The Virtues of Long-Term Investments
Obviously, the longer your money is invested, the more money you can make. Although long-term investments like real estate, business, or art do well as asset classes and are an important part of your diversified portfolio, individual stocks and mutual funds that hold dozens — or even hundreds — of individual stocks can also be very rewarding long-term investments. Stocks are riskier than bonds, but stocks should also return more in the long run.
Stocks and Mutual Funds
The concept and use of stock indexes is very important when considering investments. Each index is a single number that increases or declines based on the movement of stocks in the index. Essentially, an index is the value of a portfolio of the stocks that are held in that index.
The Standard & Poor's 500 (“S&P 500”), the most widely followed stock index, consists of 500 of America's largest companies. The Dow Jones Industrials Average, sometimes referred to as “the Dow,” is made up of 30 very large companies, all of which are also tracked by the S&P 500.
The NASDAQ market index tracks more than 3,100 stocks that trade on the NASDAQ stock market and is more volatile than either the Dow or the S&P 500.
A share of common stock is an ownership interest in a company. If you start a vintage clothing store with two friends as equal partners, you have in effect created three “shares” of stock in the store. The same ownership structure applies to publicly traded companies like IBM, Wal-Mart, or McDonald's. In the case of McDonald's, for example, if you own 100 shares of the company (at a current cost of about $4,000), you would own a 0.000008 percent ownership interest in the company and have 950,000 partners.
Ownership of common stock entitles you to possible gains from two different sources: dividends and appreciation in stock value. Dividends are paid quarterly or annually. Dividends are not guaranteed, and company management can decrease or increase them at any time. Companies typically pay dividends out of earnings. If the company's earnings increase substantially, the company will probably increase its dividend payment.
High-turnover mutual funds often increase your tax bill faster than your returns. Save them for tax-free retirement accounts, like IRAs, where rapid turnover won't result in taxes on realized stock gains.
Dividends are subject to federal and state taxes. The federal tax rate on most dividends is currently 15 percent, but this rate is likely to increase in the future — the Jobs and Growth Tax Relief Reconciliation Act of 2003, which provided tax relief on dividends, is set to expire on January 1, 2009. Also, long-term stock gains are generally taxable at 15 percent at the federal level, while short-term gains (under one year) may be taxed at your ordinary income tax rate, potentially as high as 35 percent, but these rates may also change after 2010.
You might consider reinvesting your dividends back into the stock that paid them by using a company's dividend reinvestment program (“DRIP”), a low-cost way to accumulate more of the company's shares. More information about DRIP plans is presented on page 166.
Common stocks are risky. They are not insured by any government agency, and they can rapidly decline in value. In an extreme case, you could lose your entire investment. However, from 1926 to 2002, a diversified portfolio of large-cap common stocks returned 12 percent per year, or 6 percent more per year than long-term treasury bonds, and they and other categories of stock will likely continue to outperform less-risky bonds and cash over the long run.