A whopping 90% of stock market day traders lose money, and many of their losses make incredible headlines. Think of stocks like GameStop, AMC, and Tesla. You hear about them all the time because their wild price swings make some traders millionaires while decimating other’s fortunes. One college student even committed suicide after seeing a negative balance of over $700,000 on his Robinhood Trading App.
All of this stock market drama probably has you asking, “is investing in stocks worth the risk?”
Risk vs Return
Making money in the stock market is all about weighing an investment’s risk against your expectations of a return. This is called the risk-return tradeoff. In general, when the risk of an investment is higher, you should expect a higher return for taking on more risk and vice versa.
The investments that make headlines are usually incredibly risky. This is why some of the people who invest in these risky assets make an absolute killing, while others lose it all. That’s the nature of risky investments. They give us FOMO because we see people become millionaires overnight by investing in a single meme stock. Unfortunately, this FOMO often leads people to buy into an investment once the price has already peaked, and then lose everything when the price drops. The good news is that the risky stock market investing strategies used to make headlines aren’t the only ways to invest in stocks.
Trading vs Investing
Trading is the stock market strategy that we always hear about. It involves choosing individual stocks to invest in when the price is low and then selling that stock when the price rises. Traders typically only hold a stock for a few days, hours, or sometimes minutes before selling.
The problem with this strategy is that it is nearly impossible to predict how a stock’s price will fluctuate in the short term. And if traders tell you differently, they’re lying. As was mentioned earlier, about 90% of day traders lose money. That means nearly all day traders are unable to predict how a stock’s price will fluctuate, and with those odds, you probably can’t either.
Investing is the alternative to trading. It involves building a diversified portfolio of many different stocks and holding those stocks for years or decades. By spreading your investments across many different companies, or diversifying, you reduce your odds of losing money because a larger portion of your investments has to perform poorly to generate a loss.
For example, let’s say that your friend invests all of her money into a single company, while you invest your money into an S&P 500 ETF. By choosing that ETF, your money will be invested in all 500 companies that make up the S&P 500. If only one of those companies is struggling, you have the other 499 to keep you afloat. Your friend, on the other hand, only has one company working for her and that means if they do poorly, so does she and vice versa.
Actively Managed Funds
When it comes to investing in diversified investments, there are two types of funds you can invest in. The first is an actively managed fund. These funds are curated by financial institutions to try to beat the market. That means that if the S&P 500 index, which is widely accepted as the best gauge for the overall US stock market, has a return of 10% this year, an actively managed fund tries to earn its investors a return greater than 10%.
The problem is that these funds often fail. Over a 15 year period, more than 91% of actively managed funds underperformed the S&P 500. Because of the research and analysis required for a fund manager to try to beat the market, they charge much higher fees, or expense ratios, to investors. These high fees substantially eat into your investment returns over time and can cost you hundreds of thousands or millions of dollars over several decades.
Passively Managed Funds
To save on fees, make higher returns, and reduce your risk, you can invest in your second diversified investment option, a passively managed fund. These include index funds and ETFs that track an underlying set of investments and provide the same return as those investments.
For example, if you invest in an S&P 500 ETF, the fund will provide you with the same return as the S&P 500 index. Because the fund manager doesn’t need to spend time researching and analyzing data to try and beat the index, the fees for passively managed funds are much lower. That means more of the returns you receive for taking on the risk of investing go into your pocket.
And if you stay invested in an S&P 500 fund for several decades, you have almost zero chance of losing money. In fact, the S&P 500 has had a positive return in all 20 year periods from 1872-2018. This is where the time factor comes into play.
In the short term, the stock market fluctuates wildly. For several months or even years, the S&P 500 can produce negative returns. If you only stay invested for a short time, even in a diversified investment, you risk losing money. The longer you keep your money invested, the lower and lower the probability is that you will lose money. You’ll at least break even.
But why even take on all of this risk and put in this effort to just break even? In a simulation of 10,000 investors that NerdWallet ran, based on the historical returns of the S&P 500 and Treasury bonds, investors had a 95% chance of earning nearly 3x their initial investment, while traditional savers had a less than 3% chance of doing the same.
So is investing in stocks worth the risk? If you invest in diversified, low fee funds, for several decades, and are almost guaranteed to nearly triple your money, then yes. Investing in stocks is 100% worth the risk.