Finances 101: Are Stocks Really That Great Of An Investment?

Over the last several months, I’ve read a ton of personal finance material, and it all keeps coming back to the same idea that basically says if you want to make big money, you have to invest in stocks, but as you approach your goals, you should move gradually to safer investments like bonds and treasury notes. I began to wonder how true this statement is. Do stocks really provide that much of a financial gain compared to other investments? Right now, I can buy long-term certificates of deposit that earn about 6% or so; is my money better off there?

To figure this out, I went and downloaded long term annual results of the Dow Jones Industrial Average and played around with it a bit. I figured out the percent increase each calendar year (up through 2006) and then figured out the average return over several different time frames. Here’s what I found:

Over the last 100 years, the Dow returned 7.49% in an average year.
Over the last 50 years, the Dow returned 8.40% in an average year.
Over the last 20 years, the Dow returned 10.66% in an average year.
Over the last 10 years, the Dow returned 7.79% in an average year.
Over the last 5 years, the Dow returned 5.47% in an average year.

Over an average year in the long-term history of the market, a stock investment will return better than a 6% CD investment. But in the last five years, you would have beaten your stock investment in the Dow if you had purchased a 6% certificate of deposit.

Here’s the deal: the stock market can and usually does beat other forms of investment, but when you invest you take on a risk that your return won’t be as good. An investment in stocks is not a guarantee of a good return over the short term, but over the long term you will eventually do well with stocks.

It is because of this short term risk that, as you reach your financial goals, you should move your investments into more stable forms such as treasury notes. Even though these investments won’t reach the return peaks of the stock market, they also won’t have the terrible valleys, either. That way, a major downturn in the market (the average annual rate of return for the five years between January 1, 2000 and December 31, 2002 – a three year period – was a whopping -10.03%) won’t wreck your finances.

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  1. Doug Alder says:

    For that to work you would have to be investing equally in all the stocks included in the DOW would you not? An average is just that and is composed of big, small, and medium winners and losers as well as break even stocks. So unless you are investing in a mutual fund that does invest in the whole DOW then it’s not really a good way to look at stocks as your chances of picking the ones that will return that average are practically nil. At least that’s how it looks to someone who does not invest in individual stocks.

  2. Trent says:

    You’re correct, Doug. It’s merely an average. However, given that it is an average, you have a 50/50 shot at beating that average or having the average beat you. If you’re good at picking stocks, you might beat that average over time, but are you willing to wager that you’re good enough to beat the market?

  3. efipo.com says:

    I’m still a bigger fan of real estate. Leverage with return is better than investing a ton of money with a smaller return. But I still love the stock market. It’s a lot of fun, but you have 0 control over it while real estate you have some.

  4. EasyChange says:

    I think using the DOW as the benchmark is somewhat part of the problem here.

    If you were to use a different index like the S+P500 or Russel2000 or the TotalStockMarketIndex by vangard, you’d find some better numbers.

    In this day and age, I sincerely hope that people arent putting all their eggs in the Dow’s Basket.

  5. Sean says:

    What EasyChange said… the DOW is nothing but an index of 30 of the largest and most widely held public companies in the United States. It certainly wouldn’t be a well-diversified investment. As a matter of fact, I’d call it an extremely un-diversified one, consisting pretty much exclusively of extremely large cap value stocks.

    That said, you are of course right – there are no guarantees with stocks, especially over a time period as short-term as 5 years. Over the long term, those terrible years of dismal performance are usually moderated with those wonderful years of incredible performance.

  6. Jim Lippard says:

    Regarding keeping money in CDs, keep in mind that inflation has eaten away 95% of the value of a dollar since 1915. If you want to compare cash to stocks over the long term, don’t forget to account for fluctuating interest rates, as well.

