Pros and Cons of Investing in Stocks

Plus Ways To Lower Risk

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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 it also goes down, presenting investors with the possibility for both profits and loss, for risk and return.

Key Takeaways

  • Investing in the stock market can offer several benefits, including the potential to earn dividends or an average annualized return of 10%.
  • The stock market can be volatile, so returns are never guaranteed.
  • You can decrease your investment risk by diversifying your portfolio based on your financial goals.

Stock Investing Pros and Cons

  • 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:

  1. 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.
  2. 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, however. That way, you can buy and hold even if the value temporarily drops.
  3. Easy to buy: The stock market makes it easy to buy shares of companies. You can purchase them through a broker or 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.
  4. Make money in two ways: Most investors intend to buy low 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.
  5. Easy to sell: The stock market allows you to sell your stock at any time. Economists use the term "liquid" to mean that you can turn your shares into cash quickly and with low transaction costs. That's important if you suddenly need your money. Since prices are volatile, you run the risk of being forced to take a loss.

5 Disadvantages

Here are disadvantages to owning stocks:

  1. 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.
  2. Stockholders paid lastPreferred stockholders and bondholders or creditors get paid first if a company goes broke. But that happens only if a company goes bankrupt. A well-diversified portfolio should keep you safe if any company goes under.
  3. Time: If you are 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.
  4. 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, and just check in on a regular basis.
  5. 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, such as by diversifying:

  1. By investment type: 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.
  2. By company size: There are 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-sized companies because they perform differently in each phase of the business cycle.
  3. 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 single stock.
  4. Through mutual funds: Owning mutual funds 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

How much of each type of investment should you have? Financial planners suggest you establish your asset allocation based on your financial goals and where the economy is in the business cycle.

Frequently Asked Questions (FAQs)

What does it mean to invest in stocks?

Investing in stocks means you're buying equity in a company. In other words, you're part owner, even if you only own a tiny fraction of the company.

How do you start investing in stocks?

The only things you need to invest in stocks are a few dollars and access to the market through a brokerage account. The process of opening a brokerage account is similar to that of opening a checking account.

How do you make money investing in penny stocks?

Penny stocks are very unlikely to offer dividends, which means you will make money through capital appreciation. Penny stocks are small companies that hope to grow into big ones, and there's potential to profit from that growth, but there's also the risk that the company will never grow or may even go out of business.

How much can you make investing in stocks?

Some people become very rich by investing in stocks, while others lose a lot of money and fall into debt. In general, the more money you invest, the higher your potential gains or losses. As a rough rule of thumb, the S&P 500 gained about 10% per year from 1993 through 2020, so someone who had invested all their money in an S&P index fund during that time would have made about 10% profit from their investments per year.