Stock Market Advantages and Disadvantages - AlwaysWealthy

Stock Market Advantages and Disadvantages

Every investment has upsides and downsides. Even the stock market, arguably the most popular place for people to invest their money, might not be the right investment for everyone. In this article, we take a closer look at stock market advantages and disadvantages. This will help you figure out if investing in stocks is a strategy you want to pursue or not.

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Stock Market Advantages and Disadvantages

Stock market advantages and disadvantages
Stock market advantages and disadvantages

Investing in stocks is a relatively new phenomenon. At the time of the stock market crash in 1929, only around 2.5% of Americans had invested in the stock market.

And many of them wished they hadn’t as the Great Depression took a hold of the world.

Stocks dropped over 70% in a matter of months, wiping out the life savings of Americans that were “ahead of the time” and thought they could get rich quick in the stock market.

After World War I ended, America and many other countries experienced a boom period known as the Roaring Twenties. Industries were growing, business was booming and Americans believed the good times would never end.

The idea that hard working, average Americans could get rich on the stock market was common before the Great Depression. It is strikingly similar to the culture of YOLO investors, apes and Game Stop lovers that are looking to make huge gains fast on the stock market today.

What Is the Stock Market?

When companies want additional funds to grow their operations, there are a few different ways they can do this. They can issue corporate bonds on the credit market or they can offer stocks.

An IPO, which stands for Initial Public Offering, allows a company to offer shares of the company to public investors.

For example, anyone who wants to own a share of Tesla can buy them with a broker like TastyWorks or Robinhood. This means, they now own a small percentage of the company along with many other shareholders.

Investing in stocks is simply another way of saying that you’re buying a small fraction of a company. If the company grows and performs well, its stock price might increase.

Today, around 53% of Americans own stocks compared to just 2.5% in 1929. And the stock market has significantly changed since then.

Why Invest in the Stock Market?

During the Roaring Twenties, average Americans weren’t happy with the bond yields they were getting. The prospect of making 2-3% from government bonds didn’t seem life changing enough.

Stories circulated of hard working Americans that became millionaires on the stock market. Why invest in boring bonds when you can invest in the stock market and become a millionaire?

Many American’s bought stocks on a hunch, or based on tips and recommendations they got from friends. Few people actually understood the stock market or how to properly value a company.

Today, there is more information about investing available. We have tools and resources that help us make better investing decisions. Terms like technical analysis and fundamental analysis aren’t foreign.

Read More: Investing in Stocks for Beginners

We also have more safe guards in place compared to 1929. Back then, there was no Securities and Exchange Commission (SEC) overseeing and regulating the stock market.

There was no deposit insurance in the form of the Federal Insurance Deposit Corporation (FDIC). Investing in 1929 was like the wild west.

Also, the Federal Reserve was a young institution in 1929. It didn’t step in and prop up asset prices with Quantitative Easing or by lowering interest rates. When markets tanked, there was nobody there to save investors or financial institutions by flooding markets with liquidity.

Back then the United States was still on the gold standard. This meant, the Federal Reserve couldn’t just print money to re-inflate asset prices.

But one thing didn’t change. The reasons to invest in stocks, and the narrative of getting rich quick, is as prevalent as ever. Humans were greedy in 1929 and they still are today.

Before we explore more stock market advantages and disadvantages, let’s take a short detour and talk about the bond market.

Advantages and Disadvantages of Bonds

The bond market, also known as the credit market, is a lot less understood by retail investors. Most investors grasp the stock market but fail to understand the bond market.

First of all, the bond market is a lot bigger than the stock market. The bond market is an order higher up the rank than the stock market.

This means, bond holders have preferred treatment compared to stock holders. If a company is about to go bankrupt, bond holders will receive any money that is left before stock holders see a single dollar.

Bonds are a credit instrument. When a company needs money to expand its operations, it can issue bonds or stocks. In the case of bonds, there are different ratings based on the creditworthiness of the entity that is issuing the bond.

A company that is in trouble and has a high chance of going bankrupt will receive a junk bond rating.

On the other hand, governments issue bonds as well. Government bonds can be purchased by individual investors, companies and even foreign nations. The money raised by issuing a bond can then be used to fund government spending.

Government bonds are considered risk-free investments. Or in other words, they are the complete opposite of junk bonds. The reason for this is because governments that have a central bank and control their own currency can’t go bankrupt.

In case a government is close to going bankrupt, and can’t find any buyers to sell more bonds to, the central bank steps in and buys the government debt with money printed out of thin air. This is known as monetizing the debt.

The advantage of bonds in general is that you have preferred treatment over stock owners. The advantage of government bonds is that they are literally free of default risk.

Are Government Bonds Really Risk-Free?

However, there is also something called a “soft default”. If a government overextended itself and its debt-to-GDP ratio gets too high, it might start monetizing a lot of its debt.

While you are guaranteed to get back your initial investment plus interest, central banks might have to print this money out of thin air to pay you back.

