When I first watched a BBC documentary about the stock market, I thought that buying and selling shares meant waking up at 6am UK time to tune in to the Financial Times and Bloomberg to get ahead on the latest news before the markets open, and having enough capital to be able to open and close 13-14 positions in a day. I thought it meant getting rich quick with a very high amount of risk, and that only a very select group of people are involved in stocks and shares. This year, I learned the difference between "traders" and "investors"...
The behaviour and goals of traders are similar to the perception I had from that documentary that I watched. Many are highly active, seeking big returns in a short amount of time, taking on a fair amount of risk. Conversely, investors may be more conservative and make very few investment decisions with a longer term orientation, whilst taking on lower risk. However, they typically make a modest return over the long term that can beat putting your money in a savings account. Warren Buffett, the third richest man in the world, believes that the stock market is the best place to invest. He bought his first stock when he was age 11, and today at the age of 88 is worth approximately $80 billion.
My opinion is that investing in the stock market should not be about getting rich. If you become rich through it, it's a nice bonus. Rather, it's about allowing your money to work for you and generating the best return on your investment, and there are a lot of good reasons why the stock market is a good choice. Here's why I became interested in investing in companies...
#1 Returns beat Savings Accounts and Inflation
Inflation is the rate at which the average price of goods and services in a country increases. This is really important when considering savings accounts and investments, because if your money is not growing (i.e. generating a return) at an equal or greater rate than inflation, then you're actually losing money.
What's scary is that this is actually the case in many countries. For example, the return on a Livret A in France (a standard savings account in France) is currently 0.75%, whereas inflation in the Eurozone typically fluctuates between 1.5% and 2%. Though there are advantages of being able to have instant access to the money in this account, it is a poor long term investment to place a large amount of your hard earned savings in it, as it will depreciate their value.
According to Wealth Simple, depending on how you invest your money (companies, markets etc.), the average long term returns of the stock market can be from around 5% upwards, even as good as or exceeding 10-15%. Not only does it beat inflation, it means that your money starts working for you. Which leads nicely onto point number 2...
#2 Passive Income
The idea of passive income relates to generating income without having do any physical work to make it - i.e. making your money work for you. In the same way that savings accounts generate interest, investments in certain companies can generate recurring income in the form of dividend payments - typically with a better rate of return than an interest than a savings account.
These dividends can also be reinvested in the company to buy more shares to receive a greater overall dividend payout. This is called "compounding", and its effect on your money over time looks a little bit like the graph below:
This simplified example assumes a regular deposit of £5,000 a year over 20 years (starting from year 1), with an average annual return of 5%.
At first, the effect is practically negligible, with no significant on the growth of your money in the early stages, and as such requires patience. However, years later when it kicks in, compounding can produce exponential revenue growth. By year 15, the interest generated on the savings exceeds the amount regularly deposited. Thanks to compounding, £100,000 invested has become almost £180,000 by year 20. There are people out there that have enough money invested to be able to generate enough dividend income to live off.
#3 Create long term wealth and financial stability.
As I mentioned earlier, for me investing in the stock market isn't about getting rich. Nevertheless, regular dividend payments, selling a stock at a higher price for which you bought it and reinvesting your earnings generate income for you, which supplement any other sources of income you may have.
As millennial investors, many of us are probably far from thinking about retiring, unless you are aiming for Financial Independence Retire Early (a.k.a FIRE). Many of us have few significant financial responsibilities and commitments at this stage in our lives. That's why its a perfect time to invest. The more you invest, the more significant the compounding effect, and the quicker your money will grow so that you can use it for the things that really matter to you, such as buying a house or retiring early.
#4 Reasonable Risk for young investors
Investing in stock markets comes with a higher risk than investing your money in a savings account. Companies may perform worse than expected, be impacted negatively by certain events or even go bankrupt. You could lose some or all of your investment.
I wouldn't advocate a high risk strategy, nor pure speculation. Nevertheless, these risks can be controlled to a certain extent, to the point where their level of risk is controlled and/or minimised. And even though the risk still exists, young investors with more disposable income are arguably less vulnerable to the consequences of a loss generated from one of their investments.
Here are some typical indicators of companies that will minimise your risk exposure:
- Strong Historical Brand and Good Long Term Strategy (e.g. Coca Cola)
- Regular dividend paying history, typically with a dividend that has increased over time (e.g. AT&T)
- Good financial situation i.e. able to cover short term debt, growing revenues and profits, consistent positive cash flow.
If you don't feel comfortable picking out individual companies, and prefer to spread risk across a particular market, there are other options. You can invest in a market index (the overall trend of a collection of companies, which typically rises over time), or investment Exchange Traded Funds (ETFs), which in simple terms, aim to replicate the movements of an index, market or particular companies.
#5 Possible Tax Advantages
Things can sometimes get complicated around capital gains and dividend income. However, certain countries allow you to invest in special stocks and shares investment accounts with certain tax benefits. A few examples:
The Plan d'épargne action (PEA) allows the account holder to invest up to €150,000 in companies with 75% of their permanent shares residing within the EU/EEA. Provided that no withdrawals are made within the first five years of the account opening, any capitals gains or dividend payments received are tax free. After 8 years, the rates of social charges paid upon any capital gains or dividend income is also significantly reduced.
UK residents are entitled to a £20,000 annual tax free savings allowance. Many banks offer stocks and shares Instant Access Savings Accounts (ISAs) that allow the account holder to benefit from this tax free savings allowance, so that you can invest without being taxed on your capital gains.
The 401k Savings Plan allows workers in the US to make pre-tax income contributions into their 401 account, up to a maximum of $19,000 per year. Any investments made from the 401 account are tax deferred, and tax is only paid when withdrawals are made from the account, typically after the age of 59 (around retirement).
It is important to read up about investing, understanding how the market works and how to win in the long term if it is something you are thinking about doing. However, I've been really excited to write about investing in the stock market, and I think it can be a great investment when done properly.
How did you get interested in the stock market? How has your investment journey been? Leave us a comment with your thoughts!
Millennials With Money exists to provide personal financial education to Millennials and young people, and build a community of people who are motivated to creating long term financial health.
Disclaimer: This article is for informative, non-advisory purposes. Millennials With Money will accept no liability for any losses for investment decisions made based upon the content of this article.
Average Stock Market Return: https://www.wealthsimple.com/en-ca/learn/average-stock-market-return
Inflation Defintion: https://www.investopedia.com/terms/i/inflation.asp