Trying to Make Sense of the Stock Market Madness

It’s been an exciting couple of months for the stock market. And for investors, “exciting” usually means “unsettling.”

To make sense of what’s going on, let’s listen in on a conversation between an investor and a financial advisor.

May 21, 2013

Investor: I want to invest in the stock market.

Advisor: No problem. I recommend an index fund that will match the performance of the entire US stock market. It costs 0.07% per year.

Investor: That’s cheap. I’ve heard I’ll make 12% per year in the stock market. Is that about right?

Advisor: Where did you hear that?

Investor: On a radio show.

Advisor: Not everything you hear on the radio is true. The actual long-term average for the US stock market is about 6.5%, if you adjust for inflation.

Investor: My savings account pays 0.01%, so that’s a big improvement. Great, let’s put in $10,000.

June 21, 2013

Investor: This fund you sold me stinks! You told me I’d make 6.5% a year. It’s been a month and I’ve lost 4.5%!

Advisor: The stock market isn’t a savings account. There are no guarantees. Sometimes the market goes up, sometimes it goes down. Surely you’ve noticed headlines about this before.

Investor: Yeah, but it feels different when it’s your own money disappearing. If I’m going to lose 4.5% of my money in a month, why should I invest in stocks at all? At that rate I’m better off giving the money to my brother for safekeeping.

Advisor: People invest in stocks because they’ve generally been a good bet in the past. Most of the time, investors in stocks have made money, and usually more money than if they’d invested in bonds or put the money in a savings account. I’m guessing you can’t say the same for your brother.

Investor: No, his specialty is turning money into beer. So if people usually make money in stocks, why did I lose money?

Advisor: You were invested during a period when the stock market went down.

Investor: Thanks a lot, genius. Aren’t I paying you to know when the market is going down so you can put my money someplace better until the market looks safe again?

Advisor: Nobody can predict when the market will go up or down. Here, you can borrow my copy of Rick Ferri’s book The Power of Passive Investing. It will explain just how badly you’re likely to fail if you try to time the market. And the stock market is never “safe.” If it were safe, you wouldn’t be able to make much money there.

Investor: Why not? Can’t you put my money somewhere that earns good interest but doesn’t make my principal disappear on a regular basis?

Advisor: Everybody would like to put their money somewhere like that, and plenty of advisors are selling that kind of promise. But it’s impossible.

Investor: Why?

Advisor: If there were a safe investment paying 6%, you’d buy it, right?

Investor: Of course.

Advisor: Me too. So would everyone else I know. Whoever is selling that investment will realize right away that they’re paying too much interest and could pull in just as much money by paying 5%, or 4%, or a tiny bit more than the other guy is paying.

Investor: So why doesn’t the same reasoning apply to stocks? I’ve seen some dividend stocks paying 6% or more.

Advisor: Because stocks are risky. Let’s turn the question around. You said your savings account pays 0.01%. We should find you a better savings account, but that’s for another day. Would you put your money in a risky investment that pays no more than 0.01%?

Investor: Not a chance.

Advisor: Right. Nobody would. If I’m going to put my money at risk, I demand a higher rate of return. That’s called a risk premium.

Investor: So you’re saying if I keep my money in this stock fund long enough, eventually I’ll earn 6.5%, but it might be a bumpy ride along the way.

Advisor: If only that were true. The stock market doesn’t have guarantees, remember? You can make money or lose money in stocks over a short, medium, or long period.

Investor: Aaargh! So should I keep my money in the stock market or not?

Advisor: The stock market is a good bet, but it’s still a bet, and that means you can lose. You didn’t put all of your money in stocks, right?

Investor: No, I have some in a savings account and some in CDs.

Advisor: And those accounts didn’t lose any money this month. So you didn’t lose 4.5% of your money, you lost 4.5% of part of your money. I wouldn’t put all of your money in any one type of investment.

Investor: That makes sense. How’d you get so smart, anyway?

Advisor: (rips off mask) I’m really a personal finance columnist in disguise!

Investor: (runs away)

Matthew Amster-Burton is a personal finance columnist at Mint.com. His new book, Pretty Good Number One: An American Family Eats Tokyo, is available now. Find him on Twitter @Mint_Mamster.