Note: Every individual has different parameters, such as different risk tolerances and therefore, my advice is not necessarily suited to you. Please read disclaimer at bottom.
First Reason to Invest in Stocks: Stocks Outperform
The following chart shows how stocks in the past have not only outperformed housing, but significantly outperformed it. In 26 years, it outperformed housing by more than twice as much. This is despite two significant bear markets.
The data is similar in other countries, such as Canada. According to RBC’s chart below, stocks averaged 9.6% per year for 20 years. Note that this chart, not only includes two bear markets, but also includes a 14 year housing bubble that has not burst. Despite this, stocks still outperformed housing by an average of 4.6% per year. If it did not include the bear markets in stocks and the housing bubble, stocks would have outperformed by a far wider margin.
What fuels stocks?
One word: PROFIT.
Businesses have produced profits for hundreds of years and will produce profits for hundreds of more years.
Let’s look at an extremely simple example to explain how profits fuel stocks. Let’s assume that there are 10 fruit businesses making $1 of profit each per year and they put this profit into the bank. After one year, you can say that they are worth $10 because they have $10 in the bank. After 5 years, they are worth $50. After 100 years, they are worth $1,000.
This means that businesses can theoretically go up forever.
Have you ever started or owned a business? If so, then you have invested in a business. Can you relate to the profit argument?
To not invest in stocks is similar to making a bet that businesses will stop making profits forever. There might be a probability for that, but an extremely low one.
There is another reason profit is so important. Profit makes it easier to value a business.
Second Reason to Invest in Stocks: You Can Value a Business
You can value a business based on many metrics, thanks to profit. In this simple example, we are using one metric: cash in the bank. Based on this metric, these businesses are worth $50 in year 5.
Stocks is simply a part ownership of that business and a reflection of the value of the business.
How do you estimate what the businesses will be worth in years 10 or 15? If you think people have been buying fruits for the past 50 years, then most likely people will continue buying fruits for the next 5-10 years.
You won’t be exactly right, but there is a good probability that these businesses will be worth approximately $100 in year 10.
However, valuing any other type of asset or investment is hard.
Third Reason to Invest in Stocks: Hard to Value Other Assets
Other assets do not produce profit.
The value of most other assets, other than businesses, is usually based on supply and demand. How do you estimate future supply and demand and hence future value?
According to Investopedia, the factors that drive the price of gold are central bank reserves, value of the U.S. dollar, worldwide jewelry and industrial demand and gold production. Can you predict what the central bank is going to do or the direction of the U.S. dollar? Can you tell me what the value of gold should be?
Some people say that the economy and OPEC affect the price of oil. Can you guess where the economy is going? Can you guess what OPEC is going to do next? Yes, you can guess, but how high of a probability is it that you will be right? Hence, how confident are you that you will be right?
If you buy something based on a guess, then you are relying more on chance than on confidence. You are speculating instead of investing. It is like the difference between roulette and poker. Roulette is based mainly on chance. Poker is based on skill and chance. When you play poker, you can still lose money, but you know that you have a better chance of making money when you are holding a pair than not. You can make money with roulette, but you should know which game you are playing and the difference in probabilities. Note that the richest people in the world are investors, not speculators.
Fourth Reason to Invest in Stocks: Diversify
Some people speculate only in real estate. However, we saw what can happen when a bubble bursts. Some people speculate heavily on gold. However, gold have been dropping for two years. Therefore, it makes sense to diversify and stocks is a good diversification as stocks have outperformed most assets in the long-term.
But the Stock Market is Volatile!
The one aspect of stocks that keeps most people away, is the volatility.
According to Leon Cooperman, a billionaire investor, “75% of the trading volume” has nothing to do with the valuation of the companies. This trading is mainly done by High Frequency Traders and ETFs.
The stock market, on a short-term basis, is driven by fear, greed and short-term results. This causes stocks to be undervalued and overvalued. Traders or fund managers in November 2008 may think that stocks are undervalued at that time, but they also think that prices are going lower. Since they want or need good results for December 31, 2008, they sell, which drives the prices lower, even if they think that over the next couple of years, the stocks will be fairly valued.
The market undervalued stocks in 2009 and it overvalued stocks in 1999-2000 with the dot-com stocks. But, in the long run, it always tracks value.
I will give you the same example as I gave in How to Beat Hedge Funds and Warren Buffett on how a stock can be undervalued. Las Vegas Sands was trading at $80 to $100 in 2007. Then we had the great recession. In every recession, consumers spend less on discretionaries, such as gambling, than staples such as food or utilities. Then Obama exacerbated the problem when he censured Wall Street firms for still holding conferences in Las Vegas. Investors interpreted this as: Obama does not want Americans to go to Las Vegas. LVS plunged from $80 to an extreme under-valuation of $2. This means that if you had enough money to buy out Las Vegas Sands completely, shut down the company, sold all of its assets and paid off all of its debt, you could have pocketed over a billion dollars. If you are not able to buy out and liquidate LVS, then you would buy its stock. If you are a rational investor, you would know that gambling has been around for 5,000 years and humans will continue to gamble for thousands of years after you’re dead. Therefore, you would know that gambling and conferences will return to Las Vegas. As with the fruit business example, humans have been and will continue to consume fruits and gambling for thousands of years.
The following is another example. This is Starbuck’s stock. The black line represents the stock price. The blue line represents Starbuck’s profits and is only one metric that represents the value of the business. As you can see, the value of the business kept increasing, with a slight dip in the recession, because Starbucks made profits. The stock was overvalued in 2006, undervalued in 2009 and then fairly valued in 2013.
This shows that 2009 was a great opportunity to buy this and many other stocks. Instead, many people panicked in 2008-2009 and sold when stocks were undervalued.
If a business continues to make profits, the stock will always track the value of the business eventually. This is a certainty. The stock cannot go to zero if the business makes profits. If you are invested in the fruit business, you will be confident that humans will consume fruit for thousands of years into the future. If the business generates profits, the stock cannot go to zero.
Therefore, what you should always focus on, in the stock market, is the value of the businesses. If the price is too low compared to value, you should hold or buy more. If the price is too high compared to value, you should hold or sell. You should know that Mr. Market, who throws prices at you, is bi-polar and manic-depressive.
Read Allocate 100% to Stocks.
For many people, picking stocks is too much work. The next best thing is an ETF that tracks the index.