Benefits of Investing in Stocks Versus Disadvantages
Five Benefits and Five Disadvantages of Owning Stocks
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. Below, we summarize the top five benefits and disadvantages of owning stocks:
The Top 5 Benefits of Stock Investing
- Stock ownership 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 if you understand the phases of the business cycle.
- They are the best way to stay ahead of inflation. Historically, stocks have averaged an annualized return of 10 percent. That's better than the average annualized inflation rate of 3.2 percent. It does mean that you must have a longer time horizon. That way, you can buy and hold even if the value temporarily drops. Compare stocks, inflation, and the gold price in history.
- 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. Several online brokers such as Robinhood even let you buy and sell stocks today for free.
- You can 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.
- They are easy to sell. The stock market allows you to sell your stock at any time. Economists use the term "liquid" to describe that fact that 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 five disadvantages to owning stocks.
- 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. Unfortunately, you also have to pay taxes if you make money. You pay the capital gains tax.
- Stockholders are paid last if the company goes broke. Preferred stockholders and bondholders/creditors get paid first. But don't worry, this happens only if a company goes bankrupt. A well-diversified portfolio should keep you safe if any one company goes under.
- It requires a lot of time. You've got to research each and every company to determine how profitable you think it will be before you buy stock. You've got to 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.
- It can be an emotional roller coaster. Stock prices rise and fall second-by-second. Individuals have the tendency to buy high, out of greed, and sell low, out of fear. The best thing to do is don't constantly look at the price fluctuations of stocks, just be sure to check in on a regular basis.
- You compete against professionals. 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.
The Bottom Line
A well-diversified portfolio will provide most of the benefits and fewer disadvantages than stock ownership alone. That means you should have a mix of stocks, bonds, and commodities. Research shows that, over time, it's the best way to gain the highest return at the lowest risk.
You should also own different types of stocks. 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.
You should also diversify by location. Own companies located in the United States, Europe, Japan, and emerging markets. It allows you to take advantage of growth without being vulnerable to any one stock.
Another way to gain diversification is through mutual funds. That allows you to own hundreds of stocks that are selected by the mutual fund manager. That means you are less vulnerable to any individual stock's performance. One easy way to diversify is through the use of index funds or index ETFs.
How much of each should you have? Financial planners suggest that you establish your asset allocation based on your financial goals. You should also respond to changes in the business cycle. Be aware of where the economy is in the current business cycle.