Disclaimer: All opinions expressed below are solely my own and do not necessarily represent the opinions of my employer, The Motley Fool. Also, while I will do my best to temper my words, it is very important to remember that investments in the stock market CAN lose value and that past performance is no guarantee of future results.

The Problem

April is Financial Literacy Month, and so I thought we could talk a little bit about a topic near and dear to my heart. Even before working at The Motley Fool, I was constantly surprised and concerned by all of the stories I kept reading about how unprepared many Americans are for retirement. This is a problem. Regardless of your political affiliation, I think we can all agree that Social Security (as it currently exists) is unsustainable and is going to require changes in the near future. Additionally, the increasing cost of healthcare means there’s a good chance there will be a gap between the amount of money people receive from Social Security and the amount of money people need to live comfortably in retirement. Americans need personal retirement savings to fill in the gap. We need to invest. I encourage you to watch the incredibly professional video below that explains the personal reasons why I myself invest.

I was extremely lucky in that my parents encouraged me to open up and fund a Roth IRA as soon as I was able to and always stressed the importance of contributing to my 401(k)1Thanks Mom and Dad!. I got an excellent head start on saving for retirement and had that money in the market working for me during one of the greatest bull markets of my lifetime. A lot of Americans haven’t been so lucky. I think that’s a shame, because I think everybody should be investing.

Investing’s Secret Ingredient

It’s said that money doesn’t grow on trees, and while that’s true, there is something that is just as effective:

Compound Interest.

Supposedly Albert Einstein himself said that compound interest is “the most powerful force in the universe”. While it may or may not be true that he said it, it doesn’t change the truth of the statement. There are countless examples of the power of compound interest out there on the internet, and I encourage you to do a Google search to read some yourself. However, if you just want the short version, then this article has some of the best examples I’ve seen of how powerful compound interest can be when joined with time.

I don’t want to overstate things and be hyperbolic, but the combination of investing and compound interest really is like a magical money machine. It’s like the opposite of carrying a balance on a credit card. Instead of your money working against you, your money is working for you. You can plant a $100 bill in the ground, come back 6 years later to find $200. Some stocks even pay you money to own them, which can be reinvested in the company to further increase your returns. There was a time when I owned enough Verizon stock to where they were paying me more than I was paying them for my wireless plan. It was a good feeling.

Isn’t Investing Just Gambling?

An objection I hear a lot about investing in the stock market is that it’s “just gambling”. To be honest, I don’t have a good argument against that line of thought because I have a hard time defining what gambling is. Sure, slot machines are pretty clearly gambling. So is poker, right? Maybe not, as judges have ruled that poker is more of a game of skill than a game of chance. What about daily fantasy sports? The truth is, there are elements of skill and luck in many things and it can be incredibly difficult to draw a line that everybody can agree on. So for the purposes of this article, I want to use a slightly unorthodox definition of gambling that gets more to the main thing that I think people are actually worried about when it comes to investing: What is the chance that I’ll lose money? Nearly every single game in a casino has the odds weighted in favor of the house so that, on average, people lose money. Anybody can go on a hot streak, but over the long run, the house always wins.

That doesn’t have to be the case with investing. In fact, done properly, you can think of investing as being the casino side of the above gambling equation, where the odds are weighted in your favor. I want to be incredibly clear up front: Investing is risky. The market can, and routinely does, go down, and you can lose money very quickly if you don’t know what you are doing. In fact, you probably will lose money at some point even if you do know what you’re doing. Markets fluctuate and sometimes go down and it’s unrealistic to think otherwise. Luckily, there are two extremely easy things that you can do to reduce your risk and turn what might appear to be a random and risky endeavor into a much safer way to grow your money.

Put simply: The more stocks you hold and the longer you hold them, the more you turn “gambling” into “investing”. Behold, the wonderful picture that I made all by myself2Hard to believe, I know to illustrate this:

Okay, I promise this is the last of my homemade media… for this article.

A Long Time Horizon

When I first started investing, one of the things that perplexed me is when one of the companies I owned released earnings and soundly beat expectations… only for its stock price to drop afterwards. “How”, I thought, “could doing better than people thought mean that you are now worth less than people thought?” What I came to discover is that there are many reasons why the price of a stock might change over the short term. Maybe their outlook for next quarter was a little weak. Maybe geo-political instability has the market spooked and the entire sector is down. Maybe some short-seller is loudly claiming the company is overvalued. All companies are vulnerable to any combination of the above. However, over the long term, the great companies are far more likely to outperform.

