How Investing in Stocks Can Make You Richer

 

By Dan Caplinger                  
    

Ever since the market meltdown more than four years ago, millions of people have been too scared to even think about investing in stocks. Admittedly, the financial crisis and ensuing stock market crash cost plenty of investors a huge portion of the value of their portfolios, leaving them with losses that many of them could ill afford to suffer.

But the potentially much larger negative impact that the financial crisis had is still being felt today. Because of the fear that the market meltdown brought with it, entire generations of potential investors believe that investing in stocks is akin to playing a rigged game. Those who have been too scared to put their money to work in the market have missed out on one of the biggest market rebounds in history, showing once again that when it comes to investing, stocks offer growth potential that other investments just can't match.

 

Looking at the alternatives

When you look at current conditions, the case for investing in stocks looks even more attractive. Keep your money in a savings account, money market mutual fund, or other cash investment, and you'll be lucky just to earn any interest at all. Consider the impact of inflation on the purchasing power of your cash stash, and you'll realize that every day of so-called safety you get from having money in the bank comes at the cost of long-term erosion of your money's true value. Even if you lock up your money for a relatively long period of time, 10-year Treasuries yielding 2.2% are barely enough to stay ahead of rising prices, and that's before considering the additional impact of taxes.
 

When you look back further, though, the evidence favoring stocks is even stronger. It's true that by cherry-picking certain time periods, you can find occasions on which stocks underperformed bonds and other investments. For instance, in the 30 years from 1981 to 2011, bonds beat out stocks in terms of total return. But that comparison used a particularly well-chosen endpoint favoring bonds, as interest rates in the early 1980s were well above 10% and have fallen dramatically in the ensuing decades.

 

But overall, looking at good periods and bad, stocks have delivered stronger returns by far than bonds or cash. According to figures from Ibbotson, the geometric average of returns from stocks has come in at 9.3% over the past 85 years, versus just 5.1% for bonds and 3.6% for cash.

 

What those numbers really mean

The problem with percentages, though, is that they don't tell the whole story. But when you plug in realistic numbers to go with those returns, you can see how important they truly are.

 

For instance, say you're able to invest $100 each month and get the average returns listed above. With stocks earning 9.3%, your nest egg would build up to about $196,000 in 30 years. That compares to just $85,000 for bonds and less than $65,000 for keeping money in cash over that time period.

 

As you can see, the higher returns on stocks build in a substantial amount of protection from adverse markets. Even if you earn 2 or 3 percentage points below the long-term average, you'd still likely outperform bonds and cash. And if you're fortunate enough to invest in a period when stock returns are greater than the long-term average, then you'll reap even bigger rewards.

 

How to invest in stocks without risking everything

With stocks near all-time highs, being prudent about which stocks to invest in makes plenty of sense. As you explore opportunities right now, focus on a few key ideas:

• Use index funds or exchange-traded funds to get easy diversification with modest investments. Broad-market ETF Vanguard Total Stock Market  (NYSEMKT: VTI  ) makes a good starting point for many investors because it provides a mix of U.S. companies of all sizes, avoiding the need to have separate funds to add stocks of small and mid-size companies. Adding other ETFs can further diversify into stocks outside the U.S., with iShares MSCI EAFE (NYSEMKT: EFA  ) providing broad-based exposure to stocks in some of the largest economies in the world.

• Look for short-term crisis situations with likely positive outcomes. For instance, Boeing (NYSE: BA  ) took a big hit after its Dreamliner aircraft's battery safety was compromised. For a few months, the aircraft was grounded, leading to intense investor fear. Yet the company rapidly resolved the problem, and investors have once again focused on the multitrillion-dollar potential for future orders over the next 20 years, rewarding value investors.

• Be careful with high-priced, high-growth stocks. They can be the best performers in your portfolio, but you'll suffer gut-wrenching moves along the way. Netflix (NASDAQ: NFLX  ) , for instance, soared to nearly $300 per share in 2011 before plunging 75% in the face of its ill-advised attempt to break up its DVD and streaming businesses into two separate companies. Just a couple of years later, though, Netflix has gotten its growth back, with higher prices having provided greater revenue and international expansion giving the company plenty of potential for future growth. The shares have more than quadrupled from their 2012 lows.

Step into stocks

Investing in stocks involves taking on more risk than many people feel comfortable with at first. But as a means to reaching your financial goals, owning stocks can help your money work a lot harder for you over the long haul.

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How to invest like Warren Buffett

By This Is Money

Warren Buffett is the world's third richest man with an estimated fortune of over $52bn.
But unlike the other billionaires that feature in Forbes' list of the 10 richest people in the world, Buffett doesn't have a retail empire, an oil well or a brain for computing to show for it - simply a lot of share certificates.
The 81-year-old made his money through identifying companies that he believed were worth more than their market value, investing in them and holding that investment for the long-term. And it's certainly paid off.
Class A shares in his company Berkshire Hathaway were $15 when he first took over in 1965 - they were valued at $103,500 per share by the end of August 2011.

