A hesitance some potential investors hold is that investing is like gambling. They perceive throwing money into the stock market as a similar unknown to throwing that money down on the roulette table. Both actions could leave them richer or poorer than they were initially.
While either action can impact your wealth, the probability of increasing your wealth with either action is vastly different due to contrasting business models. When gambling, you know the casino is going to win more frequently than the individual gamblers. “The house always wins” is a business model in the gambling world. A casino needs to take more money from gamblers than it gives to gamblers to make a profit.
The business model for investing is quite different. If you invest in a specific stock, you are giving a company money to indicate that you believe in its potential success. When that company earns money, you earn money too! Stockholders are rewarded when a company in which they invest grows through dividends and capital appreciation. In other words, both the company and the investor benefit from the company’s success. While the casino has a finite amount of money to spread around, necessitating most individuals to be losers while some are winners, the potential growth of a particular company is limitless.
Stocks are Still Risky
Investing in individual stocks is not a zero-sum game like a casino, but it still poses risks and is not necessarily a consistent path to building wealth. While some investors got lucky by investing in Amazon in the late 1990s, others chose to invest in Borders. Both companies started as book sellers to get books into the hands of readers in diverse locations. One is now an online retail giant, while the other closed its stores in 2011.
Investing in an individual stock is much friendlier than gambling, yet investors are still far from immune to the risk of a company failing. Businesses that once thrived fall short of keeping up with innovation and new consumer patterns. Shareholders can experience significant decreases in the value of their investment or lose that portion of their wealth entirely if a company goes bankrupt, making investing in individual stocks still far from a prudent investment for general wealth building.
How to Avoid the Risks of Stock Picking
Despite the possibility of individual companies going bankrupt, depleting any wealth invested in a specific stock, we have not experienced a situation where all companies go bankrupt simultaneously. There will always be some companies that continue to run successful business models, even when financial times are tough. My grandmother lived relatively comfortably through the Great Depression because her father ran a grocery business. This allowed him to occasionally treat my grandmother and her friends to a trip to the movies. A quick anecdote from my grandmother’s childhood tells us that folks still need to eat in the worst of times, and businesses providing basic survival services will still exist. It also shows that the owners of those essential businesses will still receive an income and still seek out non-essential goods, allowing additional businesses to stay afloat. Even in the worst of times, some businesses survive.
Since there will always be some businesses that persist through even the most trying economic times, the best way to avoid the risk of individual stock picking is to instead invest in the entire stock market. This allows you to avoid the risk of a single failed business and instead assume that at least some businesses will continue to grow and generate profits.
Investing in index funds, rather than individual stocks, is the way to eliminate the risk of losing your wealth due to a failed company. Index funds are collections of stocks. Instead of buying a piece of one company, you can buy a piece of hundreds of companies. Investing in index funds offer two safeguards for investors: First, no single company has a major impact on an investor’s wealth. Second, index funds have rules about which businesses are included to add further safeguards from the biggest losses.
The first point is intuitive. If you are investing in 500 companies simultaneously and one company has a poor year, there are 499 other companies to pick up its slack. You will not feel volatility from a single company because you are invested in so many other companies! Investing in a little piece of so many companies means your wealth grows as long as the overall economy grows. As long as business owners continue seeking to grow their wealth and businesses, your wealth grows. That feels like a safe assumption.
Index Fund Rules as a Safeguard
The S&P 500 is an index including 500 of the largest U.S. companies, and is often used to measure the health of the U.S. stock market as a whole. While there are numerous indices with different criteria, this common index is a prime example of how investing in indices reduces risk by incorporating rules about which companies are included in the index. It has a number of rules for inclusion, and companies can be added to or removed from the S&P 500 over time.
This set of rules keeps investors safe from the likelihood of a failed business. As our article on where to invest your money explains, “the S&P 500 is also considered a self-regulating index because when the total value of the company’s shares held by all stockholders (also called the company’s market capitalization) falls below a certain threshold, the company is no longer eligible for inclusion in the S&P 500 and will be replaced by another company.” The S&P 500 will not keep failing businesses in its index. Instead, it will swap them out for other businesses, because at any given moment some businesses will continue to grow.
The Market Goes Up Over Time
The business model of stocks is mutually beneficial, as opposed to zero-sum like gambling establishments. But risks remain since businesses can go bankrupt. Index funds eliminate this risk by consistently monitoring which companies are included in the index and including a large number of companies to spread out risk from any one business. An investor invested in an index fund has a mutually beneficial relationship with hundreds of companies seeking to generate wealth for themselves and their investors.
Some folks, though, still wonder if investing at all is worth it. Investing hard-earned money means not knowing what value it will have tomorrow, in a year, or in five years. That is scary for investors who spent countless hours working for that money.
While there is no guarantee that the money will grow in the short-term, and even no guarantee it will grow in the long-term, we do have history. Historically, the market has always gone up over time. While your investments may go down over a year, they will almost certainly go up over the next thirty years. There are bumps, but here is the S&P 500 performance since before 1980:
It is difficult to save enough money to retire without investing. Additionally, any money you have saved but not invested will actually lose value over time due to inflation. Investing will carry your money to keep up with inflation rather than allowing it to devalue it slowly over time.
Since the stock market goes up over the long run but not necessarily in the short term, this means investing is best for long-term objectives like paying for your child’s college in 20 years or retiring in 30 years. The shorter your planned investment term, the riskier investing in the stock market becomes. But if you invest over the long term, the market will likely go up since business owners want to grow their businesses. You may as well have a piece of their success.
If You Lose Everything, There Are Bigger Issues than the Market
In my eyes, investing in index funds is a sure bet that I will win. As many complaints as there are about capitalism, capitalism means the owners of these big businesses will keep working unhealthy hours to make their businesses thrive, and I may as well take a piece of their financial success by doing absolutely nothing. There is an endless supply of overachieving entrepreneurs ready to do far more work than I am that want to build wealth. I will happily invest in their companies to grow my wealth by relying on their enduring energy.
However, the fact that the stock market has always gone up is a reflection of historic truths. While historic data is the best data we have to make any educated decision, it is not always indicative of future performance. Theoretically, the stock market could go down at some point in the future even though it has always gone up historically.
So why am I certain investing in index funds is a win? In a hypothetical future where the stock market goes down over time, something must have happened to so badly hurt the economy that the Jeff Bezoses and Elon Musks of tomorrow are not building their businesses and generating wealth throughout the economy. That kind of event would likely involve a climate catastrophe or political upheaval so disastrous that the stock market is the last concern on everyone’s mind.
In other words, I think the U.S. stock market will continue going up through most conditions, unless the country is subjected to widespread disaster, famine, or war. In any of those circumstances, I have bigger things to worry about than index funds. In all normal circumstances, I am betting Elon continues avoiding sleep in favor of making more money, and that allows me to sleep well at night because I made the safest bet possible.
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