. Simply put, your money buys 3-5% less every year, year on year. In most situations, you're better off just buying whatever you want now, as opposed to next year, or over 25 years. Unfortunately, if you want to save your money for a future purchase, that money's going to be worth a lot less over time.

Compare. An FD or long term savings account gives you 1.5 - 2% per annum interest. Average inflation is about 3 - 5 %. That means you lose 1% on a good year, 3.5% on a bad year. That's slow death.

So why invest in a stock market? Because it pays the best over the long term.

The key here is to recognise that there is no free lunch. Whenever you choose a vehicle to invest in, you are taking a cost-benefit analysis of risk versus returns.

Think about it this way. FD's and long term savings plans pay low interest precisely because there are so many protections in place to ensure that the savings do not suddenly disappear. For example, banks are required by law to keep a certain sum of money available to support withdrawals from bank accounts. Even if the bank goes belly-up, you will get something back.

Stocks are different. Stocks represent ownership of a small piece of the company. If a company goes belly-up, you can be almost sure that you lose the money you invested, with nothing back. The upside is that when the company makes money, you make money too.

The second thing about stocks are that they are volatile like crazy over the short term. By volatile, I mean their prices generally fluctuate over a large range. Again, compare this to FD's. The returns of an FD general fluctuates between decimal places of a percentage point. The returns of stocks can be large gains OR large losses. Generally, volatility causes more people to lose money than gain it, because people tend to do things to avoid loss rather than consolidate gains. In other words, people tend to panic sell more when stock prices are low, but hold on to shares much longer than necessary to maximise their gains (another argument against short term investing).

However, it's a fairly well-known fact that over a long period of time, stocks outperform almost every other form of investment. We're talking anywhere from 7 - 15 % over the long term, year on year, and depending on your stock investment strategy. If you remember the inflation rates, that's almost 4 - 10% over inflation.

The implications of stock investing are as follows:
  1. Don't invest what you can't afford to lose in the stock market.
  2. Be honest with yourself about whether you can really afford to lose this sum
  3. Build a long term strategy for stock investment and stick to it. This is a "head-fake" to get your panic-sell and over-holding reflexes under control.
  4. Make sure it's a LONG TERM strategy. Hold those stocks for at least 15 years. That's the minimum amount of time you'll take to see long term gains on your stocks.
  5. Because you need to hold those stocks for such a long time, create an investment strategy that involves companies that will be around for the next 15 years or so.
That's the basic strategy for investing in the stock market. In future weeks I will be writing about my favourite fire-and-forget solution to investing in the stock market as a whole.

5 comments:

Savings Bond Calculator said...

Thank you for the nice post. Loved reading it. The way you have summed up the facts are impressive.

Khayce said...

Thanks!

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Pendragon said...

Let's see... 15 years... the only firms (pun intended) I can think of to invest in is Singtel, Singpost, Singapore Technologies, and AIA, Prudential, and perhaps Aviva. Mostly Nation-warded firms. I wonder if Mediacorp can be invested in?

Pendragon said...

or D&G? The corporation that makes SAF equipment?