Interest rates on savings are extremely low. The small amount of money we have left hardly yields anything. Another way to generate extra income is by investing in stocks. But due to the higher risk involved, many of us keep our money safely in our savings account. In a lecture from the Universiteit van Nederland (University of the Netherlands), Patrick Verwijmeren, Professor of Corporate Finance at Erasmus School of Economics, explains how to invest in stocks and how it can actually earn you extra income.
‘The longer you leave your money alone, the higher your return will be’
Verwijmeren mentions that the average annual return on stocks over the last 100 years is between 5 and 10%. So why go through all this trouble? Does 5 to 10% really make that big of a difference? The answer is yes, and certainly when focusing on the long term. ‘If we invest a 100 euros, a 10% return will increase our money to 110 euros next year. With the same return next year, this 10% is calculated over 110 euros instead of 100 euros, so the following year our return increases by 11 euros with a total of 121 euros.' In other words, the longer you leave your money alone, the higher your return will be.
Supply and demand
You may not believe it, but by investing only a 100 euros with an average annual return of 8%, you will have more than 200,000 euros after 100 years. This sounds really good, but unfortunately, there is always a risk involved. ‘The value of your stocks can plummet and end up being worth nothing at all. So how do you decide in which stocks to invest?’ According to Vermijmeren, it is very difficult to predict how well a specific stock will perform. ‘The value of a stock is simply based on supply and demand. The more people want a stock, the more its value increases.'
Not very different from gambling
Buying an iPhone because you believe that the iPhone is a good phone does not necessarily result in high returns because the sales figures of iPhones have already been included in the share price. 'There are a lot of professional investors who immediately buy when there is good news and sell when there is bad news. Because they can buy and sell very quickly, the price changes immediately and all this information is incorporated in the price. This makes predicting the future of a single stock very difficult, and not very different from gambling in a casino', Verwijmeren says.
Risk and return
Thus, choosing a specific company to invest your money in is very difficult. But what should we do then? ‘The most important scientific lesson about investing is: risk and return are strongly related. Our savings do not yield much at the moment, but there is not much risk involved either. On average, investing in stocks yields a higher return, but the risk of losing your money is also higher.’ Investments that, on average, yield higher returns are therefore not always better because risk plays a very important role. But low-risk investments are not always the best choice either because of their lower average return. According to Vermijmeren, the key is to try to achieve the highest return for a given risk.
‘Do not put all your eggs in one basket, but in different baskets’
We achieve the highest expected return by spreading our money. Verwijmeren uses a simple example to explain this. ‘Imagine we could choose between two companies to invest in: a company that sells sunglasses and a company that sells umbrellas. In a sunny year, the share price of the sunglasses company increases by 10% but in a rainy year, this company yields no return. The umbrella company’s share price increases by 10% in a rainy year and yields nothing in a sunny year. Imagine that the probability of a sunny year is as high as a rainy year.’ If we invest our money in only one company we either get a 10% return or nothing. If we invest in both companies and equally divide our money between them, we have an expected return of 5% in each year. Instead of running a risk, this return is now guaranteed. The lesson we have learned: Do not put all eggs in one basket but in different baskets. Forecasting the future remains difficult. But with a diversified portfolio, the future looks bright.’