The result is that you get back your principal. Nominally, you didn’t lose any money. You even got some interest on top of your principal.

But when governments and central banks keep bond yields below the inflation rate, investors in government bonds lose money in real terms. By keeping bond yields below the inflation rate, governments can gradually “inflate away” government debt.

Read More: Will the US Government Default On Its Debt?

This is a “soft default”, or if you want to use harsher language, financial repression. The International monetary Fund (IMF) has a research paper that suggests using financial repression to lessen the burden of governments that have too much debt.

The advantage of government bonds is that you get back your initial investment plus interest. The disadvantage is that you might still lose money in real terms as is the case today.

With government bond yields between 1-2% and inflation at 7.9% in the United States, you are losing purchasing power and helping the government lessen its debt burden.

Once you get back your principal plus interest, it will buy less goods and services than your money did before you bought the bonds.

Now that you understand the pros and cons of investing in bonds, and especially government bonds, let’s return to stock market advantages and disadvantages.

Specifically, let’s talk about advantages of investing in the stock market.

Advantages of the Stock Market

There are different reasons to invest in stocks. When looking at stock market advantages and disadvantages, we should consider why someone would want to invest in stocks.

As discussed earlier, when bond yields are below the inflation rate, investors lose money in real terms. The same is true for savings accounts and certificates of deposit (CDs) that barely pay any interest. Even high-yield savings accounts that pay 1% interest are not able to preserve purchasing power in moderate or high inflation environments.

With government bonds, high-yield savings accounts and certificates of deposit off the table, investors are left with few choices to preserve their purchasing power. They include stocks, real estate, precious metals, scarce commodities, Bitcoin, altcoins and more exotic investments like art, wine and whiskey.

Of all these investments, stocks and real estate are the most common and time-tested. They existed for centuries, benefit from regulatory clarity and have safe-guards in place.

Read More: Where To Invest Money To Get Good Returns

The real estate market is less liquid than the stock market. If you buy a property and want to sell it, you might have to wait for a long time until you find a buyer and are able to sell your investment. Stocks, on the other hand, are liquid. You can create a sell order in your broker account and it will likely be filled instantly or within a short period of time.

Real estate also requires dealing with larger sums of money, taking on debt, negotiating with banks, maintaining properties and handling tenants. While many people have become millionaires with real estate investing, it isn’t for everyone.

Investors that only have small sums of money to invest and prefer the liquidity, accessibility and ease of use of the stock market, might prefer investing in stocks.

Comparing the Stock Market, Bitcoin and Cryptocurrencies

What about bitcoin and cryptocurrencies? Bitcoin has been the best-performing asset of the last decade. In its short history, it has been a great way to preserve purchasing power. And unlike some people claim, bitcoin has value for several reasons and might turn out to be a great investment in the long-term.

However, bitcoin might still be too volatile or exotic for some investors. It’s a young asset without a long track record like stocks and real estate. Stocks and real estate also face more regulatory clarity than bitcoin.

For the sake of this article, we will treat bitcoin and cryptocurrency as two separate things. The cryptocurrency market as a whole consists of tens of thousands of altcoins, which promise alternative use cases or improved functionality over bitcoin. However, it appears that the entire cryptocurrency market is in a bubble.

Unless you’re willing to go far out on the risk curve, you should probably stay away from these alternative cryptocurrencies.

Pros and Cons of Gold, Index Funds and Growth Stocks

Gold has been performing incredibly poorly in the last decade. There are rumors that the gold price is artificially suppressed through the use of derivatives. But whether that is true or not, if you had invested in gold ten years ago, you ‘d have lost money in real terms. Although gold is a great asset and has a long history as a monetary commodity, it hasn’t been able to outpace inflation in the past decade.

The narrative of gold as an inflation hedge might not hold up long-term. Stocks, real estate and bitcoin were much better inflation hedges in the past decade.

The S&P 500, which tracks the top 500 companies in the United States, has returned around 8% on average per year in the last decade. This means, even with inflation at 7.9%, just investing in an index fund like SPY would have kept pace with the official inflation numbers.

However, there are some indicators that true inflation might be closer to 15%. When inflation is measured the way it was measured several decades ago, inflation today is well in the double-digit range.

If that’s true, investing in the S&P 500 would return a loss in real terms. Inflation pushes investors further out on the risk curve. If true inflation were at 15%, investors would need to beat the market to outpace inflation. Beating the market is actually hard and few people are able to do it.

Making more than the S&P 500 or Nasdaq would require investing in growth stocks that have huge upside potential. Growth stocks are a great way to outpace inflation, but they are a lot riskier than holding an index fund.

Overall, the stock market is still a relatively proven and safe way to preserve purchasing power. But as with every investment, there are risks involved as well.

Disadvantages of the Stock Market

Now that you known some of the advantages of investing in the stock market, let’s talk about disadvantages.

One of the most obvious disadvantage is the volatility of the stock market. The stock market experiences drawdowns and bear markets frequently.

