Why should I hold stocks for the long term when the risk of more companies going bankrupt increases over time?

Question

The longer the time frame, the larger the risk that any given company is going to go bust. If this is the case, then why is long term stock investing encouraged? Isn't it more risky to invest for the long term rather than the short term? In the long term, many more companies are going to go bankrupt.

In addition, the far future (measured in decades) is far less predictable than the already hard to predict near future. Why is stock market investment with a horizon of 10+ years a good idea when it looks so risky in comparison with shorter term investing?

Answer 1

Whenever I see advice for "long term investing" it usually includes the caveat of making those investments into diversified index funds such as VOO or VTI. As opposed to investments into single companies. The advantage of using an index is that with the diversification, as companies go bust (such as Blockbuster) other companies increase in value (such as Netflix). Overall, you are betting on the entire index which in the U.S. at least has a high probability of increasing over a longer time horizon.

Long-term investing in single companies is just about as risky as short-term investing, like you pointed out. Who knows what the state of these enormous oil companies like BP will be in 10 years, or if Tesla will be beaten out by the competition in 15 years. That's why index investing is better for long-term.

Answer 2

While some companies go bankrupt, some continue to exist, paying dividends until they ultimately liquidate or get bought out by another company. 'Nearly all companies go bankrupt' is an incredibly aggressive claim.

The stock market's rise and fall is based on the value placed by investors ['the free market'] on the ultimate goods and services being produced by its corporate members. That doesn't mean that stock values are always 'correct', because current stock value includes anticipated future returns [which are not guaranteed].

To say that most of these companies 'will go bankrupt' is about the same as saying 'the entire modern economy will almost entirely be wiped out'. Which, yes if true would mean that stock investments matter little, but that's because the claim itself is so extreme.

Answer 3

Your reasoning might make sense if you buy a specific set of N stocks and then leave them completely untouched. Eventually, one of them will go bankrupt and then you are invested in (N - 1) stocks. Later another goes bankrupt and you own (N - 2) stocks, etc. So, while your portfolio is still likely to grow in total value for a long while, risk does increase over time. But this is not because of bankruptcies per se; it is because you allow your portfolio to become more and more concentrated.

Note, other events outside your control like mergers and spinoffs will affect such a portfolio, so you won't strictly be waiting for bankruptcies among the same N stocks forever, but the main point stands.

So why do stock markets keep going up for centuries, even though individual companies rarely thrive for centuries? It is because new, growing companies enter the market alongside old, declining ones.

Of course, you don't receive shares of those new companies for free, but you can rebalance into them. When one of your N stocks goes bankrupt or otherwise no longer makes sense to own, you can sell it (if it still has value) and/or sell a sliver of all your other holdings, and buy a new stock.

This doesn't undo the loss you've suffered from a declining stock, but it keeps you diversified in N stocks at all times, so that it's essentially impossible for bankruptcies to wipe out your entire portfolio. This means that as long as growing companies generally outweigh declining companies in the market, your portfolio can continue to grow indefinitely.

This is exactly how index funds work.

Answer 4

According to Goldman Sachs, 10-year stock market returns have averaged 9.2% over the past 140 years. From 2010 and 2020, the S&P 500 has returned of 13.6% in the past 10 years.

Companies have been going bankrupt since companies began to exist. And despite that, the market provides a positive return.

The sky is falling. I think not. Perhaps the making of another bear market but in all likelihood, that's transient.

Answer 5

When you invest long-term, you don't invest into startup companies that might go bust any moment. Many companies have been around for decades, some have been around for over a century. It is unlikely that they suddenly announce bancruptcy without any warning signs.

Long-term investment doesn't mean you swear a holy oath to never touch or even think about your investment for the next 50 years. It simply means you don't care about the daily up and down of the stock market. You don't sweat if the news are full of doom, doom, dooooooom because the market crashed 5% today - you know that it'll eventually recover, maybe tomorrow, next week or next year.

