In the last lesson, 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, Monster Beverage (MNST), the maker of the popular energy drink, had the highest 10-year return of all S&P 500 stocks as of October 2012. If you had invested $10,000 in Monster in 2002, your investment would have been worth over $2 million by October 2012.

On the downside, since the returns on stock investments are not guaranteed, you risk losing everything on any given investment. In the early 2000s, there were hundreds of examples of dot-com investments that went bankrupt, and during the 2008 financial crisis, once-storied Lehman Brothers collapsed entirely and Wall Street cornerstone Merrill Lynch was acquired by Bank of America (BAC) at a fraction of its pre-crisis value.

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. But do consider that the average difference between the yearly high and low stock prices of the typical stock on the New York Stock Exchange is nearly 40%.

In addition to being volatile, there is the risk that a single company's stock price may not increase significantly over time. For instance, J.C. Penney (JCP) stock has lost more than 7% per year on average over the last three years, declined 13% per year on average over the last five years, and long-term shareholders have suffered an average 3% decline per year over the last 15 years. This compares with a 5% average annual return for the S&P 500 Index over the same time period, and a 6% return for the bond market.

Clearly, if you put all of your eggs in a single basket, sometimes that basket may fail, breaking all the eggs. Other times, 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 holding a larger number of stocks in a 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 Industrials Index, a basket of 30 of the most popular, and some of the best, companies in America. If during the last 100 years you had held an investment tracking the Dow, there would have been 10 different occasions when that investment would have lost 40% or more of its value.

The yearly returns in the stock market also fluctuate dramatically. The highest one-year rate of return of 67% occurred in 1933, while the lowest one-year rate of return of negative 53% occurred in 1931. 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

Despite all the short-term risks and volatility, 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 over the very long term, stocks have outperformed bonds on a total real return (after inflation) basis, on average.

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. In other words, stocks have been the best-performing asset class over the long term, while government bonds, in these cases, merely kept up with inflation.

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.

From 1926-2011, the average annual return for the S&P 500 stock index (including reinvested dividends) for a single year has ranged from negative 43% to positive 54%, while averaging about 10%. Five-year average annualized returns have ranged from about negative 12% to positive 24%.

These returns easily surpass those you can get from any of the other major types of investments. Again, as your holding period increases, the expected return variation decreases, and the likelihood for a positive return increases. This is why it is important to have a long-term investment horizon when getting started in stocks.

Why Stocks Perform the Best

While historical results certainly offer insight into the types of returns to expect in the future, it is still important to ask the following questions: 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 money at a 6% interest rate, or would you have rather been an owner, seeing the value of your investment grow several-hundred fold?

Because of the risk, stock investors also require the largest return compared with other types of investors before they will give their money to companies to grow their businesses. 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. Being an owner certainly exposes you to greater risk and volatility, but the sky is also the limit on the potential return.

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. To be effective, 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.