Step 8: The Advantage of Stocks

The safest place to put your money is under your bed. When your bed is in a locked vault. And that vault is inside a well-defended castle.

But there’s a problem with that. While it’s highlyunlikely that your money will disappear in that scenario, keeping your money locked away guarantees that your savings won’t grow over time. In fact, it’s even worse. Thanks to the forward march of inflation, the money that you have locked away in your castle vault is actually losing value over time.

That’s going to make it really tough to afford a comfortable retirement. Or buy a new home. Or travel the world. Or… well, just about anything you’d like to do that requires a significant amount of money.

If you’re already independently wealthy and it’s millions or billions of dollars that you’re locking away, then this may not be something you need to lose sleep over. But if you’re like most people, growing your savings over time is essential if you want to afford a comfortable retirement.

Even if you don’t lock it away
Ok, it’s a bit ridiculous to think that somebody would lock away all of their money like that.

But it’s not just stuffing your cash under the mattress that will lead to a penny-pinching retirement. A 10-year German government bond yields less than 2%, and you won’t get much (if any!) more from a one- or two-year Festgeld account or life insurance.

As we learned in Step 1, compounding investment returns over time can change your life — not to mention your retirement account. But as we also saw in Step 1, there’s a huge difference between what happens to savings that are invested in low-yielding vehicles versus cash you put into higher-return alternatives, like stocks.

For instance, collecting 1.5% annually will turn a €2,000 investment into €3,126 over 30 years. Conversely, a 9% annual return — which is what the DAX has delivered on average over the past 30 years — will turn that same €2,000 into €26,535. That’s the difference between a penny-pinching retirement and a retirement spent on beaches and cruise ships.

The casino stock market
Many investors were burned during the Neuer Markt. That much is true. But the reason that they were burned might surprise you.

That reason was (drumroll, please): They sold too soon.

Even those investors who bought into the DAX at the height of the bubble in 2000 would have managed a 49% gain, or 3.1% annually,had they simply held through 2013. That’s right, even if you had invested at one of the worst times to ever invest — a period that included the breakdown of the Neuer Markt, the 2008/2009 global financial crisis, and the ensuing Eurozone crisis — your average annual returns were still better than what you could hope for from most fixed-income investments today.

As Warren Buffett’s mentor Ben Graham said:

“In the short run, the market is a voting machine but in the long run it is a weighing machine.”

As anybody who’s tried to bet on the outcome of Deutschland Sucht den Superstar would know, trying to guess the outcome of a voting machine is a dicey proposition. When using a weighing machine, however, there is a scientific basis for the outcome.

It’s similar with the stock market — short-term fluctuations, which can be driven by fickle human passions, can be very difficult to predict. Longer-term movements, on the other hand, reflect growth and expansion by individual companies and the economy as a whole, and can be gauged with far more confidence.

Your secret weapon: Time
If you haven’t already guessed it, your trump card in the long-term investing game is … well, the long term. Data from the Deutsches Aktieninstitut shows a wide variation in the one-year returns for the DAX. Between 1984 and 1985, for instance, investors made an incredible 84%, while the year between 2001 and 2002 brought a gut-wrenching 44% loss.

When you look at the same data over longer periods of time though, the variation in results contracts considerably. The results also become extremely favorable for investors.

Going back to 1963, there hasn’t been a single 30-year period in which DAX investors haven’t had a positive gain. Over that 50-year stretch, investors would have had at least a 6.9% average annual return, though annual returns have been as high as 10.9%. The latter means a total gain of more than 2,100% over those 30 years — a return that would have turned the €2,000 investment mentioned above into nearly €45,000.

This is a secret you won’t hear most investment professionals in Frankfurt talking about. You can fly to the U.S. and visit Wall Street but you won’t find it there, either. All over the world, the “smart money” of the investing world is hung up on one-year time periods … if not even shorter stretches. Their oversight is your opportunity.

The stock advantage for you, me, and everyone
How much of your portfolio is dedicated to stocks and stock funds depends on a lot of different factors (some of which we tackle here in this 13-Step guide). But one thing is true for nearly everyone: The long-term earnings power of stocks make them a powerful addition to a savings portfolio.

Action: Visit this chart [link opens PDF file] from Deutsches Aktieninstitut and explore the difference short-term investment returns and long-term investment returns.