Pros and Cons of Investing in Stocks
Plus Ways to Lower Risk
What are the pros and cons of investing in the stock market? Historically, the stock market has delivered generous returns to investors over time, but stock markets also go down, presenting investors with the possibility for both profits and loss; for risk and return.
Grow with economy
Stay ahead of inflation
Easy to buy and sell
Risk losing it all
Takes time to research
Emotional ups and downs
5 Benefits of Stock Investing
Stock investment offers plenty of benefits:
- Takes advantage of a growing economy: As the economy grows, so do corporate earnings. That's because economic growth creates jobs, which creates income, which creates sales. The fatter the paycheck, the greater the boost to consumer demand, which drives more revenues into companies' cash registers. It helps to understand the phases of the business cycle—expansion, peak, contraction, and trough.
- Best way to stay ahead of inflation: Historically, stocks have averaged an annualized return of 10%. That's better than the average annualized inflation rate. It does mean you must have a longer time horizon. That way, you can buy and hold even if the value temporarily drops.
- Easy to buy: The stock market makes it easy to buy shares of companies. You can purchase them through a broker, a financial planner, or online. Once you've set up an account, you can buy stocks in minutes. Some online brokers such as Robinhood let you buy and sell stocks commission-free.
- Make money in two ways: Most investors intend to buy low and then sell high. They invest in fast-growing companies that appreciate in value. That's attractive to both day traders and buy-and-hold investors. The first group hopes to take advantage of short-term trends, while the latter expect to see the company's earnings and stock price grow over time. They both believe their stock-picking skills allow them to outperform the market. Other investors prefer a regular stream of cash. They purchase stocks of companies that pay dividends. Those companies grow at a moderate rate.
- Easy to sell: The stock market allows you to sell your stock at any time. Economists use the term "liquid" to mean you can turn your shares into cash quickly and with low transaction costs. That's important if you suddenly need your money in a hurry. Since prices are volatile, you run the risk of being forced to take a loss.
Here are disadvantages to owning stocks:
- Risk: You could lose your entire investment. If a company does poorly, investors will sell, sending the stock price plummeting. When you sell, you will lose your initial investment. If you can't afford to lose your initial investment, then you should buy bonds. You get an income tax break if you lose money on your stock loss. You also have to pay capital gains taxes if you make money.
- Stockholders paid last: Preferred stockholders and bondholders/creditors get paid first if a company goes broke. But this happens only if a company goes bankrupt. A well-diversified portfolio should keep you safe if any one company goes under.
- Time: If buying stocks on your own, you must research each company to determine how profitable you think it will be before you buy its stock. You must learn how to read financial statements and annual reports and follow your company's developments in the news. You also have to monitor the stock market itself, as even the best company's price will fall in a market correction, a market crash, or bear market.
- Emotional roller coaster: Stock prices rise and fall second-by-second. Individuals tend to buy high, out of greed, and sell low, out of fear. The best thing to do is not constantly look at the price fluctuations of stocks, just be sure to check in on a regular basis.
- Professional competition: Institutional investors and professional traders have more time and knowledge to invest. They also have sophisticated trading tools, financial models, and computer systems at their disposal. Find out how to gain an advantage as an individual investor.
Diversify to Lower Investment Risk
There are ways to reduce your investment risk. Diversify:
- Investment types: A well-diversified portfolio will provide most of the benefits and fewer disadvantages than stock ownership alone. That means a mix of stocks, bonds, and commodities. Over time, it's the best way to gain the highest return at the lowest risk.
- Company sizes: That includes large cap, mid cap, and small cap companies. The term "cap" stands for capitalization. It is the total stock price times the number of shares. It's good to own different size companies because they perform differently in each phase of the business cycle.
- By location: Own companies located in the United States, Europe, Japan, and emerging markets. Diversification allows you to take advantage of growth without being vulnerable to any one stock.
- Through mutual funds: That allows you to own hundreds of stocks selected by the mutual fund manager. One easy way to diversify is through the use of index funds or index ETFs.
The Bottom Line
The Balance does not provide tax, investment, or financial services and advice. The information is being presented without consideration of the investment objectives, risk tolerance, or financial circumstances of any specific investor and might not be suitable for all investors. Past performance is not indicative of future results. Investing involves risk including the possible loss of principal.
FINRA. "The Reality of Investment Risk." Accessed Oct. 8, 2020.
Federal Reserve Bank of St. Louis. "Net Corporate Dividend Payments." Accessed Oct. 8, 2020.
U.S. Securities and Exchange Commission. "Answers to Test Your Money Smarts," Page 1. Accessed Oct. 8, 2020.
IRS. "Topic No. 409 Capital Gains and Losses." Accessed Oct. 8, 2020.
Investor.gov. "Stocks." Accessed Oct. 8, 2020.
Federal Reserve Bank of St. Louis. "Stock Market Strategies: Are You an Active or Passive Investor?" Accessed Oct. 8, 2020.
Investor.gov. "Market Capitalization." Accessed Oct. 8, 2020.