1. Over the long term, stocks have historically outperformed all
From 1926 to 1999, the stock market returned an average annual 11.4
percent gain. The next best performing asset class, bonds,
returned 5.1 percent.
2. Over the short term, stocks can be hazardous to your financial
If you thought the Dow's 554-point drop on Oct. 28, 1997 was rough,
consider the 508-point drop 10 years earlier, on Oct. 19, 1987. The
1997 decline was a mere 7.2 percent, while the 1987 crash -- the worst
one-day drop in stock market history -- chopped 22.6 percent off
the value of stocks in a mere six-and-a-half hour trading day.
3. Risky investments generally pay more than safe ones.
Investors demand a higher rate of return for taking greater risks.
That's one reason that stocks, which are perceived as riskier than
bonds, tend to return more than bonds. It also explains why long-term
bonds pay more than short-term bonds. The longer investors have to
wait for their final payoff on the bond, the greater the chance that
something will intervene to erode the investment's value.
4. The biggest single determinant of stock prices is earnings.
Over the short term, stock prices fluctuate based on everything from
interest rates to investor sentiment to the weather. But over
the long term, what matters is earnings. If a stock's earnings rise
substantially over the course of 10 years, so will its share price.
5. A bad year for bonds looks like a day at the beach for stocks.
In 1994, the worst year for bonds in recent history, intermediate term
Treasury securities fell just 1.8 percent, and the following year
they bounced back 14.4 percent. By comparison, in the 1973-74 crash,
the Dow Jones industrial average fell 44 percent. It didn't
return to its old highs for more than three years or push significantly
*above* the old highs for more than 10 years!
6. Rising interest rates are bad for bonds.
When interest rates go up, bond prices fall. Why? Because bond buyers
won't pay as much for an existing bond with a fixed interest rate
of 6 percent as they will for a new one that is paying, say, 7 percent
or more. Conversely, when interest rates fall, bond prices go up
in lockstep fashion. And the effect is strongest on bonds with the
longest term, or time to maturity. That is, long-term bonds get hit
harder than short-term bonds when rates climb, and gain the most
when rates fall.
7. Inflation may be the biggest threat to your long-term
While a stock market crash can knock the stuffing out of your stock
investments, so far -- knock on wood -- the market has always bounced
back and gone on to new heights. However, inflation, which has
historically stripped 3.2 percent a year off the value of your money,
rarely gives back what it takes away. That's why it's important to
put your retirement investments where they'll earn the highest
8. U.S. Treasury bonds are as close to a sure thing as an investor
The conventional wisdom is that the U.S. Government is unlikely ever
to default on its bonds -- partly because the American economy has
historically been fairly strong and partly because the government can
always print more money to pay them off if need be. As a result,
the interest rate of Treasuries is considered a risk-free rate, and
the yield of every other kind of fixed-income investment is
higher in proportion to how much more risky that investment is
perceived to be. A word of caution, though: Even the U.S. Government is
not powerful enough to overrule the laws of economics, and if the
government ever did get desperate enough to print lots of extra cash to
pay off bonds, that would generate soaring inflation and make the
bonds -- paid-off though they may be -- worth less than investors expected.
9. A diversified portfolio is less risky than a portfolio that is
concentrated in one or a few investments.
Diversifying -- that is, spreading your money among a number of
different types of investments -- lessens your risk because even if some
of your holdings go down, others go up, or vice versa. On the flip
side, a diversified portfolio is unlikely to outperform the market by
a big margin for exactly the same reason.
10. Index mutual funds often outperform actively managed funds.
In an index fund, the manager sets up his portfolio to mirror a market
index -- such as Standard & Poor's 500-stock index -- rather than
actively picking which stocks to purchase. And by the strange math of
mutual funds, average is often enough to beat the majority of
competitors among actively managed funds. One reason: Few actively
managed funds can consistently outperform the market by enough
to cover the cost of their generally higher trading fees.
Next: The good, bad and ugly