But if warning signs appear that your investment is in trouble, that the company or companies you bought stock in might go belly up - you may well terminate it and move your money elsewhere.

This is a low-stress and most-of-the-time profitable way to invest because stocks don't move rapidly (most of the time) but in general they go up. By relying on the long-term trend, you don't need to sweat it buying at the perfect moment and hitting the right moment to sell, because a few cents don't make much of a difference over ten years or so.

Answer 6

Companies don't go bankrupt at random. If a company is in trouble, there are usually warning signs, and you don't hav to keep holding it if things look bad. And well-run companies are often able to weather problems and recover. Or some other company will swoop in and acquire them, and you'll get their stock in exchange. Losing all your investment is a rare occurrence.

Yes, sometimes good companies become bad investments. General Electric was a stalwart for over a century, but it is now outdated, like the horse-and-buggy industry when automobiles arrived. But it has been on a slow decline, and if you held shares you could sell them. And then you replace them with something that fits into the modern economy better.

And you don't just invest in one company. An equally important investment philosophy is diversification. If you're wealthy enough you can buy shares of many different companies -- if one of them goes bankrupt, it's just a small part of your portfolio. But most of us do this by buying mutual funds. You can buy index funds, or if you're a little more adventurous you buy managed funds -- the fund managers look for specific companies that seem in good shape, and try to sell off the bad ones before they crash and burn, so you don't have to do all this research yourself. If they miss something here and there, it's still just a small part of their portfolio.

Answer 7

Stocks on average go up, but sometimes they go down. So when one invests in stocks, one is accepting risk in exchange for a positive expected value. You're making a trade of a benefit (positive returns on average) in exchange for a cost (risk of losing money). If you do this longer, you of course get more cost (more time over which you're risking your money), but you also get a higher benefit. You question is a bit like asking "Why should I stay at my job? The longer I work there, the more of my time I have to give up." If you're willing to work there any time at all, then you think the money is worth giving up your time. If the trade is favorable in the short run, why is it unfavorable in the long run? With investing, the case is even stronger for the long term, because you keep getting the same gain, but the standard deviation is proportional to the square root of the time frame. So investing for 25 years gets you 25 times the benefit of investing for 1 year, but only 5 times the standard deviation. And the situation look even better if you subtract the standard deviation from the expected returns to get a "reasonably likely worst case scenario". On a short enough time scale, this is negative, but on a long time scale the standard deviation becomes negligible compared to the expected returns.

Answer 8

You don't buy stocks and then ignore them.

Either you or your advisor needs to either keep up on trends and news, buying and selling stocks dynamically on a "best bet" basis... this is called the "Rain man stock picker" method. Or, by having a fixed investment plan in which buys and sells are done according to a plan in response to published market data, in which case no "Rain Man" is needed, just an intern to make the scheduled buys and sells. Which can be automated on a computer, really.

This means "you" will be actively walking your way out of stocks as they fall, and buying into stocks as they rise. By the time they bankrupt, you are long gone.

As you can see, this is way too much task load for you to DIY.

A basket of stocks

To the bare novice, investing seems like a game of "picking stocks". You can do it that way if you really want to. If you did, you would end up with a basket of stocks. Okay.

Well, if someone selected a basket of stocks, and then sold you shares in that basket, it would be the same as you buying those stocks individually - except you would trade it as one unit. This is a thing, called a mutual fund. This is the key to consumer investing.

You can get two kinds. Kind #1 is "Rain Man stock picker guy" aka a managed fund. This is where a smart stock picker and research staff simply research and trade stocks all day, always trying to beat the market. They are picking for you. You pay them a tribute of about 1.5% per year for their services.

Markets have an index (basically the sum of all stocks on a list such as S&P 500) and you can use them as a gauge to determine how well your picker is picking. Can they beat the market average? You bet. Can they beat the market average by more than their 1.5% expense ratio? HAHA... interesting science on that point.

