JumboCash: Stock Market 101

Last week, we established the basic relationship between risk and return as well as how diversification can reduce risks. The next step in understanding investments is to understand how stocks work, how they can deliver returns and why they are risky.

One of the most widely known security types are stocks, commonly referred to as "equity." When corporations want to raise money to expand their businesses, they can sell ownership of the company by issuing shares of the company to the public. So by purchasing even one share of Apple Inc., you can legally own a portion of the company and thus be entitled to a portion of any future profits they earn.

There are two main ways to achieve a return on investments in stocks: dividends and price appreciation. When a company makes a profit, they can choose to distribute a portion of those profits to shareholders, typically in the form of cash, which is called a dividend. On the other hand, some companies choose to reinvest their profits into the business to further expand. In fact, many publicly traded companies are not profitable, but investors are willing to buy their stock with the expectation that the company will earn profits in the future.

Aside from the cash flow from dividends, investing in stocks can lead to a return through price appreciation. If you own shares of a company and that company becomes more valuable, the shares you own will be worth more. Hence, other investors could be willing to buy the shares you own for a higher price than what you originally paid.

Although stocks can lead to high returns through dividends and price appreciation, they are among the riskiest assets. There is no guarantee that a business generates high profits or does so for a long time period. As the economy evolves, businesses are constantly created and shut down.

By looking at the annual returns of the S&P 500, an index that tracks the performance of the U.S. stock market, the risks of investing in equity become very clear. From 1928 to 2015, the average returns for the S&P 500 were around 10% annually. However, the standard deviation of those returns, a measure of the dispersion of return outcomes, is about 20%. Because the standard deviation is so much greater than zero, the returns fluctuate a lot: They are not consistently around 10% each year.

A way of illustrating the variation of returns, and the potential risks involved with stocks, is by looking at some of the worst performing years. In 1931, the total return of the S&P 500 was an astounding -44%. In fact, there were 11 years when the S&P 500 declined over 10%. In 1957, however, the total return was a whopping 53%.

Overall, it is clear that the high average annual returns of stocks do not guarantee high performance in any given year. The risk of low-performing years exemplifies the risk involved in equity investing; but, in the long run, bearing such risks has the potential for high average annual returns.