Here’s a good example of this. Take a look at the graph above. The graph represents the performance of a stock over a 5 month period. You don’t have to understand what those red and green bars mean, just know that the blue line indicates how much one share of stock in this mystery company was worth over those 5 months. It’s an ugly graph for a stock, and it’s made even uglier if you squint your eyes to read the numbers on the y-axis. The stock went from over $40 a share to a little over $10 a share. So if you invested $5,000 into this company it would’ve gotten cut down to around $1,250. That’s bad, and it’s performance like this that can make people think that investing is no better than gambling.

Now take a look at this graph. This is the exact same company as the previous graph. However, instead of a relatively small 5 month time frame, it’s zoomed out to a 15 year time frame. That hypothetical $5,000 from the previous graph that turned into $1,250? Well, thanks to a 7:1 stock split and some crazy appreciation, that $5,000 would’ve turned into over $250,000 in under 7 years. The time frame from the previous graph is the area within the red box. That five month period which looked so horrible before is noticeable, but ultimately looks like little more than a speed bump on this stock’s rocket trajectory to greater heights (it feels like that analogy went off the rails a bit3Editor: And this paranthetical didn’t help.  Neither did this footnote.). It’s not the only big drop for the stock, either. There have been a few times during this company’s history where the stock has dropped 25%. This is why a long time horizon is key, and how investing for the long term can reduce the risk of losing money from short term moves.

If you’ve read about my greatest investing mistake, you might recognize that the above stock is Netflix, but this phenomenon is not unique to Netflix. Amazon is another one of the greatest investments of the past two decades and has had even more breathtaking drops than Netflix, including a 25% drop as recently as 2015. Yet, over the past decade, the stock has increased around 20x. Even the greatest companies go through tough periods.

Again, while emphasizing that past performance is no guarantee of future results, take a look below at the range of how stocks have performed over varying holding periods from 1950 to 2012. Pay particular attention to the lower range of return for stocks as holding periods get longer. Historically, there hasn’t been a 20 year period where stocks have lost money.

Here’s another way to present the information. If you’re saving for retirement and retirement is 5+ years away, then time is on your side. Use it to your advantage.

Diversification

But a long time horizon isn’t all that you need. I use Amazon and Netflix for my examples above, and both have been amazing investments, but not all investments are winners. Some don’t provide good returns no matter how long you hold onto them. The failure rate for companies is shockingly high. Even the large companies aren’t immune: only 12% of Fortune 500 companies from 1955 were still in the Fortune 500 sixty years later. So if you decide to put all your eggs into one basket, you might get a Netflix or an Amazon, but the odds are against you. So how do we put the odds more in our favor like we did with our longer time horizon?

Diversification.

To stick with our gambling analogy, let’s think about roulette. Investing in just one stock is like putting all your chips on a single number. If it hits, you could win big, but there’s a much better chance of a different number coming up instead. But what if you could put your chips on all of the numbers? That way, no matter which number hits, you’re a winner. That’s the theory behind diversification. The more numbers that you have your chips on, the better your chance of hitting a big winner like Netflix or Amazon. Normally, spreading your money around like that at a roulette table isn’t a winning strategy, because the odds are weighted in favor of the casino, but remember that this is the special investing casino where the odds are weighted in our favor. How can this possibly be? Because when you invest in a company, your downside is capped, but your upside is virtually unlimited. The most you can ever lose in a company is 100% of what you put in. That sounds like a lot, but it’s dwarfed by the amount you could make by investing in a winner. Remember the Netflix example from above? That $250,000 best case scenario can pay for many, many losers that even go to zero.

Buying shares in a bunch of different companies might sound daunting and time consuming, but luckily there are investment vehicles that make it incredibly easy: Index funds. When you put money into an index fund, it uses your money (and money from many other people who are also invested in the fund) to buy shares of many different companies based on whatever index that particular fund follows. For example, one of the most popular types of index funds would be an S&P 500 index fund that invests in 500 of the largest publicly traded companies in the United States. So simply by purchasing one fund, you get exposure to 500 companies. Instant diversification.

