Pros and Cons of Investing in Stocks

Investing in stocks means that you own a piece of a company that you buy a stock in. As the company grows, you can expect the stock to deliver a return on your investment. What are the pros and cons of investing in the stock market?

Historically, the stock market has delivered generous returns to investors over time, but it also goes down, presenting investors with the possibility of both profits and loss, for risk and return.

Stock Investing Pros and Cons

6 Advantages of Stock Investing

Stock investment offers plenty of benefits:

1. Takes advantage of a growing economy: As the economy grows, so do corporate earnings. That's because economic growth creates jobs, which creates income, which creates sales. The fatter the paycheck, the greater the boost to consumer demand, which drives more revenues into companies' cash registers. ​​It helps to understand the phases of the business cycle—expansion, peak, contraction, and trough.
2. Best way to stay ahead of inflation: Historically, over the long term stocks have yielded a generous annualized return. For example, as of January 31, 2022, the 10-year annualized return for the S&P 500 was 15.43%. That's better than the average annualized inflation rate. It does mean you must have a longer time horizon, however. That way, you can buy and hold even if the value temporarily drops.
3. Easy to buy: The stock market makes it easy to buy shares of companies. You can purchase them through a broker or a financial planner, or online. Once you've set up an account, you can buy stocks in minutes. If you're a small business owner, you may even be able to invest in stocks through your business.
4. Don't need a lot of money to start stock investing: Most retail brokers such as Charles Schwab, let you buy and sell stocks commission-free. Some brokers such as Fidelity also don't require account minimums. If the stock you want to buy is too expensive, you can also buy fractional shares if your broker allows for such investment.
5. Make money in two ways: Most investors intend to buy low then sell high. They invest in fast-growing companies that appreciate in value. That's attractive to both day traders and buy-and-hold investors. The first group hopes to take advantage of short-term trends, while the latter expect to see the company's earnings and stock price grow over time. They both believe their stock-picking skills allow them to outperform the market. Other investors prefer a regular stream of cash. They purchase stocks of companies that pay dividends. Those companies grow at a moderate rate.
6. Liquidity: The stock market allows you to sell your stock at any time. Economists use the term "liquid" to mean that you can turn your shares into cash quickly and with low transaction costs. That's important if you suddenly need your money. Since prices are volatile, you run the risk of being forced to take a loss.

6 Disadvantages of Stock Investing

Here are disadvantages to owning stocks:

1. Risk: You could lose your entire investment. If a company does poorly, investors will sell, sending the stock price plummeting. When you sell, you will lose your initial investment. If you can't afford to lose your initial investment, then you should buy bonds.
2. Common stockholders paid last: Preferred stockholders and bondholders or creditors get paid first if a company goes broke. But that happens only if a company goes bankrupt. A well-diversified portfolio should keep you safe if any company goes under.
3. Time: If you are buying stocks on your own, you must research each company to determine how profitable you think it will be before you buy its stock. You must learn how to read financial statements and annual reports and follow your company's developments in the news. You also have to monitor the stock market itself, as even the best company's price will fall in a market correction, a market crash, or bear market.
4. Taxes: If you sell your stock for a loss, you may be able to get a tax break. However, if you sell your stock for a profit, you'd be liable to to pay capital gains taxes.
5. Emotional roller coaster: Stock prices rise and fall second by second. Individuals tend to buy high out of greed, and sell low out of fear. The best thing to do is not constantly look at the price fluctuations of stocks, and just check in on a regular basis.
6. Professional competition: Institutional investors and professional traders have more time and knowledge to invest. They also have sophisticated trading tools, financial models, and computer systems at their disposal.

Diversify To Lower Investment Risk

While investing in stocks is riskier compared to bonds, there are ways to reduce your investment risk, such as by diversifying. Diversification means investing in different types of assets, across different sectors so that you spread out your risk. If one type of stock or asset goes down in value but other types of investments go up or stay the same, your entire portfolio is not impacted in a big way.

Here are some ways you can diversify your stock investments:

1. By investment type: A well-diversified portfolio will provide most of the benefits and fewer disadvantages than stock ownership alone. That means a mix of stocks, bonds, and commodities. Over time, it's the best way to gain the highest return at the lowest risk.
2. By company size: There are large-cap, mid-cap, and small-cap companies. The term "cap" stands for "capitalization." It is the total stock price times the number of shares. It's good to own different-sized companies because they perform differently in each phase of the business cycle. For example, large cap companies are considered more stable and less susceptible to share price volatility. On the other hand, small cap companies might be riskier and prone to share price volatility but offer greater growth potential.
3. By location: Own companies located in the United States, Europe, Japan, and emerging markets. Diversification allows you to take advantage of growth without being vulnerable to any single geography.
4. Through mutual funds and ETFs: Owning mutual funds or exchange-traded funds (ETFs) allows you to own hundreds of stocks selected by the fund manager. One easy way to diversify is through the use of index funds or index ETFs.

The Bottom Line

There are clear benefits and drawbacks of investing in stocks. Historically, stocks have generated generous returns over the long-term but investing in stocks also comes with significant risk. Risks of stock investing can be spread across different stocks, sectors and geographies, in a process called diversification.

How much of each type of investment should you have? Financial planners suggest you establish your asset allocation based on your financial goals and where the economy is in the business cycle.

Frequently Asked Questions (FAQs)