You may be hesitant to invest in the stock market because it feels too risky. However, consider the risk you are taking with your financial future by avoiding the stock market. The primary reason to invest in the stock market is the potential for a much higher return, especially in low interest rate environments. Most of us need the potential for long term growth provided by the stock market to meet our retirement needs. If you invest all of your money in fixed income you may struggle just to keep up with inflation and you run the risk of outliving your money.
Historically, stock market returns have been almost double those earned by bonds. According to the Ibbotson SBBI (stock, bonds, bills and inflation) report, between 1926 and 2014 the average annual return on Small Stock was 12.3%, Large Stock was 10.1%, Government Bonds was 5.5%, Treasury Bills was 3.5% and Inflation was 3%. This illustrates that investing at least some of your portfolio in stock can provide a much greater opportunity than fixed income to meet your financial goals.
Investing in the stock market is not without risk. As with all investments, we must take on greater risk to earn a greater return. However, there are many ways to help manage the volatility of the stock market. Before investing in stocks make sure your financial affairs are in order. Pay off your credit cards, establish an emergency fund and put money that will be needed over the next five years into less volatile fixed income investments. The stock market is for long term investing. It can provide the opportunity to earn higher long term returns but you can count on some volatility along the way. By creating a buffer to cover short term needs you will be less likely overreact to fluctuations in the market and sell when the market is down.
You can also buffer stock market risk by creating a well-diversified portfolio comprised of mutual funds invested in stocks or bonds from a variety of different size companies, different industries and a variety of different geographies. Investing in a single company can be very risky but investment in mutual funds can reduce this risk. When investing in mutual funds your money is combined with that of other investors and invested, by a professional manager, into a large number of stocks or bonds. Investing in a large number of companies enables you to spread out your risk.
Dollar cost averaging, where you automatically invest a set amount on a regular basis – usually monthly or quarterly, can also reduce risk. Rather than investing a large amount all at once, when the market may be high, you gradually invest over time. With dollar cost averaging you buy more shares when the market is low and fewer shares when the market is high.