It is fairly often that I hear someone say their money isn’t in the stock market because they could lose it all. Instead, they prefer to place their money in high-yield savings accounts (HYSAs), CDs, or a super-conservative fixed income fund. Let’s talk about why this thinking is flawed and how it can guarantee a failure to launch for your retirement.
Historical stock market returns
I’m going to talk about the market via the major indices, since that is the easiest benchmark by which we can measure success or failure. The Dow Jones inception year was 1896. Since then, average annual returns have been 5.4%. That’s not to say there haven’t been significant periods of downturns, but regardless of this the average annual return is still 5.4%. The S&P 500 has boasted a 10-11% return since its inception in 1926. So an investor that started investing in the S&P 500 in 1926, would be very, very old, and very, very wealthy. We like wealthy. Going forward, I’ll use the 5.4% and 10.5% in a couple of examples.
The power of inflation
Inflation is a powerful force that many people don’t pay much attention to, though they should. Over time, inflation can actively lower the purchasing power of the money you currently have. For example, if you put $20k in your safe for 5 years, and during that 5 year period we experience 10% worth of inflation (2% per year), your $20k now has $18k worth of purchasing power. Crazy, right?!? By the way, this is a completely realistic inflation estimate. Now let’s remember that the Dow returned an average of 5.4% since 1896. At the same time, we averaged 2.8% inflation annually. That means if you had $100 in 1896, you would need almost $3,100 in 2020 in order to have the same purchasing power. This is the problem with leaving money uninvested – it doesn’t grow. Let’s look at the example below to see how someone would have done investing that same $100 in the stock market.
Example: $100 invested in Dow in 1896
Return: 5.42% annually on average
End Balance: $69,575
As you can see, the individual that invested the $100 in the Dow in 1896, outpaced inflation by a significant amount. Remember, your $100 would only need to grow to $3,100 in order to maintain its purchasing power. We have returned nearly 22 times that amount by investing in the stock market and allowing market forces to work. We’re only talking about $100 here! Just think if $1,000 was invested in the same year and left untouched for a century – it would be worth almost $695k.
Now let’s look at the S&P 500. By tracking this index, your $100 investment in 1926 would turn into $1.3MM. Yes, you heard that right – a measly investment of $100 can balloon in excess of $1MM in 95 years. I know, you’re probably thinking you don’t have 95 years of time to invest since you’re already 30 and just reading this article. But fear not, even if you did this same thing at age 30, you would have approximately $65,800 by the time you turned 95. CRAZY!
Disclaimer: there are variables in this that I am not accounting for, such as dividends, taxes, varying periods of bull/bear markets, etc. I used the 5.4% and 10.5% average return for simplicity to show the huge advantage investors can gain by participating in the stock market.
Investing in stocks is REALLY easy
So now you are left wondering what you are supposed to do with all of these information bombs I just dropped. Well, luckily for both of us, investing in stocks is easier than ever. All you need is a brokerage account and we have a multitude of low-cost brokerage firms available to use. These include Vanguard, Fidelity, Schwab, and many others. Opening accounts at any one of these brokerages is easy, and can normally be done online in a couple of minutes. Each of these firms offer their own low-cost index funds in both ETF and mutual fund form, as well as target date funds, and individual stocks. Index funds are broad funds that aim to match the benchmark they are attempting to replicate, i.e. the Dow Jones or S&P 500, etc. So, theoretically, if you could have bought a Dow Jones index fund in 1896, you would have experienced returns very similar to the 5.4% previously mentioned. Would it be identical? No. But the results would be very close.
Short vs. long-term
Even though we can show a 5.4% return over 124 years, the stock market as a whole does come with risks, and individual stocks are even riskier. So putting your savings account that is earmarked for a down payment on a home in 3 years into stocks is extremely risky. This is why the rule of thumb is that short-term investments should not be placed in the stock market. For example, the Dow experienced losses of 6%, 7%, and 16% in 2000, 2001, and 2002 respectively. Had you invested the down payment for your home in 2000, you would have lost 29% of your money. In 2003, the Dow returned 25%, but what if you found a home you loved before that recovery? I’m not writing this to stoke fear or predict that this will happen to you, but rather, set realistic expectations on what to expect from stock market investments.
Personally, I love Vanguard funds. But recently, I love Fidelity a little bit more due to their app and user interface. I currently hold 100% Fidelity Total Stock Market Index Fund (FSKAX) in my Roth IRA and a mix of FSKAX and Tesla in my HSA (note that Tesla is the ONLY individual stock I own). I will probably continue to hold FSKAX exclusively in my Roth IRA until a few years out from retirement. Vanguard has a similar fund called the Vanguard Total Market Index Fund (VTSAX), which is so comparable that you likely would never see a difference in the two. The Schwab Total Stock Market Index Fund (SWTSX) is their version of these same funds with their own brand applied.
Planning for the future
As with everything else we talk about here at The Wealthy Idiots, the content here should be incorporated into your overall financial plan. For my wife and I, our plan is to continue to hold a large quantity of stock investments for the remainder of our life. Due to this investment being spread over 25-50 years, we feel the risk is minimal. This is just one piece of our plan as we are also including social security, pensions, and real estate holdings. Whatever you choose to invest in personally, just make sure you’re assessing your own risk tolerance and ensuring it aligns with your short and long-term goals. Happy investing!