Stocks are by far the best way for the average American to build wealth over the long run. However, there are thousands of equities to choose from, so it can be difficult to decide where to start. There are two main ways to get exposure to stocks in your portfolio: You can invest in individual stocks, or you can own them indirectly through mutual funds or ETFs.
Let's go over the reasons you need stocks in your long-term investment portfolio and how to choose the best investing approach for you.
Stocks are the best long-term investment for Americans of all ages. Image source: Getty Images.
Most Americans don't own stocks
As I wrote in an article last year, more than half of Americans aren't invested in the stock market at all -- not even through an employer's retirement plan. In the Bankrate survey that produced this finding, these were some of the most common reasons respondents said they didn't put their money in the stock market:
- I don't have the money to invest.
- I don't know where to start.
- I don't trust the stock market.
Whatever the excuse, for most people, it is just that -- an excuse. You can start investing easily, and with less than $100. And so long as you invest wisely and with the long term in mind, the stock market isn't nearly as risky as you might think.
Reasons that stocks are the best investment for the average American
Simply put, stocks are essential components of Americans' long-term investment strategies because they have outperformed every other major investment asset class, including bonds and money market instruments, over long time periods throughout history -- even when those time periods include market crashes.
To illustrate this, here's the performance of stocks and bonds during the 1926-2010 time period (84 years), which includes the Great Depression, the tech crash of 2000, and the Great Recession:
|
Asset Class |
Average Annualized Return |
Value of $100 invested in 1926 |
|---|---|---|
|
Small-cap stocks |
12.1% |
$1,605,500 |
|
Large-cap stocks |
9.9% |
$298,200 |
|
Government bonds |
5.5% |
$9,300 |
|
Treasury bills |
3.6% |
$2,100 |
Data source: Raymond James Financial.
To be perfectly clear, stocks didn't always outperform bonds during these time periods. The worst year that government bonds had during this time produced a loss of 17.1%. Meanwhile, the worst single year large-cap stocks saw a staggering decline of 67.6%. The point, however, is that over long periods of time, stocks clearly win, despite their volatility.
Further, while I believe that stocks are hands-down the best long-term investment, that doesn't mean everyone should have only stocks in their portfolio. In the interest of diversification, it's important to know the basics of asset allocation and maintain an age-appropriate mix of stocks and bonds.
Should you invest in funds or buy individual stocks?
Fewer than 15% of Americans own individual stocks, and for good reason. Investing in individual stocks takes a lot of work, and it can be far riskier than investing in funds, especially if you don't really know what you're doing.
I've said before that to effectively invest in individual stocks, you need three things: time, knowledge, and desire. You need the time to keep track of how the companies you invest in are doing, you need a good working knowledge of how to analyze potential stock investments, and you need to have the desire to use your time and knowledge to construct a portfolio. You also need capital, as it's difficult to properly diversify a stock portfolio without at least a few thousand dollars to work with.
If you have all of those, we encourage you to invest in individual stocks.
The reality, however, is that most Americans don't have all of those characteristics. And if you don't, mutual fund or ETF investing can be the smartest way to buy stocks. In fact, Warren Buffett, widely considered to be one of the greatest stock-pickers of all time, has said that the best investment most Americans can make is a low-cost S&P 500 index fund.
In a nutshell, by using funds to invest in stocks, you're taking most of the company-specific risk out of the equation. For example, suppose you take Buffett's advice and buy a low-cost S&P 500 index fund like the Vanguard S&P 500 ETF (VOO -0.41%). This spreads your money across 500 stocks, so even if one of the index's biggest constituents -- say, Apple or ExxonMobil -- performs terribly, your portfolio won't take a big hit.
When not to invest in stocks
Let me emphasize that Americans should own stocks as long-term investments. Any money you'll need to use within the next five years or so would be better off invested in a more stable but lower-growth type of investment, e.g., fixed-income assets or cash equivalents such as CDs. For example, if you have $10,000 set aside to help your child pay for college in two years, keep that money out of the stock market.
The bottom line is that over long periods of time, there's no asset class that has a time-tested history of delivering the same kind of returns the stock market has. It's just a question of which is more appropriate for you -- individual stocks or investing in stocks through funds.
