Some of you are still unconvinced of the uses and appeal of the stock market. Any financial planner will tell you that you should not start investing in the stock market until you have three months living expenses set aside in a liquid account, so don’t interpret my advocacy of the stock market for long-term investment to mean that you shouldn’t have any money in the bank.
Looking at the market objectively is harder than either the bull or the bear thinks.
In this lesson, we will look at history and see what has really happened over the years with stocks, Treasury notes and bank CDs, and then you can decide what you think with real information rather than just a bundle of prejudices. Remember what I said the first night of class — critical thinking is the hallmark of an educated person.
In the chapter, we look at the historical return of various important classes of investment. Since the stock market is not a monolithic institution, but is made up of equities of various levels of risk and financial stability, we will divide up the stocks into classes and look at the history of those classes for both risk and reward. Not surprisingly, those that have been the most volatile and risky are also those that have had the most reward potential.
The Ibbotson chart on page 279 illustrates the difference in return on various asset classes. Please note that the vertical axis of the chart is logarithmic. What that means is that the difference between $1 and $10 on the chart is as tall as the difference between $1000 and $10,000. For that reason, psychologically the chart understates the difference between the returns on the various classes. Look at the final numbers. $1 invested in 1925 in Treasury bills would now be worth $15.64. Remember that yields on T-bills are closely tracked by CDs. On the other hand, $1 invested in small company stocks would not be worth $6,640. Or, $1,000 invested then would now be worth more than $6 million! The relationship is such that if you used a linear scale of $1 = 1 inch, the return on small company stocks would be more than a tenth of a mile high. This doesn’t mean that you could buy one small company stock — it is a diversified portfolio of small company stocks, some of which would surely fail and others that would be up much more than six thousand times.
Small company stocks are also the most risky of the various asset classes, and that illustrates a very important financial principle: High Return requires high risk. However, the longer the period that you have before you have to liquidate your investment, the less your risk of loss becomes.
Now, since most of you are in your 20s or 30s, when you think about investments in 401(k) or IRA accounts, what asset class do you think makes the most sense?
Once you start investing, one of the things that you need to do is be able to calculate the return on an investment. What percentage return did you REALLY get? Just as we found that loan rates were not always what they seemed, rates of return on investments can be figured in various ways. The second part of this chapter discusses the various methods of computing return.