Back to the Basics: Why Buy Stocks?

In my first article in this series, I got just about as basic as you can get, looking at exactly what investors get when they buy a stock. I know some readers may be itching to get right into it and start figuring out which stocks to buy, but others may not even be convinced that buying stocks is such a good idea. So let's go ahead and take a look at why you would even bother investing in stocks. After all, there's a nice, warm spot under your bed for your cash, right?

3 cheers for stocks
The stock market can seem like a bit of an intimidating beast. Turn on CNBC during market hours and you're met with 15 different rapidly scrolling bars on the screen showing a gibberish-looking array of letters and numbers, while commentators -- sometimes five or more at once -- frantically shout in the middle of the screen. Not exactly a welcoming picture.

But for many investors, it'd be a mistake to exclude stocks as part of their portfolio. While investors will have their individual situations, there are three primary reasons everyone should at least consider stocks.

  1. Returns. Over the long term, stocks have delivered impressive returns. According to the 2002 edition of Jeremy Siegel's book Stocks for the Long Run, stocks returned 6.8% per year above inflation between 1871 and 2001. That compares with a loss of 0.1% per year for gold and an average gain of 2.8% per year for bonds. Cash, of course, almost always has a negative return as it earns nothing and simply absorbs the impact of inflation. But over the past 10 years, the stock market has actually fallen more than 6% as measured by the S&P 500, which is a good reminder that the returns from stocks may not always be consistent. However, the stock market's history gives us good reason to think that over longer stretches investors can do very well.
  2. Ease. Though at first the stock market can seem intimidating, it's actually one of the easier investments you can make. Once you have an account set up with an online broker, investing in a stock or a stock fund is as easy as clicking a mouse. The same is typically not true of investing in an apartment building, a race horse, a Picasso, or a vineyard.
  3. Diversification. Investors with all of their eggs in one basket are betting an awful lot on what happens to that basket. Investing in stocks in general not only gives you exposure to a different asset class, but it also allows you to invest in such disparate areas as multinational software companies, U.S. fast-food restaurants, or Chinese oil companies.

But how should you invest in stocks?
Just because you may be convinced that investing in stocks is a good idea doesn't mean that you have to try to be the next stock-picking genius. In fact, this isn't the ideal approach for most investors. Fortunately, there's a very simple way to figure out which approach to stock investing you should take.

Ask yourself this question: How much time am I willing to dedicate to studying companies, reading financial reports, and doing other work necessary to identify and keep track of top-notch stocks? Now don't just skip over this. Take your eyes away from your computer screen for a moment and really think about it.

Have your answer? While there isn't a specific number that I would say pushes you in one direction or another, the way you thought about that number tells the tale. If you found yourself begrudgingly thinking "Well, I guess I can put X amount of time into it because I know I have to," then we'll call you a Category One investor (more on that in a moment).

If, on the other hand, you're excited enough about stocks and learning to invest that your thought process was, "I'm willing to put in whatever amount of time is needed -- this sounds interesting and fun," then you can take a seat with the Category Two investors.

Category One investors
There's nothing wrong with not being interested in stocks. I love researching companies, I don't enjoy lobster, and I hated the movie Titanic. We all have our individual interests and preferences.

However, as we discussed above, there are good reasons for almost everyone to have some amount of their portfolio in stocks, so we need to discuss options for investors who would rather not spend much time on their investments. One option is to hire a financial advisor to help you out. This can be a great way to handle the situation since it relieves you of the time commitment and puts it in the hands of someone who is presumably well-versed in the field. If you choose this, though, the onus is on you to make sure that you are investing with someone that actually knows what they're doing and, maybe more importantly, will respect your wishes.

Another option is to do it yourself and simply stick with low-cost index funds. Funds such as the Vanguard 500 Index Fund (FUND: VFINX  ) and the Wilshire 5000 Index Fund (FUND: WFIVX  ) simply match the performance of major stock market indexes and assess very low fees on investors. Returns from index funds will, by definition, never "beat the market," but it's just about the easiest way to invest. For those interested in this type of investing, the works of Vanguard founder Jack Bogle are a great place to start.

