Stock market investing can play a crucial role in life, especially if you’ll be depending on savings to keep you afloat during your retirement years.
The longer we live, the more money we’re going to need, and stocks, while risky, can provide better returns than other types of investments. Yet many of us don’t understand the basics of stock investing.
“By and large, people are pretty clueless,” Olivia Mitchell, executive director of the Pension Research Council at the University of Pennsylvania, told the Los Angeles Times after she and a colleague studied Americans’ financial literacy.
That may explain why more than half (52 percent) of American adults have no money at all invested in stocks, according to a 2015 report by CNN, citing a Bankrate survey.
What’s your stock market aptitude? Test yourself with this quiz, and get up to speed at the same time:
True or false: Stocks outperform other investments over the short term
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This is a tricky question. While stocks outperform many other investments in the long run, say, over 10 years, the shorter the time horizon, the more unpredictable, and thus risky, stocks become. So the answer to this question is false.
Day trading and other forms of short-term investing are far too risky for the average investor and are not a good strategy for your retirement savings.
For a vivid illustration, look at the performance of the Dow Jones Industrial Average market index over the last 10 years in this chart by Macrotrends. In 2007, your investments might have been cooking along nicely. The next year, though, the market fell 37 percent, taking with it many years’ gains.
Collectively, the losses in 401(k) plans and IRAs totaled $2.8 trillion as of early December 2008, according to the Pittsburgh Post-Gazette.
Over the long term, however, stocks outperform most other investments.
If you look again at the Macrotrends chart, you can see that the stock market has not only recovered from the recession but has gained more than 30 percent over 2007 values.
True or false: When companies pay shareholders, it’s called interest
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The answer is: False. Payments made to shareholders are typically called dividends, not interest.
When you invest in a stock, you become part-owner of a company. When you buy a bond or put money in a bank account, you’re loaning money. Dividends are payments made to owners. Interest is a payment made to lenders.
Some companies never pay dividends, using the money instead to grow the company. While dividends should never be the sole determinant when buying a stock, they can be a great perk.
Interest, as mentioned above, is money earned by lending money to a bank, company or government agency. Here are four common ways to earn interest on your savings:
- Money market deposit accounts: They’re available from banks and credit unions, but don’t expect interest rates above 1 percent. Your money is insured up to $250,000 by the Federal Deposit Insurance Corp. (Money market mutual funds are a different product and are not federally insured.)
- Savings accounts: Bank and credit union savings accounts are insured, and yields (interest rates) are running as high as 1 percent.
- Certificates of deposit: CDs tie up your money for a period (called a maturity), usually from three months to five years. The longer you’re willing to invest in the CD, the more interest it pays.
- Bonds: When a corporation, nation, state or local government borrows, it issues bonds. As with CDs, you agree to lend for a certain period of time, typically from one to 30 years, and in return you receive periodic interest and the return of your principal when the bond matures. Because the federal government has the authority to print money, its bonds are typically considered the safest. But rates are low, currently less than 2.4 percent on a U.S. 10-year bond.
True or false: You can make money in stocks even when they go down
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It may surprise you, but the answer to this one is true. You mostly hear of investors making money from stocks when prices rise. But there’s a sophisticated and risky investing strategy — not for amateurs — called “shorting,” in which you bet against a stock’s price.
The basics: If you think a stock is going to fall, you can borrow the shares through a brokerage firm and sell them. When the price falls, you cover the short by buying shares and using them to cover the short sale.
Example: You think Amazon, currently trading at $300 a share, is overvalued and about to drop. You borrow 100 shares through your brokerage firm and sell them, netting you $30,000. Two weeks later, the stock falls to $200. You go out into the open market, buy 100 shares for $20,000 and give them to your broker to cover the short position. You profit by $10,000.
The reason shorting stock is risky is because it often involves short-term price movements, which, as described above, are hard to anticipate. In addition, when you buy a stock, your losses are limited by your investment. When you short a stock, there’s no limit to your potential losses.
Going back to our Amazon example, if you pay $300 for a share, you can’t lose more than $300: The stock can’t go below zero. But if you short it at $300, and you were wrong and the value of the stock doesn’t go down, there is theoretically no limit to how much you can lose. The higher the stock goes, the more you lose until you pay back the broker.
If you’re tempted to take up day-trading, read this first: “Ask Stacy: Can I Make a Living Trading Stocks?”
Should most investors stick with mutual funds actively managed by experts?
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No, they should not. The stock market is a place where we often put too much faith in experts. Arguments for managed mutual funds can be persuasive, but the fact is that unmanaged index funds outperform the vast majority of mutual funds actively managed by experts.
The reason unmanaged index funds outperform the experts is simple: The experts actively managing funds charge big bucks for their expertise.
Among the proponents of index funds is billionaire investor Warren Buffett who made a million-dollar bet that managed hedge funds could not outperform his investment in the Vanguard 500 Index Fund over the course of a decade. More than eight years into the bet, the index funds are “killing it” as Fortune reports.
Only a few expert managers outperform the stock market and even they have trouble maintaining their results over time. The famed PIMCO Total Return (bond) Fund offers a good example. Founded and managed by bond “guru” Bill Gross, it produced excellent earnings for many years but lost investors’ money in 2013. Gross left the company, and in 2014 Ford Motor Co. dropped the fund from its employees’ 401(k) offerings.
As Money Talks News founder Stacy Johnson says, “Just buy an unmanaged index fund and be done with it.”
How did you do on the quiz? If you’d like to learn more about investing, we’re here to help. Check out:
- “13 Dumb Investing Moves and How to Avoid Them“
- “How to Get Started Investing When You Don’t Have Much Money“
- “Five Simple Ways to Invest Your Retirement Money“
How comfortable are you with investing in stocks? Post your comments below or on Money Talks News’ Facebook page.
Stacy Johnson contributed to this post.