Have you ever been tempted to "play the stock market" by following a hot tip, only to watch your shares plummet? Do you want to invest, but feel overwhelmed by all of your choices? How do you know if you should invest in stocks at all? As a female financial advisor, I hear these questions a lot.
Here's a powerful, yet simple guideline I personally love: Don't put money in stocks unless you can afford to leave it there for at least 5 years -- and ideally as long as 10 years.
What's the rationale behind this time frame?
The short answer is that it dramatically increases the odds that you will have a positive return on your investment.
To more fully explain, let's start with the definition of a stock. A stock is a piece of ownership in a business. If you buy a share of that business at a reasonable price and the business prospers, over time, you can expect the price of your share to go up with the business' earnings. The problem is that this relationship is not perfectly linear. In the short run, human emotions like greed and fear are the primary drivers of stock prices. In contrast, over the long term (defined as a 10-year plus period), the key driver of stock prices is the earnings the company is generating.
It's not so far off from building a classic wardrobe. In any given year, you may have one or two pieces that are in style and a few pieces that are not in style, but over the long run, if you stick with the classics you can stay on track and easily adapt to new trends.
The financial version of doing this is to own a diverse basket of stocks. A common one is called the S&P 500, and represents shares of 500 large US companies such as Apple, Exxon, and General Electric. How has the S&P 500 performed over time?
We have good stock market data back to 1926. If we were to look at rolling 5-year periods for the S&P 500, we'd find that 86% of the time, stocks generated a positive return. This means that going back to 1926, if you were invested for a five-year period, you had an 86% chance of earning a positive return. To add icing on the cake, the average return of all 5-year rolling periods was 9.8%.
Now, what happens if you stretch the time period out to 10 years? Since 1926, rolling 10-year returns were positive 95% of the time with an average 10-year return of 10.5%. So, not only did an investor have a high likelihood of earning a positive return, it was also a strong return. But if you look at just individual calendar years, in only 72% of the years from 1926 to 2012 did stocks have a positive return.
Sure, you can trade in and out of stocks over shorter periods of time, but the odds are not in your favor. On top of this, you may incur trading and tax costs that can add up quickly, further diminishing your overall return. While past performance is never a guarantee of future returns, history suggests that a strategy of patient investing gives you a greater chance of success.
[This post originally appeared at MoneyZen.com. For more MoneyZen in your life, follow Manisha on Twitter at @ManishaThakor, on Facebook at /ManishaThakor, or sign up to receive Manisha's MoneyZen blog via email by clicking here.