Image: Stopwatch © Steve Allen, Brand X, Getty Images

In the lesson Stocks 102, we noticed that the difference of only a few percentage points in investment returns or interest rates can have a huge impact on your future wealth. Therefore, in the long run, the rewards of investing in stocks can outweigh the risks. We'll examine this risk/reward dynamic in this lesson.

Volatility of single stocks

Individual stocks tend to have highly volatile prices, and the returns you might receive on any single stock may vary wildly. If you invest in the right stock, you could make bundles of money. For instance, Eaton Vance (EV -0.05%, news), an investment-management company, had the best-performing stock over a recent 25-year period. If you had invested $10,000 in 1979 in Eaton Vance, assuming you had reinvested all dividends, your investment would have been worth $10.6 million by December 2004.

On the downside, since the returns on stock investments are not guaranteed, you risk losing everything on any given investment if the company ceases to exist.

Between these two extremes is the daily, weekly, monthly, and yearly fluctuation of any given company's stock price. Most stocks won't double in the coming year, nor will many go to zero.

In addition to volatility, there is the risk that a single company's stock price may not increase significantly over time.

Shares of General Motors essentially spun their wheels over the four decades before investors begin to question whether the automaker had reached the end of its road as a viable company. The stock cost $50 in 1965, reached an all-time high of $93.63 in April 2000 and fell back to around $50 by late 2003. It was mostly downhill from there; the stock slid below $1 in May 2009 as investors anticipated the company's eventual Chapter 11 bankruptcy filing.

Though dividends would have provided some ease to the pain, investors would have been better off had they invested in a bank savings account.

Clearly, if you put all of your eggs in a single basket, you'll be left with an omelet if that basket falls apart. Other times, though, that basket will hold the equivalent of a winning lottery ticket.

Volatility of the stock market

One way of reducing the risk of investing in individual stocks is by diversifying your portfolio. However, even a portfolio of stocks containing a wide variety of companies can fluctuate wildly. You may experience large losses over short periods. Market dips, sometimes significant, are simply part of investing in stocks.

For example, consider the Dow Jones Industrial Average ($INDU +0.30%), a basket of 30 of some of America's biggest and best-known companies. If during the last 100 years you had held an investment tracking the Dow, there would have been at least 10 occasions when that investment would have lost 40% or more of its value.

Annual stock market returns can also fluctuate dramatically. Stocks' one-year rate of return in 1933 was 67%; just two years earlier, the annual return was negative 53%. It should be obvious by now that stocks are volatile, and there is a significant risk if you cannot ride out market losses in the short term. But don't worry; there is a bright side to this story.

Over the long term, stocks are best

Stocks as a group have had the highest long-term returns of any investment type. This is an incredibly important fact! When the stock market has crashed, the market has always rebounded and gone on to new highs. Stocks have outperformed bonds on a total real return (after inflation) basis, on average. This holds true even after market peaks.

If you had deplorable timing and invested $100 into the stock market during any of the seven major market peaks in the 20th century, that investment, over the next 10 years, would have been worth $125 after inflation, but it would have been worth only $107 had you invested in bonds, and $99 if you had purchased government Treasury bills.

This is the whole reason to go through the effort of investing in stocks. Again, even if you had invested in stocks at the highest peak in the market, your total after-inflation returns after 10 years would have been higher for stocks than either bonds or cash. Had you invested a little at a time, not just when stocks were expensive but also when they were cheap, your returns would have been much greater.

Time is on your side

Just as compound interest can dramatically grow your wealth over time, the longer you invest in stocks, the better off you will be. With time, your chances of making money increase, and the volatility of your returns decreases.

The average annual return for the Standard & Poor's 500 Index ($INX +0.11%)for a single year has ranged from negative 39% to positive 61%. Stocks held for five years have seen annualized returns ranging from negative 4% to positive 30%. This underscores the importance of a long-term investment horizon when you are getting started in stocks.

Why stocks perform the best

But why, exactly, have stocks been the best-performing asset class? And why should we expect those types of returns to continue? In other words, why should we expect history to repeat?

Quite simply, stocks allow investors to own companies that have the ability to create enormous economic value. Stock investors have full exposure to this upside. For instance, in 1985, would you have rather lent Microsoft (MSFT -0.92%, news)money at a 6% interest rate, or would you have rather been a shareholder, seeing the value of your investment grow several-hundred fold over the next 15 years?

Because of the risk, stock investors also require the largest return compared with other types of investors. More often than not, companies are able to generate enough value to cover this return demanded by their owners.

Meanwhile, bond investors do not reap the benefit of economic expansion to nearly as large a degree. When you buy a bond, the interest rate on the original investment will never increase. Your theoretical loan to Microsoft yielding 6% would have never yielded more than 6%, no matter how well the company did.

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The bottom line

While stocks make an attractive investment in the long run, stock returns are not guaranteed and tend to be volatile in the short term. Therefore, we do not recommend that you invest in stocks to achieve your short-term goals. For best results, you should invest in stocks only to meet long-term objectives that are at least five years away. And the longer you invest, the greater your chances of achieving the types of returns that make investing in stocks worthwhile.