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Stocks have historically been the best investment vehicle, yielding the highest rate of return.   On average, stocks have returned a little above 10% per year, which is more than any other investment options available to investors, including bonds, real estate, commodities and cash.   With a 10% return you can double your money every 7.2 years.  If you want to know how long it will take to double your money at any rate of return, simply apply the rule of 72, that is, divide 72 by the expected rate of return and the result is the number of years it will take to double your money.

The challenge with stock investments is that along with high returns comes risk.  Your goal should be to maximize your investment return while minimizing your risk to match your particular risk tolerance.  When we talk about risks associated with stock, there are two types of risks that you should be concerned about.  The first is company risk, and the second is market risk.  You should understand these two types of risk as you develop your portfolio strategy.

Let’s first talk about company risk.  When you buy stock in a particular company, you become a partial owner of that company, albeit, as an individual investor you are most likely a passive investor with no say in how the company is managed.   As the owner you expect to be rewarded with the profits, or earnings, generated by the company.  If the company is growing, you may pay a premium price for it because you have expectations that you will reap the rewards of future profits.  However, companies operate in a competitive environment where many things can go wrong, and the profits that you are expecting may not materialize.  For instance, new competitors may come into the market place, forcing price pressures that eat into your margins, reducing profits.  The cost of raw materials may increase, which also reduces profits.  The company strategy may be flawed and the business may not grow as expected.  Key employees may leave, and the company may struggle without the original intellectual leadership.  The list goes on an on.

The good news for investors is that company risk can be avoided.  This is done through diversification, meaning, you spread the risk across many companies, and if one of those companies gets into trouble the overall impact on your portfolio is minimum.  There are basically two ways to diversify your stock investments.  One is by buying several individual stocks in multiple industries and managing your own portfolio.  However, there are many challenges with managing your own portfolio of individual stocks:

1. You have to buy several stocks in order to reach an acceptable level of diversification, and this may require a higher initial investment than you can afford.
2. You have to have a good understanding of accounting so that you can study these companies’ financial statements and get a good grasp of their financial situation.
3. You have to have the time to follow these companies and be aware of any developments that may impact their future value.
4. You have to worry not only about buying stock, but also about selling.  A company stock that is a good investment today may not be such a good investment in the future, as company conditions and the price of the stock change.

Unless you have enough money to invest, the time to research and the talent to know when to buy and sell individual company stocks I would recommend that you don’t follow this approach.  A much easier way to achieve diversification is by buying mutual funds that invest in several company stocks.  One option is to buy index mutual funds which simply try to replicate the performance of a particular stock index, such as the S&P 500 index of the 500 largest corporations in America.  The main advantage of buying an index mutual fund is that these funds charge a much lower expense fee than actively managed funds because they don’t have large expenses with research.  The disadvantage is that you are buying the market average.  I think you can do better than that.

If you want better than market average return on your stock mutual funds you need to invest in actively managed mutual funds.  These funds are managed by professionals backed by research staffs and they try to pick the best company stocks they can find for the right price.  They actively buy and sell stocks based on their professional judgment.  These mutual funds follow a particular investment style, and you should feel comfortable with the fund manager and his or her style.  It is also recommended that you read and understand the fund prospectus so that you don’t invest in something you are not comfortable with.

It is true that most actively managed mutual funds do not perform as well as the market averages, and that is why some financial advisors say you should invest in index funds.  At least this way you are guaranteed market average and you are charged a lower fee.  However, mutual fund performance information is easily available, and you should be able to identify stock mutual funds that have consistently beaten market averages.  One excellent way to find such funds is by looking at the Morningstar ratings.  Morningstar does a good job of comparing mutual funds to their peers with similar investment styles and to the related indexes.  Based on their risk adjusted return the mutual funds get rated from 1 to5 starts.  The ones you should be focused on should have 4 or 5 stars.

One of my favorite all time mutual funds is Selected American Shares, which is a 5 star mutual fund.   They have consistently beaten the S&P500 in the 1 year, 3 years, 5 years and 10 years performance comparisons, and their fees are very reasonable.  The managers at Selected American Shares heavily invest their own money in the fund, which is an excellent indicator that they believe in they own strategies.  These guys really understand value investing and have done a great job for their clients.

Now let’s talk about market risk.  Market risk is the risk that the entire stock market will go down.  The markets are influence by economic and political changes that are beyond anyone's control.  There is no easy way to avoid market risk.   The only solution here is to invest for the long term.  If your investment goal is for a short-term horizon (less than 5 years) then you should probably not be fully invested in stocks.  But if you have a time horizon of 10 years or more, the short-term fluctuation of the market will not impact your end goal.

Now that you understand the risks of investing in stocks, you can prepare an effective investment strategy that will yield high returns while keeping your risks under control.  This way you do not need to fear these risks and can stick to your strategy regardless of market conditions.

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