Part 19 (1/2)

2000.

10.14% .

2005.

3.00%.

1996.

22.87%.

2001.

12.06% .

2006.

13.62%.

1997.

23.74%.

2002.

24.66% .

2007.

4.24%.

1998.

30.95%.

2003.

25.28%.

2008.

40.97% .

1999.

19.81%.

2004.

10.59%.

2009.

27.76%.

NoteThe S&P 500 is a stock-market index, which is like a thermometer: It's a single number that gives you a quick reading on the value of a group of stocks. There are all sorts of indexes, including the Dow Jones Industrial Average, the NASDAQ Composite, and the S&P 500. The latter tracks the performance of 500 of the largest U.S. stocks.

As you can see from the table, stocks soared during the late 1990s' bull market, fell during the early 2000s' bear market, and had trouble deciding what to do during the past 5 years. And note that while the S&P 500 index returned an average of 6.07% during the 15 years between 1995 and 2009, not one of those years actually produced returns near the average (2007 came closest, but that was still nearly 2% below the mark).

These fluctuations mess with the average investor's mind: He panics and sells when prices drop, but then falls victim to what Alan Greenspan called ”irrational exuberance” (basically, getting way too excited) and buys when prices soar. That's a sure way to lose money. Smart investors understand that average isn't normal, so they brace themselves for fluctuations and try not to buy and sell on impulse. (You'll learn more about smart investor behavior on Being on Your Best Behavior Being on Your Best Behavior.) The future is not the past Overall, the value of the stock market increases with time. But over the short term, market movements are wild and unpredictable. During any given year, the stock market might return anywhere from 50% to +100%. Over long periods of time-think decades-the market is less volatile and its returns are smoother. Looking at 30-year periods, the U.S. stock market is likely to produce growth between 515%.

In the short term, other types of investments can and do offer better returns than stocks. During any given 1-year period, stocks will outperform bonds only 60% of the time. But over 10-year periods, that number jumps to 80%. And over 30 years, stocks almost always win: Siegel found that ”the last 30-year period in which bonds beat stocks ended in 1861, with the onset of the U.S. Civil War.” (For more on this concept, see this article at Get Rich Slowly: tinyurl.com/GRS-stock-history.) There's just one problem: Past performance is no guarantee of future results. This is true both for individual stocks and the market as a whole. Just because the market has had average annual returns of 10% since 1926 doesn't mean it'll do so in the future. (In fact, many smart folks believe returns will be modest over the next few decades.) Still, if history is any indication, investing in stocks is the best way for you to meet your financial goals. As long as businesses can make a profit-even when they borrow money-stocks will outperform bonds and inflation. All the same, smart investors hedge their bets and manage risk by adding a healthy dose of other types of a.s.sets, especially bonds.

But what exactly are stocks and bonds, anyhow? Let's take a brief detour to learn about the tools of investing.

NoteRisk and return are inseparable. If you want high returns, you have to accept that you'll sometimes suffer big losses, which may affect your future plans. If you're risk averse-not willing to risk losing money-you can find ”safe” investments, but they'll offer low returns so it'll be more difficult to meet your goals.

The Tools of Investing a.s.suming you're an average individual investor, you've got two primary tools at your disposal: stocks and bonds. (Other a.s.set cla.s.ses include real estate and commodities like gold and oil-but investing in these isn't appropriate for the average Joe.) You can buy stocks and bonds directly, or you can buy collections of them called mutual funds. You're probably vaguely familiar with these terms, but it never hurts to do a quick review.

Stocks and Bonds Let's say your best friend Mary wants to open a pizza parlor, but she needs some money to do it. She comes to you with a business proposal that offers you two options. Here's the first: - For $10,000, you can own 10% of the restaurant. In return, she'll pay you a piece of the profits every 3 months. These dividends don't amount to much (maybe a few hundred bucks a year), but they'll give you a reliable stream of income. Plus, you can sell your share of the owners.h.i.+p (your stock) anytime.If Mary's business is going gangbusters and makes good profits, you might be able to sell your stock to your friend Rhoda for $15,000 or even $20,000-much more than it cost you. But if your neighbor Phyllis opens another pizza parlor next door, it'll probably dent Mary's business. In that case, you might only be able to sell your stock for $8,000 or even $5,000.

When you buy stock, you're buying small slices of equity (owners.h.i.+p) in a business. As the company goes, so goes your investment: There's always the risk that the company will make a mistake, face stiff compet.i.tion, or that the public's whims will change. When this happens, the value of the stock can drop permanently or the company can go out of business.

This sort of uncertainty might scare you. Sure, the constant stream of dividends would be nice, but you don't like the idea that the value of your investment will jump around all the time-or maybe even drop to zilch. In that case, Mary gives you another option: - If you lend Mary $10,000 for 5 years, she'll pay you 3% interest, or $300 a year. And at the end of the 5 years, she'll repay your $10,000 loan (or bond). What's more, you can sell this loan just like you could sell your stock. For example, if you decide you need the $10,000, you can sell the loan to your friend Rhoda, but she may not want to pay you the full $10,000.Again, imagine Phyllis opens a pizza parlor next door to Mary's. She, too, is asking people to lend her money, but she's offering to pay 8% over 5 years. If Rhoda can buy an 8%, 5-year bond for $10,000, why would she pay you the same amount for a 3% bond? Instead, she might offer to buy it from you for $7,500. On the other hand, if Phyllis is only paying 1% interest on the loans she's taking, Rhoda might be willing to pay a little extra for your bond, since you're offering the best deal in town.