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___________Chapter 9: Funds for Longer-Term Needs: Stock Funds
Add regularly to your stock investments
Although the stock market may be able to double the purchasing power of your money on average every ten years, the real key to creating wealth with stocks is investing in them regularly. Put $1,000 into stocks, and ten years later, you’ll probably have $2,000. But if you put $1,000 into stocks every year for ten years, you end up with $14,000 — that’s 700 percent more. Remember the power of combining these two simple but powerful financial concepts: Regular savings and investing in growth-oriented investments lead to simply amazing long-term results.
Another advantage of buying in regular chunks (some call this strategy dollar<ost averaging, a subject I cover in Chapter 6) is that it softens the blow of a major decline. Why? Because you’ll make some of your stock investments as the market is heading south; perhaps you’ll even buy at or near the very bottom. After the market rebounds, you’ll show a profit on some of those last purchases you made, which will help to soothe the rest of your portfolio — as well as your bad feelings about the stock market. If you had used-dollar cost averaging during the worst decade for stock investors this century (1928-38), you still would have averaged 7 percent per year in returns despite the Great Depression and a sagging stock market.
Stocks and Funds
Mutual funds are the way to go when you want to invest in stocks. Stock funds offer you tons of diversification and a low-cost way to hire a professional money manager. In Chapter 2,1 discuss at length why purchasing individual stocks on your own doesn’t make good financial sense. (If you haven’t read Chapter 2 yet and you believe that buying individual stocks is the best route for you to take, please read it.)
Stock funds reduce risk and increase returns
There’s really no way around it: Invest in stocks, and you expose yourself to risk. But that doesn’t mean that you can’t work to minimize unnecessary risk. One of the most effective risk-reduction techniques is diversification — owning lots of different stocks to minimize the damage of any one stock’s decline. Diversification is why mutual funds are such a great way to own stocks.
Part II: Establishing a Great Fund Portfolio
Unless you have a lot of money to invest, you can only cost effectively afford to buy a handful of individual stocks. If you end up with a lemon in your portfolio, it could devastate the returns of your better performing stocks. Companies are quite capable of going bankrupt. Even those that survive a rough period can see their stock prices plummet by huge amounts — 50 percent or more — and sometimes in a matter of weeks or months.
Even with the extended bull market in recent years (a bull market is one in which stock prices are rising; its opposite is a bear market), certain individual stocks have taken it on the chin. A good example is the technology stock ATC Communications, which was widely touted on Internet message boards in late 1996 after a seven-fold rise in price over the prior year. After peaking in the mid- 20s in October 1996, the stock plunged more than 90 percent in a matter of months and didn’t rebound. Problems can take many years to develop as well. IBM was once considered to be among the more reliable and safe blue chip stocks. After trading as high as 175 in the early 1980s, it plunged 77 percent to a low of almost 40 in 1993. As of this writing, it’s up to about 115.
Of course, owning any stock in a company that goes bankrupt and stays that way means that you lose 100 percent of your investment. If this stock represents, say, 20 percent of your holdings, the rest of your stock selections must increase about 25 percent in value just to get your portfolio back to even.
Stock mutual funds reduce your risk by investing in many stocks, often 50 or more. If a fund holds 50 stocks and one drops to zero, you lose only 2 percent of the value of the fund if the stock was an average holding. If the fund holds 100 stocks, you lose 1 percent, and a 200-stock fund loses only 0.5 percent if one stock goes. And don’t forget another advantage of stock mutual funds: A good fund manager is more likely to sidestep investment disasters than you are.
Another way that stock funds reduce risk (and thus their volatility) is by investing in different types of stocks across various industries. Some funds also invest in U.S. and international stocks (even though the fund names may hide this fact).
Different types of stocks don’t always move in tandem. So if smaller-company stocks are being beaten up, larger-company stocks may be faring better. If growth companies are sluggish, value companies may be in vogue.
If U.S. stocks are in the tank, international ones may not be. (I discuss these different types of stocks later in this chapter.)
Chapter 9: Funds for Longer-Term Needs: Stock Funds 215
You can diversify into different types of stocks by purchasing several stock funds, each of which focuses on different types of stocks. There are two potential advantages to this diversification. First, not all of your money is riding in one stock fund and with one fund manager. Second, each of the different fund managers can focus on and track particular stock investing possibilities.