Is it safe to invest in stocks?
I hope so. I’ve got a ton of money invested in stocks so it better be safe.
If you consult books on investing in the stock market, most will tell you that the market returns somewhere around 10% a year including dividends. But they will also say that stocks are inherently risky.
So 10% per year is the average gain. There are also years when the market drops by 30% or 35%. In fact, the annual returns of most major market indexes are highly variable.
We’ll take a look at the returns over annual periods of some major indexes, one broad large-cap, one mid-cap, and one small-cap, and to remind ourselves, these would be the broadly accepted divisions between them.
- large-cap, any company that has a market capitalization over $10 billion
- mid-cap, any company with a market capitalization between $2 billion and $10 billion
- small-cap, any company with a market capitalization between $300 million and $2 billion
Companies below $300 million are often referred to as micro-cap. They tend to be thinly traded and so not as easy to buy and sell and are often on less-regulated exchanges. So since we are concerned here with avoiding risky stocks, we should be steering clear of mico-cap stocks.
First, we need to consider what kind of investor you are and then the main alternatives to investing in stocks.
What kind of investor are you
These are the questions we need to answer.
- What is your time horizon?
- what are your anticipated money inflows, or earnings?
- and when do you need to draw funds from your investment?
- Risk tolerance, how much risk are you able to tolerate
- Risk appetite, how much risk do you desire?
- Whether you want to leave a legacy behind?
If you can clearly articulate all the answers to the questions above, you are at least in a good place to start investing.
Anyway, for the moment let’s assume that you expect to be earning more or less consistently over the next 20 or 30 years and then you would want to start drawing down on your nest egg. That you will let your kids fend for themselves and that you are a bit unsure of your risk tolerance and your risk appetite which is why you are asking this question in the first place.
So we’ve established that you need to invest, or at least save, you know there is the stock market and you are concerned that it is risky, so what are the alternatives to stocks?
Alternatives to investing in stocks
Here are the main alternatives to investing in stocks
- Fixed interest investments
- Real estate
I suppose we could also consider cryptocurrencies but they haven’t been around long enough that we could be confident in the returns or in the safety of such investments.
Fixed interest investments
This is a big subject. There are a number of different kinds of fixed interest investments.
- Bonds, including government, municipal, corporate
- Preferred stock
- Certificates of deposit
- Mortgage-backed securities
- Certain mutual funds and interest-paying ETFs
- Savings accounts are a kind of fixed interest investment
The total amount of money investing in the bond market is estimated at over $100 trillion while the total invested in stock markets is around half that amount. So fixed interest investments are a big deal.
There is an important point with fixed interest investments. They are all linked to the Central Bank’s rate of interest that applies in whatever country where you live. In the US this is the Federal Funds Rate which is the interest rate banks charge each other to lend funds on a short-term, or overnight basis.
What is more, when we say a fixed rate of interest, that usually means that the rate we are paid is fixed for a limited period of time in relation to the central bank rate. Now if the rate is fixed for the life of our bond or certificate, then fine it is fixed. But the interest could be fixed for less than the whole period. If the rate could be adjusted every 6 months or every year and we are holding it for longer than that period then it is semi-fixed or effectively floating.
So then the question becomes, how much more does the bond issuer, or fixed interest investment issuer need to offer, over and above the central bank rate in order to entice customers to invest? The answer is that depends on how the market’s assessment of the riskiness of the investment.
Junk or investment grade
Sticking with bonds for the moment, at the risky end of the scale we find low-grade junk bonds rated at BB or lower while the other end of the scale, so-called investment-grade bonds will be rated AAA. These ratings are given by bond rating agencies and let investors compare one bond with another.
Low-rated junk bonds have a higher risk of default, while investment-grade bonds are nearly as safe as government-issued bonds guaranteed by the central bank, in the case of the US, Federal Government.
The important point here is that even with fixed interest investments there is a risk. There is the risk that the issuer of the bond will default and you will only receive some of the coupons or principal due back to you. That happens with junk bonds and with some municipal bonds.
If you have purchased long-term fixed interest investments there is also the risk that inflation will erode the value and your bond could end up being worth less when it matures than when you bought it. Even if you decide to sell your bonds in the bond market before they expire, the bond market will adjust the prices to reflect expectations of inflation.
The other fixed interest investments
The basic point with fixed interest investments across the board is that they are all linked to the central bank rate. This includes preferred stocks, mortgage-backed securities, interest-paying mutual funds and ETFs, certificates of deposit, and even regular savings accounts. The interest rates only increase when the riskiness of the investment increases. Since we are concerned with risk in the first place, this just means there is no free lunch to be had.
If interest rates are low, and right now they are at a historical low, then fixed interest investments are really only attractive as a store of value and not for any income-generating qualities.
A lot has happened in recent years to make investing in real estate more accessible to retail investors. It is an area that has its own dynamics and market trends. I actually think investing in real estate is a good way to diversify your investments as real estate markets are not going to track the stock market indexes.
You will find a common theme with investing that applies to real estate as well. The more you look for upside exposure to capital appreciation, the more you will be inevitably exposed to downside risk as well. What’s more, because real estate follows its own course if you are going to invest in higher-risk real estate then you will need to learn about the area in order to manage your risks.
It doesn’t make sense to buy other currencies as investments rather assets to trade for short-term profits. Of course, you can buy stocks or bonds in other currencies, but then you are adding the currency risk to the risk of the stock or the bond itself.