A market drawdown is when stock prices lose a significant amount of their value. There are different types of stock market crashes.

When the stock market loses 10% or more of its value, this is a correction. And when stocks tank more than 20%, this is a bear market. Corrections are quite frequent. Bear markets are less frequent but a possibility.

Read More: How to Survive the Coming Economic Collapse

During the stock market crash of 1929, stocks lost most of their value and took a decade to recover. The burst of the Dotcom Bubble in the early 2000s is another example of a bear market. Technology stocks dropped over 70% in a matter of a few months.

And finally, during the Global Financial Crisis of 2008, stocks experienced a huge decline. The Federal Reserve intervened with massive levels of Quantitative Easing and by lowering the Federal Funds Rate to zero.

Since then, the stock market was in a more than decade long bull market that got into hot water during the Covid-19 pandemic in 2020.

Stocks sold off sharply again but recovered in record time due to the Federal Reserve’s aggressive asset purchases. In 2022, as inflation hit a 40-year high, the Federal Reserve tanked markets again by tapering its asset purchases and hiking short-term interest rates.

Stock Market Volatility

As you can see, the stock market is very volatile. It depends on the Federal Reserve’s monetary policy and what else is happening in the world.

If you invested all your life savings in the stock market and were planning to retire in 2008, you saw your life savings evaporate in front of your eyes, making retirement impossible or painfully difficult.

Investors that held onto their stocks throughout the Global Financial Crisis until today didn’t lose money.

But those that panic-sold their shares and realized losses, experienced the brutality of the stock market first-hand. The 1929 stock market crash and the Global Financial Crisis of 2008 were both traumatizing events for investors.

And while the Federal Reserve is on a mission to prevent the “Everything Bubble” from popping, there is no guarantee it will be able to save markets and prevent a deflationary economic crash in the future.

What are other stock market advantages and disadvantages? Well, there is one more important disadvantage of stocks.

Stock Market Vs. Bond Market

There are several stock market disadvantages, but this one is widely misunderstood or ignored.

The stock market is simply the tail of the credit market. If problems brew in credit markets, they will eventually reach the stock market. In other words, the stock market is mostly at the mercy of the bond market.

Experienced bond traders and investors might spot problems or opportunities well in advance of stock market investors.

For example, prior to the Global Financial Crisis in 2008, credit markets were flashing red flags well before unsuspecting stock investors noticed that their stocks aggressively sold off.

As a stock market investor, you will always be at the mercy of credit markets. This is why good investors must have at least a basic understanding of credit markets.

Counter-Party Risk

Counter-party risk is when a third party has access to your funds and could default, freeze or prevent you you from accessing your funds for a variety of reasons.

Canadians experienced counter-party risk recently when bank accounts and credit cards of people were cut off in response to supporting the trucker’s convoy.

Another example of counter-party risk is when you lend someone money or deposit money at a bank. The borrower, or the bank, is the counter-party.

Read More: Is Your Money Safe In Banks?

There are of course safe-guards in place like FDIC insurance that insure bank deposits. The Securities Investor Protection Corporation (SIPC) insures cash deposits and stocks at brokerage accounts.

For example, when you hold stocks at an SIPC insured broker in the United States, your cash is insured up to $250,000 and your stocks up to $500,000. However, who is to say the SIPC doesn’t have its own counter-party risk?

The bottom line is, even if your cash and stocks are insured in case your bank or broker goes out of business, there is no guarantee how fast and how much of your money you’ll get back in a real-life situation.

The FDIC and SIPC are underfunded, which means they don’t have enough money to insure all depositors or investors in case of a large-scale, systemic collapse of the banking system.

For that event, the Federal Reserve exists as ultimate backstop. In a worst-case scenario, the Federal Reserve could just print money and make depositors and investors whole again.

But there is and will always be counter-party risk when holding money or stocks at a financial institution like a stock broker.

This is where Bitcoin is interesting. If you hold your own private keys, you eliminate counter-party risk. If you buy art, gold, rare wines or whiskeys and hold them yourself, there is no counter-party risk either.

Summary: Stock Market Advantages and Disadvantages

As you can see, there are pros and cons to every investment. There are stock market advantages and disadvantages. But we also touched on advantages and disadvantages of bonds.

Proper investing isn’t possible without some sort of understanding of macroeconomics and macro trends. If you don’t known how inflation works, or what financial repression is, you won’t be able to make smart long-term investment decisions.

There is absolutely nothing wrong with investing in the stock market. Alongside real estate, bitcoin and scarce commodities it is probably one of the better investments out there.

The same cannot be said about the bond market right now, which turned from risk-free investment into return-free risk.

As always, it’s important to do your own research and understand what you’re investing in. Regardless if you decide to invest in the stock market, bonds, real estate or bitcoin, you should be aware of the risks associated with each investment vehicle. When it comes to stocks, exploring stock market advantages and disadvantages is a great first step to find out what type of investment you’re comfortable with.

April 6, 2022