This week, let’s get back to the basics.
Question: What is a stock and why do you make money when you invest in one?
Let’s say your friend, Suzy, owns a car wash. The business is pretty successful. The cost of running the car wash is $10,000 a year, and the business brings in $12,000 a year. Suzy gets to pocket the $2,000 profit.
Suzy also has a gambling problem. She believes she has a fool-proof way of betting on sports, but, as it turns out, she doesn’t.
Suzy needs money, and fast. She approaches you and says, “I will sell you part of my business. For $5,000 I will sell you a 50% stake.”
Another way of saying this is: “You will own 50% of the stock in my business.”
The next year love bugs are much worse than usual. Desperate citizens flock to the carwash. At the end of the year, the business shows a profit of $4,000. As a 50% shareholder, you receive $2,000.
If you invest in Apple you may own .00001% of the shares. So, you are eligible for .00001% of the profit. It is the exact same concept. The more Apple grows, the more you make.
That’s it. That’s a stock.
Question: What is a bond and how do you make money when you invest in one?
Bonds are actually much easier to understand. A bond is a loan. You know when you put your money into a savings account and receive .01% interest? What does the bank do with your money?
They loan it out at much higher rates and pocket the difference. Banks are unbelievably profitable. That’s why there is a bank on every corner.
So if you own a bond, in a sense, you are the bank. Let’s say Sarasota Memorial Hospital is constructing a new building and they need money. They could issue a bond that basically says: “If you give us $10,000, we will give you one bond on which we will pay you 3% interest. At the end of ten years we will repay the loan back to you. You will get your $10,000 back.”
You see? You are the bank.
I often wonder why people put money into savings accounts. You can skip the bank and just invest directly where the bank invests their money. But that is a topic for a future article.
Bonds are more stable than stocks, but stocks, historically, have returned far more. Risk equals reward.
Let’s take a look at economic history. I want to extinguish the idea that these vehicles can lose a bunch of money.
What we are about to look at is the 5-year average return for indexes.
Question: What is an index?
The S&P 500 index is a composite of the 500 biggest companies in the U.S. The Bond index is a composite of thousands of bonds (loans).
I’m trying to make the point that while, yes, there are bad years here and there, it doesn’t really matter.
Get ready to have your mind blown.
Let’s start with bonds. The Bond Index has been tracked since 1975.
The Worst Five Year Period:
An average return was 2.1% between 2012-2017.
The Best Five Year Period:
An average of 18.42% from 1981-1986 (this was during a time of hyperinflation. Bond returns and interest rates are closely related).
Since interest rates are so low, it is reasonable to assume low returns going forward, but still far higher than a CD. Was there ever a five-year return that averaged a negative number? No. In fact, there has never been a two-year span where the average was negative for bonds.
Next up are U.S. stocks. The S&P Index has been tracked since 1945.
The Worst Five Year Period for U.S. stocks
The markets returned an average of -2.3% from 2000-2005. The markets returned -2.3% on average from 1969-1974. That’s it. Seriously, those are the only two times.
I really want this to sink in.
In modern economic history, there are two instances where the five-year average was negative and even those are low single digits.
Why are you worrying? Be confident that five years from now your account will be worth more than now.
Please stop looking at your account every day. It. Doesn’t. Matter.
I want you to help your friends too. Next time you see them tell them the fact that:
Over any ten-year period, in economic history, the stock market has gone up.