A lot of people trade currencies a lot of the time. The foreign exchange, or Forex markets are available round the clock today, and like the bond market, the volume of trading on the Forex exchanges far outstrips the volume of trading of stocks.
You will find people who claim to have made a great deal of money on the Forex markets, but you will find many more who have lost money. Also unlike stocks and bonds, there are no safe ways to buy regular amounts of value stocks or robust ETFs and reliably build a nest egg over a lifetime of earning.
Commodities are similar to currencies in this respect. There are ways to trade commodities for short-term profit, but your focus is more likely to be on technical trends in market prices rather than building value over time.
Yes, you can take a long-term view on precious metals or rare earth metals and build ETF positions that have high exposure to these commodities accordingly. But that is more like viewing certain commodities as a sector in the broader stock market and it will have risks associated with that sector.
If we think of straight cash as an investment, that is really saying that we expect the value of all other liquid assets to decline. This can be a good thing as part of an investment or trading strategy when you are trying to avoid being over-exposed to a market downturn.
But again, I would say this should be a part of an investment and trading strategy and not a long-term strategy in itself. That would be like hoarding banknotes under a mattress. The times that cash appreciates in value with respect to other asset classes are called periods of deflation. They happen but they don’t tend to last long. It is much more usual for the economy to be in a period of inflation, where cash is losing value with respect to other asset classes.
Back to stocks
So now that we have dealt with the alternatives, and they are all worthy of our attention in their own ways, what about our original question:
Is it safe to invest in stocks?
As I said before, let’s look at the returns over a long time frame of three groups of stocks, large-cap, mid-cap, and small-cap. For large-cap we will use the Standard and Poor’s 500 Index. For mid-cap, we’ll use the Standard and Poor’s 400 Index and for small-cap, we’ll use the Russel 2000 Index.
But first let’s look at the large-cap index that is the most followed by the general public, the Standard and Poor’s 500 Index. This is what the annual returns of the Standard and Poor’s 500 Index look like every year since 1929 immediately when the stock market crashed.
Even though the average returns were actually 7.77% over that long historical period, as the chart shows, the returns pretty much jump all over the place. If I can indulge a little more statistics, the standard deviation is actually 19% which is very high when you consider the average is only 7.77%.
It is hardly surprising that we hear so many stories of people who dabble in the stock market and are put off by big losses. If your entry into the market coincides with a big down move, that can easily be enough to dissuade the average beginning investor.
But what if our time horizon is much longer than a single year? This is what the average returns over successive periods of 10-years, 20-years, and 30-years look like. Since our data only starts in 1929, our 30-year average return starts in 1959.
Here we see that if your time horizon is 10 years, then you may need to be concerned with your timing if you are going to just invest in a large-cap indexed fund. Over rolling 10-year periods, since 1939 there were a few occasions when average annual returns dipped below zero.
Things are a little better if we have a 20-year investing window. The worst 20-year rolling period ended in 1949 when annual returns averaged 0.96%, i.e. just under 1%. I am sure this is why my grandfather had a very negative view of the stock market and wouldn’t put his savings anywhere near stocks.
There were also quite a few years when 20-year rolling average returns topped 10%. However, the 30-year rolling returns are consistently positive. The worse 30-year period ended in 1957 with average annual returns of just 5.68% while the best returns were over the 30-year period were 11.16% ending in 2004.
Large-cap vs mid-cap and small-cap
So how do things look when we compare the annual returns of the large-cap index with mid-cap and small-cap. Here the data only stretches back to 1985. This is what that looks like.
I think what we see here is that on an annual basis the mid-cap and small-cap indexes pretty much correlate with the large-cap index. Just from eyeballing the situation, small-cap seems to have higher peaks and lower lows and there was a period from about 1997 to 2003 when the indexes came a bit unhinged.
Generally, though we could conclude from the observation that they move in concert that they are subject to the same market sentiments. There is accepted wisdom that there are seasonal patterns when small-cap outperforms large-cap, but that is a subject for another time.
So as regards our original question, whether it is safe or not to invest in stocks, I think we can conclude that large-cap, mid-cap, and small-cap as a large group are more or less similarly risky.
One big caveat here, if you are going to be investing in a small number of stocks then be aware that individual large-cap stocks are going to be less risky than any individual mid-cap or small-cap stock.
A low-risk way to invest in stocks
If you are looking for a low-risk way to invest in stocks and you are starting with a small initial capital that you will build over time, then by far the best approach is to make regular monthly purchases of the same dollar amounts of a small group of low-volatility index-linked Exchange Traded Funds or ETFs.
Questions and answers
Q. Can you lose all your money in the stock market?
A. As we have shown in this article there are periods when stocks perform well, i.e during bull markets, and periods when stocks lose money i.e during bear markets. If you are unlucky enough to enter the market for the first time just before a bull market turns into a nasty bear market you will see the value of your stock holdings drop significantly. However, as we also note the stock market recovers after bear markets, and over the long-term stocks are profitable.
Q. How much should you invest in stocks first time?
A. Today most of the large brokerages do not impose a minimum and most will also allow you to buy and sell fractions of the stocks listed on the main exchanges. However, you also have to get real about investing. To build a meaningful nest egg you should be investing at least 10 to 15% of your income. But if you can only start with a very small amount like $50 or $100 then it is better to start with that than to delay.
Q. What is the safest stock to invest in?
A. If you are looking for the safest stocks you want to find low volatility stocks and preferably ones that pay dividends. Another very safe approach is to invest in an Exchange Traded Fund or ETFs that invests in low volatility stocks. Here is a list of low volatility ETFs.
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