Putting it All Together

Still uncertain? Need to see some hard numbers to be convinced to pull some of that money out of your savings account and invest it into the market? Well, let’s look at an example of what happens over the course of 10 years for somebody who started investing at one of the worst possible times: 2007, right before the great recession. Some of my fellow collaborators in Fool School put together the below video to compare the returns of a savings account versus the returns of an S&P 500 index fund. It’s the most compelling evidence I can think of to show how investing is one of the greatest ways to grow wealth.

https://www.youtube.com/watch?v=SLfErGv3UGA

This goes back to what I mentioned earlier. Even if you know what you’re doing, you can and almost certainly will lose money over certain one, three and five year periods. You must master your emotions and not sell during downturns; instead, stick to a consistent strategy of buying and holding during both bull markets and bear markets. Then, over the long run, you should end up well ahead.

Just the Beginning

Consistently contributing to an index fund is a great start. If that’s all you do and just stop there, then you’ll still be well ahead of the game and doing better than lots of people. However, if you’re interested in going the extra mile and trying to be an overachiever, here are some more things to look at:

Tax advantaged accounts – I hate most everything about taxes, and they can ultimately have a massive impact on your returns. Luckily, there are a number of accounts that are “tax-advantaged” to help avoid losing a big chunk of your money to Uncle Sam. The best known one is the 401(k), but there are also IRAs and 529s and HSAs. If you’re willing to put up with the restrictions inherent to these accounts, they definitely can make a lot more sense than a normal brokerage account. And if your company offers matching funds for your 401(k), I very strongly suggest contributing enough to max out those matching funds. It’s virtually free money.

Look at fees – Fees matter. Potentially a lot. Most people don’t pay attention to management fees that funds charge, or don’t even realize that they are paying fees. They are compound interest’s evil twin; compound interest is your friend when it comes to investment returns, while compounding fees can really end up taking a bite out of your total returns. It can make a huge difference to shave off even a fraction of a percentage point in fees charged. If you’re looking for low-fee index funds, Vanguard is well regarded for their selection of offerings.

More diversification – An S&P 500 index fund focuses on American companies. While many of those companies do a lot of business overseas, there’s still a lot of markets outside of the United States. If you’re willing to stomach a little more risk, then looking into some international exposure could help increase your overall returns. S&P 500 funds also only look at the largest US companies (sometimes referred to as large-cap companies). Much like with international exposure, if you’re willing to take on a little more risk, look at adding some mid-cap or micro-cap funds (or even a total market fund) to help increase your returns.

Bonds – The stock market is great when you have a long time horizon, but not everybody does. As you get closer to retirement and your time horizon shortens from ten years to five years to three years, having money in the stock market gets riskier and riskier. Conventional wisdom is that as people near retirement, more and more of their retirement portfolio should be transitioned from the stock market to bonds, which are considered lower risk (and also lower reward). Portfolios can be re-balanced manually, but there are also Target-Date Funds which automatically re-balance your portfolio for you based on an expected retirement date to make sure you aren’t exposed to more risk than you should be as you near retirement.

Investing in individual stocks – I would be remiss if I didn’t at least touch on the possibility of investing in individual stocks. I don’t want to get into it much here, but if you find the whole idea of investing interesting and want to learn more, then it’s certainly something worth investigating. It can be time consuming, requires control over your emotions, and can be riskier, but done properly, it can also be more rewarding. If you want to learn more, you can of course visit The Motley Fool’s website, listen to their podcasts, or read their books.

Some Final Caveats

The title says, “Everybody Should Be Investing”, but that’s probably not entirely true (“Almost Everybody Should Be Investing” just doesn’t quite have the same ring to it). For people who are carrying credit card debt or have other high interest debt (i.e., not a mortgage), you’re almost certainly better off paying those debts down first before investing. Also, because having a long time frame is such a key advantage and you don’t want to be a desperate seller, it might make sense to make sure you have a rainy day fund to cover any emergencies before sinking any money into the stock market. The last thing you want to do is have to potentially sell low to replace a flat tire.

Finally, I understand that for people with lower incomes, it can be quite challenging to find money that can be set aside to invest and it can seem quite daunting. Don’t let that discourage you. Starting as early as possible is so important and setting aside even a tiny amount of money can lead to bigger things. Seriously, it’s hard to overstate just how important starting early is. Check out this example of how simply starting early can trump saving for longer. Bag a few lunches at home instead of going out. Skip the coffee run once or twice. Choose water over a soft drink. There are apps like Robin Hood which let you invest for free. It doesn’t matter if it’s $5 or $50, just do everything you can to start now.

When retirement time comes around, you will be so glad that you did.

Closing Disclaimer: It’s important enough to be worth repeating one last time. All opinions expressed above are solely my own and do not necessarily represent the opinions of my employer, The Motley Fool. Investments in the stock market CAN lose value and past performance is no guarantee of future results.