John Bogle crunched a bunch of historic data and said "they don't, except occasionally by luck, and they can't repeat it". A fund manager replied:

"LOL, too bad consumers can't just buy the index!"

And so Bogle created a mutual fund that is exactly the S&P 500 called VFINX. This is the second, formula-based basket of stocks I referred to: the index mutual fund. And because interns and scripts work for peanuts, the expense ratio is blissfully low - like 1/20, maybe 0.08%. That means you are making 1.42% more money per year, assuming your stock picker is just average.

Bogle put the research into a book, called "Common Sense on Mutual Funds", if you want the details.

A fund like VFINX (now VFIAX or VTSAX) is a "fire and forget" investment for a consumer. I'm mentioning Vanguard funds so Bogle can make a little on the good idea, but every major broker offers these. Some even charge outrageous and unnecessary sales loads!

And the fund performance speaks for itself. Just compare any index fund to a managed fund trading the same kind of stuff (e.g. large-cap managed funds to S&P 500 index funds).

Note that comparing index funds (especially index ETFs) to the market can get weird, because they fold dividends back into the fund value, so it may actually outpace the S&P.

As such, ETFs are a big help on tax day, because you don't have to report within-mutual-fund trades or dividends every year nor pay taxes on them. No income or taxation occur until you sell the ETF.

ETFs are simply mutual funds packaged and traded as a stock - VOO and VTI are the ETF versions of those funds I just named. Normal mutual funds have a special trading mechanism (they sell only at end of day, and the day after you notify to sell) whereas ETFs trade instantly when the market is open.

Answer 9

As Nosjack pointed out, passive investment is more wisely done on a diversified group of large well-managed companies than on a small selection.

If you really want to focus on a small selection, you must be actively monitoring their performance, management appointments and decisions, trends within their main markets, behaviour of rival companies, etc. That's a serious commitment of your time - and there can be no "holidays" from it.

Those exceptions who chose to buy into Coca-Cola, Pepsi and other established consumer brands may well have reaped rewards over decades as passive investors. But the investment could have been lost had managements of these companies not reacted quickly enough to market trends or the effects of their own decisions, e.g. Coca-Cola changing the taste of their flagship product without prior consumer approval.

What's more, even with index investing there will still be periodic drops in the entire market that have to be hedged against since heavy losses sustained in later life cannot be recouped in the remaining years.

It's no simple one-line solution, this investing thing.

Answer 10

That's why people usually invest long-term in ETFs instead of individual stocks. I am not saying it is not recommended to invest long-term in any stock. You can do that if you do extensive due diligence and research about the companies you plan to buy in. If you don't have the time or don't want to do research, ETFs like VOO or SPY are the safest bets. Yes some companies may go bankrupt but it is extremely unlikely that S&P500 will go down in the long term. If it does, we have a bigger problem than our investments.

Answer 11

I'm not sure I agree on the premise

The longer the time frame, the larger the risk that any given company is going to go bust.

It's a common mistaken belief that if I for example flip a coin ten times and it lands heads 9 times then the probability of landing tails the next one is much higher than 50%. This is not the case. The individual flipping of the coin is always 50% (assuming non biased coin). When in advance asking what is the probability to get exactly heads 9 times in a row and tails once in row, that one is minuscule but that is a completely different scenario.

Now back to your question. Holding stocks for long term is less risky which is backed up by simply looking at the statistics. Look for example at the following graph which shows a index that almost contains all stocks listed on Nasdaq.

From the above it can clearly be seen that if over long term it is highly likely that your stock will have increased in value. You can also see that the graphs contains spikes, these are short term and if you are determined to only trade on a short term then you might sell in one of these (which many do). Now you might try to counter with ''yeah, the overall market may have increased but there have been companies which have gone bankrupt along the way''. That's true. But investing in a already established company which has succeeded is for more unlikely to go bankrupt than a newly started one.