Category Two investors
Ben Graham -- who is basically the Yoda to Warren Buffett's Luke Skywalker -- wrote in his book The Intelligent Investor that the investment approach that an investor should take depends largely on "the amount of intelligent effort the investor is willing and able to bring to bear on his task."

For investors willing and able to put in the necessary time and effort for research, investing in individual stocks can be a rewarding experience both financially -- if you're able to find stocks that perform well -- and educationally.

For the investors who fall into this group, be sure to stay tuned -- the remaining articles in this series will be aimed at you and specifically focused on how to invest in individual stocks.

In the meantime, head down to the comment section and feel free to raise questions about this article or offer suggestions for future articles in the series.

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Fool contributor Matt Koppenheffer does not own shares of any of the companies mentioned. You can check out what Matt is keeping an eye on by visiting his CAPS portfolio, or you can follow Matt on Twitter @KoppTheFool or on his RSS feed. The Fool's disclosure policy prefers dividends over a sharp stick in the eye.


Read/Post Comments (6) | Recommend This Article (10)

Comments from our Foolish Readers

Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On January 31, 2011, at 7:05 PM, beechtree1 wrote:

    Of course, this series is very, very important for us

    beginners to the task. May I suggest that you compile it in an easy to refer to format.

  • Report this Comment On January 31, 2011, at 9:03 PM, drillerjim101 wrote:

    As a happy investor of the past 30 years I can testify that few endeavors are as rewarding. Successful companies worldwide demonstrate not only what makes the world tick but point towards powerful opportunities for the alert and educated investor. The resources available to us through the Motley Fool are among the finest I've ever seen.

  • Report this Comment On February 01, 2011, at 6:14 AM, Julianoli wrote:

    Great article

  • Report this Comment On February 01, 2011, at 10:08 AM, Merton123 wrote:

    This is a great article. The only change that I would suggest is replacing the Vanguard Standard and Poor 500 index with Vanguard Total World Stock Index Fund (VTWSX). From and indexing perspective VTWSX is the ring that controlls all other rings - a quotation from the Hobbit. The American Stock market only comprises 40% of the global stock market. The United States is a mature economy. The majority of the growth is occurring outside of our borders in China, India, Brazil. VTWSX gives you exposure to both emerging markets, and the mature markets (e.g., Japan, Western Europe, and United States).

  • Report this Comment On February 01, 2011, at 10:48 AM, Merton123 wrote:

    I will expand about indexing for the Category 1 investors. The majority of mutual funds underperform their respective indexes by their costs ratios. Therefore Vanguard was created for those people who didn't want to underperform the index by the cost ratio. The next question is which index (or mix of indexes) will provide the best overall return? Burton Malkiel in his national bestseller "A random walk down wallstreet" goes indepth about the optimum mix of small cap index funds, real estate index funds, large cap index funds, bond index funds, and international index funds. The major mutual funds families like Vanguard, Fidelity and others also have created life cycle funds where you can invest in one mutual funds which invests in a mix of various indexes. I will let the other Motley Fool readers expand upon the "best" life cycle mutual fund.

    For the category two investors:

    There is an active debate going about which asset class provides the best overall return. Motley Fools have created two mutual funds run by the same management team - Independence fund and American Fund. The Independence fund is a global fund and can invest anywhere in the world. The American Fund invests the majority of the money in American small and midcap stocks. I believe that all things being equal that the Independence Fund will outperform the American Fund because the majority of the growth opportunities are outside of our borders. The opposite opinion is that american small caps is where the growth is and the American Fund will outperform the Independence Fund. I am putting my Roth IRA money in the Indepedence Fund so have a vested interest in the first opinion :)

  • Report this Comment On February 02, 2011, at 4:59 PM, WestBend1 wrote:

    Matt,

    What is the difference between investing in a total stock market ETF, such as VTI, and a total stock market mutual fund? Which is better for most investors?

    I appreciate any information you can give me.

    Thanks,

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