    As for real estate, I think investing in real estate in 2006 is, in many cases, like investing in tulip bulbs in the Netherlands in 1636. BTW, it’s far easier to purchase and liquidate holdings in the stock market than to purchase and liquidate real estate holdings. The “control” you have over a real estate holding is that you can fix it up and make it look nice–but you can’t change its location or change market conditions. And while you hold it, you’ve got maintenance, insurance, and mortgage costs to account for.

  7. Ralph Morgan says:

    I’d be wary of the idea that “as you reach your financial goals, you should move your investments into more stable forms such as treasury notes” – this only makes sense if you have a set goal (eg. $1m for retirement by age 65) and you then want to spend down that money to $0 by a certain date (eg. by age 90). In that case investing in treasury notes with a known return will give you maximum certainty that you meet you goal (having $0 left when/if you reach age 90).

    However, if your financial plan is more general and has no fixed time frame (eg. to achieve best possible return on your investments for a particular level of risk over the long term) you would stay more heavily invested in growth assets (eg. stocks, real estate) even after you’ve “retired”. In this case you never “reach” your financial goal, so you would maintain the same asset allocation regardless of age or financial situation.

  8. Jim Lippard says:

    Ralph: The whole point of shifting your asset allocation into more stable investments as you approach retirement is a decline in appetite for risk (and the decline of available time to recover from loss).

    BTW, my “95% of the value of the dollar” lost since 1915 was from memory; some online websites say it’s 87% lost since 1950 and 95% since 1913 (not 1915).

  9. It’s worth noting that there’s a huge difference between 6% and 7.5% (using the 100 years). After inflation you could be looking at a 2% gain vs. a 3.5% – the later being nearly almost twice as much.

    As EasyChange said, I’d love to see more stocks involved like a Wilshire 5000 and possibly something involving some foreign stocks.

    As to what efipo.com said, I’m not convinced that you have any more control over real estate than you do over the stock market. That said, real estate does allow for cheaper and greater leverage it would seem.

  10. Toby says:

    Quote:
    But in the last five years, you would have beaten your stock investment in the Dow if you had purchased a 6% certificate of deposit.

    But you forget that 6% CDs haven’t existed for the past five years, rates have just recently climbed to these levels. The US had some of the lowest interest rates in long while in the last five to ten years.

    Perhaps you should compare these numbers against US Treasury Bond rates or CD rates over same time frames to get a better comparison. I also second the notion of comparing against the S&P 500 or Russell 2000 indexes instead of the Dow.

    -Toby

  11. tanya says:

    Is there a difference in txing CD’s, Savings account or stock market earned money?

  12. gretchen says:

    one must remember that if one invests in the stock market 1. there are broker fees and other costs which averagae 2% and 2. you have to keep watch of your portfolio and read and evaluate to make sure you are in safe territory. also, all these averages (above) assume you put money in on a given date and left it there for the period mentioned. your particular situation may be different. my point of view is: by putting my money into cds, i have no fees whatsoever and when a cd comes due, i can renew it or cash it online or on the phone w. my bank. i have no day to day or week to week worries about managing my money. my money just keeps growing slowly. i think my money has grown on average by 5% apy over the past 15 years or so. all of that return is mine. my retirement is in an equally safe and slow growing plan and in spite of being a modest one income household with children, i will have a very healthy situation at retirement and i always have money to buy a new car outright or pay for vacations, etc. i ask: why are the stock market and other noninsured and uncertain investments so popular? why is there no emphasis put on simple saving and economizing?? (remember how much peace of mind i have.) please comment on this if you would — i cannot find anyone who discusses this.

  13. felix says:

    Hi Trent, regarding the comparison between the DOW average and CD’s, it’s not really a fair one. First of all, as another reader points out, the DOW average is just that, an average. You lumped the losers together with the winners. Secondly, stocks not only appreciate in value but they pay dividends as well. Suppose you own a stock that grows 5% a year in the last 5 years but it also pays a dividend of 5% each year. Now what would be better?

    If stock investments aren’t that great there wouldn’t be a Warren Buffet, right? (Even though that is an extreme case)

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