Keep it simple: Investing the Warren Buffett way

It sounds remarkably simple, but given the ups and downs of the stock market, it takes a high level of discipline, nerve and conviction in your decisions.
Although Buffett has never written a book detailing his investment style (there was one authorised biography), much can be gleaned from the annual letter he sends to Berkshire shareholders.
He doesn't view the purchase of shares in a company as buying a stake in that business, but believes that the investor should feel that they are actually buying that business outright. Because of that he looks for quality management, a durable competitive edge and low capital expenditure.
Companies tend to have a strong brand name - Coca Cola, McDonalds and Gillette feature in his holdings - and a good history of solid earnings growth. We run through how Buffett invests his money.

'Rule No.1: Never lose money. Rule No.2: Never forget rule No.1.'
Value investing
'It's far better to buy a wonderful company at a fair price than a fair company at a wonderful price.'
The basic premise of Buffett's investing style is buying something for less than it's actually worth. This sounds simple enough, but unearthing these stocks and prove difficult and it's easy to mistake a company that is unloved by the market because nobody has spotted its opportunity with one that is simply a dog. For that reason, Buffett applies some of the measures that are listed below.

Strong profitability
'If a business does well, the stock eventually follows.'
Buffett prefers to invest in companies with a proven level of strong profitability, giving more credence to this than what analysts predict will happen in the future. He looks at a number of measures to assess a business's profitability, including return on equity (ROE), return on invested capital (ROIC) and a company's profit margin.
ROE is a measure of the rate at which shareholders are earning income on their shares and Buffett uses this measure to see how well a company is performing compared to other businesses operating in the same sector. You can calculate the ROE by dividing the company's net income by the shareholder's equity. It is believed that Buffett prefers a company that has an ROE in excess of 15%. He also looks for companies with above average profit margins, which can be calculated by dividing net income by net sales. The higher the ratio, the more profitable the company based on its level of sales.

Calculated gamble: Buffett will invest in unloved stocks but bides his time and says people should not trade too often

Not too much in debt
'Should you find yourself in a chronically leaking boat, energy devoted to changing vessels is likely to be more productive than energy devoted to patching leaks.'
However, a company with a high ROE could be being fuelled by substantial levels of debt, which Buffett is keen to avoid. For this reason he also takes into accounted the ROIC. This helps take debt out of the equation by adding it back to the shareholder equity before doing the calculation. This can be calculated by dividing a company's total liabilities by its shareholder equity - the higher the ratio, the higher the level of debt the company is using to fuel its growth.
He doesn't like over-indebted companies, as he says each year in his Berkshire Hathaway letters, because they could become vulnerable in a credit squeeze or when interest rates are rising, as they have been doing recently.

Understanding the business
'Risk comes from not knowing what you're doing.'
Buffett will only invest in businesses he can understand and analyse, rejecting those that operate in complicated markets or where he is unsure of their operating model. He describes this as his 'circle of competence'. He has largely ignored the technology sector because he claims not to fully understand their business, but prefers retailing, food and insurance stocks.

Strong management
'It's better to hang out with people better than you, ... Pick out associates whose behaviour is better than yours and you'll drift in that direction.'
Buffett places great emphasis on the quality of a company's management. According to Robert Hagstrom, author of 'The Warren Buffett Way', he asks three questions of a company's management team - are they rational, do they admit to mistakes and do they resist the institutional imperative? He takes a dim view of management teams that simply follow the crowd, copying the lead of competitors. He also likes companies to have been floated for a 10-year period before investing, but says he never interferes with the running of a company.

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The 'Moat'
'Your premium brand had better be delivering something special, or it's not going to get the business.'
Buffett coined the phrase 'moat' to refer to the competitive advantage or unique proposition that gives a business protection against their competitors. He says those businesses that have a wider moat will offer more protection to the main core business, which he refers to as the castle. This could be geographical, entry costs, a strong brand name or owning a particular patent. Buffett tends to pick companies that offer strong brand names, even though there is a lot of competition in their particular markets. Examples include MacDonalds, Coca-Cola and Gillette.
Moats are important to investors because if a business develops a successful product it is likely to be aped by competitors. How effecitively it can survive is largely determined by how its product differs from the others in the market and why consumers will keep coming back.

Long-term hold
'Our favourite holding period is forever.'
When Buffett buys a stock he buys it with the view of holding it for life. He holds a number of permanent stocks in his portfolio, including Coca-Cola, GEICO and Washington Post, which he claims he'll not sell even if they appear to be significantly overpriced. This approach has led to accusations that his portfolio has a number of 'tired' stocks in it, but Buffett thinks investors are too quick to buy and sell.

Don't rush
'You do things when the opportunities come along. I've had periods in my life when I've had a bundle of ideas come along, and I've had long dry spells. If I get an idea next week, I'll do something. If not, I won't do a damn thing.'
Boredom can cause rash buying decisions, forcing the investor to buy stock at the wrong time. Buffett has proved to be a master at the waiting game, preferring to sit on his cash rather than buy into a company just for the sake of it. He understands markets rise and fall and would prefer to wait until he feels a stock is cheap enough to buy. Buffett says investors would be better off if they could only invest a limited number of times, so they would make sure they were making the right investment.


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