There are two powerful motivations at work in every investor. One is the desire for gain, and the other is the fear of loss. How you balance those two motivations determines your personality as an investor, and how much risk you're willing to take to meet your investment goals. As a rule, investing in stocks is considered a higher-risk approach, while savings accounts and similar guaranteed products are considered conservative. However, a number of factors make stocks the better long-term investment.
The return of most investments goes up and down over time. Stocks are among the most volatile, and they can be downright frightening as a short-term investment. However, in the longer haul they outperform every other major type of asset. Since 1926, the stock market has averaged a 10 percent return on investment, well ahead of bonds and fixed-interest products such as Treasury bills and certificates of deposit. Those are conservative, low-risk investments with low yields, but even those provide a larger return than a savings account.
Savings accounts are insured by the Federal Deposit Insurance Corporation for amounts up to $250,000 per investor per institution. That makes them exceptionally safe places to keep your money. Unfortunately, in the investment world safety means low returns and in early 2012, returns on savings accounts were a fraction of a percent. Money market funds are special mutual funds that function much like a bank account but pay higher rates of interest. Certificates of deposit, or CDs, offer higher rates but require you to lock away your money for a set period of years. All are safe ways to hold your money, but they offer little other than safety.
Risks of Stocks
That doesn't mean safety isn't an issue. The stock market offers many risks to investors, and it's certainly possible for the market to deal you a devastating blow at any time. Even powerful, well-established companies can fail if their management doesn't keep up with the times or if they are superseded by new technologies. An ill-timed downturn in the markets can take away a large part of your portfolio's value overnight. If some of your holdings are overseas, currency exchange can erode your returns. So can taxation, unless you're holding your investments in a tax-sheltered plan such as a 401(k) or an IRA.
Risks of Savings Accounts
A lot of investors don't realize that safe, conservative savings products have risks of their own. For one thing, their return depends on interest rates, and those are subject to large-scale market forces. You can pick better-than-average stocks and prosper in bad times, but you can't do anything about the interest rates. Another crucial factor is inflation, especially in times of low rates. Steady rises in the cost of living erode the purchasing power of each dollar in your portfolio, and if the interest on your savings is lower than the rate of inflation, it's just the same as losing money.
The Effect of Higher Returns
In the late stages of your investment plan, when you're getting near retirement, it makes sense to have a large part of your portfolio in savings products, where your capital isn't at risk. However, in the early days when time is on your side, stocks are the better long-term investment. Imagine you've invested $100 in stocks, while your neighbor invests that same $100 in savings products. After 25 years in savings products averaging a very generous 5 percent, that $100 would be worth $339. That same $100 in stocks, averaging the historic 10 percent per year, would have compounded to $1,083.
Fred Decker is a trained chef and certified food-safety trainer. Decker wrote for the Saint John, New Brunswick Telegraph-Journal, and has been published in Canada's Hospitality and Foodservice magazine. He's held positions selling computers, insurance and mutual funds, and was educated at Memorial University of Newfoundland and the Northern Alberta Institute of Technology.