In 2022, the U.S. stock market experienced what we call in finance a bear market. There was a prolonged drop in stock market prices because of the Russia-Ukraine war and tightened monetary policy. The S&P500, the U.S. broad market index kept falling by more than 20% from its high at the beginning of 2022.
Source: Google Finance
But if this scared you and you concluded investing in stocks is not a good idea, you must think again.
Financial literacy is critical for building wealth. It is important for any person to know how market trends work, but particularly important for younger adults who are in their 20s.
Although I have taken the U.S. stock market as an example for this post, the principle applies to almost any country with a developed stock market.
In this blog, I will highlight two key points:
- Investing in stocks should always be done for the long term. If you look at the data over the long run, the overall stock market gave an average annual rate of return of 10% to 14%.
This chart from Google Finance shows that S&P 500 index, which is the benchmark index for US stock Market has an upward trend over the long run.
Sure, there are years (including 2020, 2022 as you see in the chart below) when it has fallen sharply because of various economic reasons. However, in the long run (5 yrs or more), if you see the trend line, it is going upwards.
So, yes if you just invested at the beginning of 2022 and wanted to take out your money after that, you would lose money on your investment. But if you plan to withdraw the same money in the next 5 or 10 years, I am sure it is going to fetch a much higher return.
2. Business Cycles are real
The reason for this is due to the occurrence of business cycles or sometimes what we call economic cycles. Most stable economies exhibit boom and bust. The chart below shows how there are periods of expansions and recessions where the GDP and stock market grow and contract respectively.
Most governments including the U.S. government through their fiscal policy and the Fed, through monetary policy, take corrective measures to bring the economy back on track. For the US, the target rate of inflation is 2% and the target unemployment is around 5%.
Over the long run, most stable countries show a pattern of economic growth as seen by the black trend line sloping upwards.
So yes, if you invest in the stock market for a long term, greater than 5-10 years, you should get a positive return. It will still be positive even after adjusting for inflation.
So don’t panic and start selling when the market starts falling, instead, wait and let it recover.
This actually would be the best time to start investing or adding more towards your monthly contributions. The best way to do that is by following a safe investment strategy such as dollar cost averaging. I have discussed that in detail in my previous articles on personal finance.
Have a balanced portfolio
But don’t put all your money in the stock market. For any investor, it is critical to have a balanced portfolio. Make sure to have an optimal mix of riskier and safer asset classes based on your age and risk tolerance.
Bonds are a relatively safer investment option compared to stocks, real estate, and gold, and therefore, have low returns on them.
Anyone who is less than 50 years old can have more of their money invested in the stock market versus anyone who is 50 and above. As you approach retirement age, you would like to have less money invested in the stock market and more in safer options. So, whenever you want, you can withdraw your money without worrying about market fluctuations.
Investing in stock is done to make your money grow over time. Yes, overtime is the keyword here. It is not meant for becoming rich overnight or for short-term gains.
Also, it is best to start investing early to reap the maximum benefits. Although, starting at any age is better than not starting at all unless you are close to your retirement age. Ideally, as soon as you get your first job you should think about investing a portion of your salary. You can start with 10-15%.
Create an emergency fund and pay off debt first
But before you start any type of investment, ensure you have enough cash to cover at least 3-6 months of expenses in an emergency fund. Usually, people like to keep it safe in an FDIC-insured high-yield savings account. This is the liquid money that will cover any type of contingency, which you can withdraw whenever you want to.
So it is essential you save enough money to cover the downpayment of your house, job loss, car breaking down, or any unforeseen event where you need immediate cash.
This is especially true if people fear a recession coming in 2023. Having a buffer in a safe place such as a savings account will give you peace of mind.
Also, don’t forget to clear all the high-interest loans (over 5%), such as credit cards. Western countries have taught the world to live on credit. We buy almost every single day so many things on credit cards. But sometimes people don’t realize it and by living above their means, go into a debt spiral.
The interest rate that you are paying on credit card loans is usually higher than what you earn from savings.
We must remember that we do most investments for the long run. We won’t get a 10%-12% guaranteed return from investing in stocks the very next year. It takes at least a couple of years to average out market fluctuations.
Cherry-picking stocks is not worth it
As I mentioned in my other article, it’s always best not to invest too much money in individual stocks. It’s too much work to go through the company’s financials, thoroughly reading their annual reports (10-Ks) and quarterly reports (10-Qs) to understand the company’s fundamentals and prospects.
Even professionals and seasoned investors cannot time when to buy or sell stocks based on the earnings call of the companies. The reason is simple. The stock price that we see on the market has already incorporated any type of news that is available to the public. Thus everybody already knows and you won’t know any better story.
You will not know any insider news about the company’s prospects unless you are the owner of that company or in the senior management. Speculating what the price is going to be tomorrow will be nearly impossible to do.
Diversification is the answer
Index funds or ETFs in this case are the best and safe options because they diversify your risk across so many different stocks. So even if one or a few companies underperform, you will be still fine.
With ETF you have to set reminders for periodic contributions. Which type of fund is right for you depends on many factors. I have a detailed article on this topic here if you want to learn more.
My two cents
So, after you have saved for an emergency fund and paid off high-interest debt, start by investing at least 10%-15% of your paycheck every month. You can put this money in some type of broad-based index fund on an ETF. You make monthly contributions so that your investment grows over time. The good thing about index funds is that they are automated. Money automatically transfers to your brokerage account from your checking account.
The key takeaway from this article is that do not panic if you see the stock market going down in a particular year. This is not the time to sell. In the current scenario, it is a good idea to invest the money that you have sitting idle in your bank account. Do it after paying off your high-interest debt and establishing an emergency fund to meet your 6 months’ expenses.
Spend wisely and realize the importance of saving and investing. Most millionaires are not just born wealthy. They just make good investment decisions early in their life and build wealth. Instead of spending a lot of money on things that actually depreciate in value, such as buying a fancy car, they save and invest that money from the beginning. As their investment grows, they begin to reap its benefits for a substantial part of their life. Investment in a diversified portfolio is an easy passive way of getting rich, where money does the work for you.
