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20 questions, No. 2: Why would you buy stocks?

Updated: May 3, 2013 12:14PM

As the market reaches new lows, and retirement savings appear to have gone down the drain, it's certainly understandable that anyone would ask: Why buy stocks?

You'll have to step back from current events and your emotions to examine the reasons for buying stocks, now or at any time. This is not a response to the question of whether this is the "right time" to buy, or an answer to the question on everyone's mind: "Have we hit bottom yet?"

The real question is whether stocks (equities) are an asset that can make your wealth grow -- or just a "trick" that has lured Americans into unreal hopes and dreams, followed by financial disaster.

How stocks work

First, what are stocks? They are shares of ownership in a company to get capital for expansion, and to reward the original investors who will now have a marketplace to sell their shares.

The only reason to buy shares in a company is because you believe the business will grow. That growth is measured by the company's total after-tax earnings -- divided by the number of shares it has sold to investors -- which are reported to the public every three months.

The company will retain some of those earnings for future growth, and may pay out some of its earnings as dividends.

If investors think the company will continue to grow, they will be willing to pay more for the shares of the company's stock. If a company is expected to earn $1 per share this year, and $2 per share next year, stock buyers may be willing to pay a price that represents 10X (10 times) next year's earnings. That is, they would be willing to pay $20 per share for the stock.

Of course, if earnings fall, they will rush to sell the stock. Once a company's stock is trading publicly, every transaction is made at the price that buyers and sellers agree upon. That is, if General Electric is trading at $7 a share, that means someone wanted to sell at that price, and someone else felt it was time to buy!

The long run for stocks

Stock market performance over the period from 1980 to 2000 was one of the best 20-year periods in history. Even the "dot-com crash" of 2000 didn't alert people to market risk. It did, however, demonstrate the value of "diversification" among stocks. Still, Americans came to believe that the stock -- and housing -- market, could only rise meteorically.

If only investors had some historical perspective, their expectations about stocks -- and home prices -- would have been realistic.

Actually, the stock market -- over the long run -- is far less risky than most people think today.

According to Ibbotson, the market historians, there has never been a 20-year period -- going back to 1926 -- where you would have lost money in a diversified portfolio of large-company American stocks, with dividends reinvested -- even adjusted for inflation.

Let's take a closer look at that fact.

First, you need a diversified portfolio of large-company stocks, such as a mutual fund that tracks the S&P 500 stock index. Second, it requires that dividends be reinvested -- as automatically happens in your retirement plan.

The third part about beating inflation is important too. When paper money is losing value, many investors turn to stocks, which represent real assets. Finally, you need at least a 20-year time horizon!

So, why buy stocks?

No one suggests you put all your money into stocks. It's always good to have some "chicken money" in the bank to ride out the ups and downs of the market.

But if you believe in the future growth of the economy, and if you believe in the future of our free enterprise system that has created so much opportunity for so many people, then you want to own stocks.

You don't have to pick individual stocks. In fact, you want to spread your investments over many stocks through a mutual fund. And you don't have to pick the right time to own stocks, or to sell. Even Warren Buffet makes mistakes.

All you have to do is keep investing on a regular basis, if you believe in the future of America.

And that's The Savage Truth!

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