In last week’s post I explained what the three main forms of business ownership are: sole proprietorship, partnership and corporation and I explained that a stock is a share of corporate equity or basically a piece of ownership in a corporation. So why do people invest in stocks? There are all sorts of things out there that people believe about the stock market. Some believe that that the stock market is practically a casino since stock prices change randomly, others believe that stocks are controlled heavily by big business and that its none of their business to be involved in in them, yet other people believe that they can simply do without stock investment simply because they don’t care about finance or business. All of these things are simply untrue. The stock market is not a casino because an intelligent investor can grow their money safely by buying stocks below their intrinsic value and holding them for the long term. As for the second assertion it is true that businesses do have a direct effect on their stocks but the idea that the management officials in a company somehow work for their own benefit is completely without base. The managers of a corporation must act in the best interest of the corporation’s owner, that is, the stockholders, and not just the institutional ones according to the law, because they are considered agents of those owners. Though I cannot cite any specific source I’m certain that lawsuits have occurred where stockholders have sued their corporation’s mangers for not acting in their best interests. The third reason that people avoid that stock market is the one that I seek to explain most thoroughly.
Simply not being interested in stock is not a valid reason to avoid stock investments. The first step to understanding why is inflation. Most people know inflation as a general rise in prices in the economy, which is true. It is more important for anyone who has saved any significant amount of money is that inflation also corrodes the amount of “stuff” that their money can buy. For example let’s say that I have $100 dollars and as of right now in 2014 the price of one gallon of milk is $10 then say that over ten years inflation occurred such that the price of milk is $20 in the year 2024. In 2014 at the price of $10 I could buy 10 gallons of milk. After the ten years pass and the price of milk changes to $20 if I still have my $100 under my mattress, I would now only be able to buy 5 gallons of milk. On average each year for this to work about 7% inflation would have had to occur. If I had invested my money in stocks, bonds, certificates of deposit, or anything else and earned a return of 7%, I would still have the buying power to buy 10 gallons of milk. The effects of this effect on a larger scale say on money being saved for retirement savings can be devastating, since more money and a greater number of years exist in which inflation can act. The only way to completely or partially counteract this effect is through intelligent investment practices. Thus our purpose as investors is not to get rich quick, but rather to mitigate the effect of inflation and the decrease in buying power of money.
Why can’t I just invest in bonds or put my money in a bank? In the long run stock outperform bonds by a long shot. In the last 12 months the Standard and Poor’s 500 stock market index had returns of 17.78 percent while the Barclays Aggregate Bond market Index had returns of 0.50 percent within the same period. The rate of inflation for this year was 1.5%. Bonds would not have cut it and bank accounts would not even have come close. The only investment that couldn’t shielded against inflation was the stock.
To recap, investment is performed to allow a person’s savings to maintain their buying power in the face of inflation. While there are many types of investment choices out there, stocks are the ones that are most likely to provide an investor returns above the level of inflation in the long run.
The author is a student, not an attorney at law or finance professional. As such, this article is not intended to constitute legal or finance advice and is offered as is.
If you have any questions please post them in the comments below and I will attempt to get back to you!