Stocks are an integral of almost any investment portfolio. They can provide both cash flow and capital appreciation. We discuss the top 7 reasons for investing in stocks.
- High Potential Returns
- Cash Flow
- Economic Growth
- Inflation Protection
- Flexibility and Choice
- International Diversification
First of all, let us define what a stock or a share is. A stock represents fractional ownership in a company. When we buy stock in a company, we become shareholders of that company.
Being shareholders of a company gives us certain rights. The most important ones are benefiting from its future growth, receiving excess cash flow from its profitable operations, and having a say when it comes to deciding about the future of that company.
With those characteristics, it is easy to make the case and identify reasons for investing in stocks. In the next few sections, we analyze 7 important reasons why we should own equities in our investment portfolio:
1) High Potential Returns
The main reason why most investors are attracted to the stock market is its potential for high returns. Compared to other asset classes, stocks have tended to offer higher returns throughout history.
The additional risk we take when we invest in stocks compared to other asset classes such as bonds or cash, usually translates into higher expected returns. As a result, in the long term, and in most situations, stocks are a great vehicle to grow our wealth over time.
2) Cash Flow
At its core, the wealth a country produces comes from combining capital and labor. Capital provides those things that require an initial outlay (infrastructure, machinery, systems, tools, etc.) and workers put their knowledge, effort, and time.
The value of the goods and services produced is then divided between capital and workers. The percentage that goes to capital varies depending on the country, and fluctuates every year, but tends to oscillate between 30% and 40%.
If we are shareholders of companies, we can benefit from the portion of the economic output that goes to the owners of that capital. At the same, it is worth mentioning that this does not require us to invest our time or effort in the process. We can be generating additional income while we sleep.
3) Economic Growth
Because being shareholders allows us to benefit from the success experienced by the companies we own, it also allows us to benefit from the growth of the economy. When economic activity increases, the volume of sales and corporate profits usually rises too.
In addition, if we have a well-diversified stock portfolio, it does not matter which sector is growing the most. We benefit from the general level of economic growth in the economy.
4) Inflation Protection
Related to the previous point, when there is inflation in the economy and prices rise, the nominal volume of sales and, in many cases, profits tend to rise. This is because companies can decide to increase the price of the goods and services they sell.
While inflation will not make us richer, as money loses value in the process, stocks do offer us a relatively good level of protection against the nasty effects of inflation, especially when compared to other asset classes, predominantly bonds and cash.
At this point, it is worth highlighting that stocks also suffer if inflation is too high. This is because those situations lead to inefficiencies in the economy, as well as social unrest, and that will ultimately impact corporate profits negatively.
5) Flexibility and Choice
Another great advantage of investing in stocks is the almost unlimited choice of investment options available us. We can invest in the stock market directly by purchasing shares of individual companies or through investments funds, such as index funds or ETFs.
And our options are almost infinite. We can choose pretty much any country in the world, our favorite sectors, types of companies, brands, etc. The stock market offers a lot of flexibility so that we can build our ideal portfolio.
6) International Diversification
Due to the flexibility offered to us by the stock market, stocks and funds are an excellent option to boost the degree of diversification of our portfolio by investing in international markets. This can be as simple as buying an ETF that tracks the global MSCI World index, composed of all developed countries.
Investing internationally will reduce our exposure to the ups and downs of our domestic economy. Even though we live in an interconnected world, not all countries are doing well or poorly at the same time. By geographically diversified, we avoid worst case scenarios while benefiting from the long-term growth of the global economy.
Finally, another reason for investing in stocks is their liquidity. Stocks are very liquid assets, which can be bought and sold at almost any time, with very low transaction costs, and at very transparent prices.
Compared to a real estate investment, whose purchase and sale are associated with the payment of multiple taxes and fees, a relatively long waiting time, and in a market where prices are opaque and may be dependent on negotiation between individuals, stocks are a much more comfortable investment.
I hope you are motivated and convinced of the reasons for investing in stocks. They offer good investment potential, low costs, convenience and the potential to diversify our wealth.
Does that mean we should invest everything we own in stocks? Absolutely not. The best risk-adjusted returns are obtained when stocks are combined with other asset classes. Do not forget that stocks are quite volatile, and there have been long periods of poor performance in the past.
As a consequence of that, it is advisable to also look at other asset classes, such as bonds, commodities, real estate, gold, and other alternatives.
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