Stock Market Pros and Cons - Investing

When you buy a lottery ticket, you're confident that the maximum amount that you can lose is limited to the price of the ticket. The same logic actually applies to buying stock; the most that can be lost is what you paid for it. While the lottery offers a grand prize, there is no set prize amount when you invest in a stock. So, how high can a stock price rise? Some have been going up for years and are still rising. Stocks, therefore (at least theoretically), have unlimited profit potential. Investing in the stock market has proven to be quite rewarding over time. Although stocks go up and down, sometimes with great volatility, they've generally appreciated for more than sixty years. Stocks have historically returned more than ten percent annually, outpacing inflation.

Unfortunately, there's no magic formula for making money in the stock market. Patience, however, has proven to be a key ingredient. Historically, most market declines have not lasted more than five years. For those investors capable of waiting it out, the stock market is comparatively safe. There have been only six losing five-year periods in the last sixty such time frames. Patient investors who hold a well-diversified portfolio of stocks have, for the most part, been rewarded.

Of course, it's always a possibility that you could lose everything that you have invested in an individual stock. Even if you don't lose all, substantial losses can, and do, occur. The market does fluctuate, which can be both a good and bad thing. Profits can be made from either an upward move (known as selling long) or a downward move (selling short). An incorrect guess could cost you greatly either way.

For investors who buy and hold securities, their maximum potential loss is their entire investment, while their maximum potential gain is limitless (again, theoretically). Short sellers, on the other hand, have completely different risks and rewards. Since the short seller makes his maximum profit from a downward movement in a stock's price, he is hoping that the price falls as far as possible, even to zero (in other words, bankrupt). He can then make a profit equal to the proceeds of the original short sale. Zero is as far as a stock's price can fall, so that's the short seller's maximum profit potential. What the short seller doesn't want is for the stock to go up. This is because he has sold the stock at what he believes is too high a price and hopes to buy it back more cheaply when the price has fallen. Buying it back at a higher price would result in a loss. Since there's no limit to how high a stock could rise, in this situation there would be no limit to the amount that the short seller could lose.

Generally speaking, bonds and money market funds tend to be the safest investment vehicles, since their prices usually do not change too erratically. Preferred stocks have slightly more risk, and common stocks are the riskiest of all. The offset is that the high-risk situations usually also offer the highest potential rewards. And while stocks must be considered somewhat risky, it cannot be overlooked that they have outperformed all other financial instruments over the long term.

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