A good investment strategy rests on the correct allocation of your wealth into various investments. One of these investments is the stock market. For the average person it is generally recommended that the strategy includes equal parts of three investment types: one third in cash (bank savings) one third in property, one third in equities (stocks).
No investment is risk free, as the recent crash has demonstrated. Banks can crash, as has happened to many (a few hundred over the past two years). Property can crash, as has happened to the housing market over the past two years. Individual stocks can crash (e.g. Enron). Even the stock market can crash as has recently occurred.
So where does an investor build wealth?
While all three investment types are still valid, the stock market remains one of the most valuable sources of investment income. However, whereas we have in the recent past become used to investing and forgetting, knowing our investment would increase, we now need to accept that all investments need to be monitored.
A review of the S&P 500 index over the past 30 years is illuminating. The S&P 500 index is made up of the average of the top 500 public stocks in America. The movement of the index is, therefore, a very good proxy for the movement of the stock market as a whole. The value of the index is currently (September 2010) approximately 1120. In September 1980 it was 125. The index has therefore increased 940%, or just over 7.5% compounded annually. Looking further, in September 1995, the index was 584. The increase since then has been just under 100%, or just under 4.5% compounded annually. If you take into account the dividend yield of about 2% the average return is about 6.5% annually which is a significant return on investment compared to bank interest of currently under 1%. (Indexarb:S&P 500 dividends.)
It is a fact that the American market as measured by the S&P 500 reached 1120 in 1998, and has now hit that point again. An investment over that period has remained flat (in terms of market price) but has still produced dividends, at an average of 2% per year (dividend yield), once again re-iterating the fact that the stock market is still a long term investment opportunity.
It has to be emphasized that we are talking here about investing, not speculating or trading. An investor wishes to safely keep and accumulate passive wealth. A speculator looks for high return opportunities which have a high risk, such as start-up companies, turn around companies and so on. Alternatively they leverage their investment through borrowing or buying derivatives (options, futures, hedges). These can make you rich overnight. They can also bankrupt you overnight. A trader buys and sells, often making only a relatively small profit on each transaction. However, it only takes a couple of bad trades to lose your money.
There is no guarantee that the stock market will continue growing. Similarly, there is no guarantee that any particular bank will stay afloat. After all, if a major company like Enron could crash and a major company like AIG needed assistance, then the future is never guaranteed. However the history of the stock market over the past thirty years – which included at least two crashes (2002, 2008) – has shown that a well-managed company that provides essential services will provide a safe haven for your wealth.
[It is advised that you consult an investment advisor and personal tax advisor before making any investments].