by audiostar » Wed Mar 12, 2008 6:33 pm
I hope this helps. This is an excerpt of an article I did for Lehman Brothers in April last year. Yours trully was requested by Lehman's Philippine agent, Roberto Herrera-Lim to do an article on the feasibility of holding on to stocks for the long haul. I deleted some technical stuff in this post.
Cheers!
In the long run, the rewards of investing in stocks can outweigh the risks.
It is widely known that individual stocks tend to have highly volatile prices, and returns you might receive on any single stock may vary wildly. If you invest in the right stock, you could make bundles of money.
On the downside, since the returns on stock investments are not guaranteed, you risk losing everything on any given investment. There are hundreds of recent examples of dot-com investments that went bankrupt or are trading for a fraction for their former highs. Even established, well-known companies in the U.S. such as Enron, Worldcom, and Kmart filed for bankruptcy, and investors in these companies lost everything.
Between these two extremes is the daily, weekly, monthly, and yearly fluctuation of any given company’s stock price. Most stocks won’t double in the coming year, nor will many go to zero. But do consider that the average difference between the yearly high and low stock prices of the typical stock on the Philippine Stock Exchange is about 60%.
In addition to being volatile, there is the risk that a single company’s stock price may not increase significantly over time.
Clearly, if you put all of your eggs in a single basket, sometimes that basket may fall, breaking all the eggs. Other times, that basket will hold the equivalent of a winning lottery ticket.
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One way of reducing risk in investing in individual stocks is by holding a larger number of stocks in a portfolio. However, even a portfolio of stocks containing a wide variety of companies can fluctuate wildly. You may experience large losses over short periods. Market dips, sometimes significant, are simply part of investing in stocks.
For example, consider the Philippine Stock Exchange Index, a basket of about 30 of the most popular and some of the best, companies in the Philippines. If during the last 20 years you had held an investment tracking the index, there would have been six different occasions when that investment would have lost 10% or more of its value.
The yearly returns in the stock market also fluctuate dramatically. The highest one-year rate of return of 224% occurred in 1986, while the lowest one-year rate of return of negative 41% occurred in 1997. It should be obvious by now that stocks are volatile, and there is a significant risk if you cannot ride out market losses in the short term. But don’t worry; there is a bright side to this story.
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Despite all the short-term risks and volatility, stocks as a group have had the highest long-term returns of any investment type. This is an incredibly important fact! When the stock market has crashed, the market has always rebounded and gone on to new highs. Stocks have outperformed bonds on a total return (after inflation) basis, on average. This holds true even after market peaks.
This is the whole reason to go through the effort of investing in stocks. Again, even if you had invested in stocks at the highest peak in the market, your total after-inflation returns after 20 years would have been higher for stocks than either bonds or cash. Had you invested a little at a time, not just when stocks were expensive but also when they were cheap, your returns would have been much greater.
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Just as compound interest can dramatically grow your wealth over time, the longer you invest in stocks, the better off you will be. With time, your chances of making money increase, and the volatility of your returns decreases.
The average annual return for the Philippine Stock Exchange Index for a single year has ranged from negative 41% to positive 224%, while averaging 28%. After holding stocks for five years, average annualized returns have ranged from negative 16% to positive 76%, while averaging 20%. Finally if your holding period is 20 years, you never lost money, with 20-year returns ranging from positive 18% to positive 28%, with the average being 24%.
These returns easily surpass those you can get from any of the other major types of investments. Again, as you holding period increases, the expected return variation decreases, and the likelihood for a positive return increases. That is why it is important to have a long-term investment horizon when getting started in stocks.
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While historical results certainly offer insight into the types of returns to expect in the future, it is still important to ask the following questions: Why, exactly, have stocks been the best performing asset class? And why should we expect those types of returns to continue? In other words, why should we expect history to repeat?
Quite simply, stocks allow investors to own companies that have the ability to create enormous economic value. Stock investors have full exposure to this upside. For instance, would you rather lend the Philippine government money at today’s 7% interest rate for the next 10 years, or would you rather be an owner, seeing the value of your investment grow several hundred fold?
Because of the risk, stock investors also require the largest return compared with other types of investors before they will give their money to companies to grow their businesses. More often than not, companies are able to generate enough value to cover this return demanded by their owners.
Meanwhile, bond investors do not reap the benefit of economic expansion to nearly as large a degree. When you buy a bond, the interest rate on the original investment will never increase. Your theoretical 10-year loan to the Philippine government would never have yielded more than 7%, no matter how well the country did. Being an owner certainly exposes you to greater risk and volatility, but the sky is also the limit on the potential return.
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While stocks make an attractive investment in the long run, stock returns are not guaranteed and tend to be volatile in the short term. Therefore, I do not recommend that you invest in stocks to achieve your short-term goals. To be effective, you should invest in stocks only to meet long-term objectives that are at least five to ten years away. And the longer you invest, the greater your chance of achieving the types of returns that make investing in stocks worthwhile.