Suppose I had a choice between: (i) £1,000 cash, (ii) £34.50 per year in passive income for 10 years followed by £1,000, or (iii) an unspecified return for an unspecified time. Which would I choose?
Investing in the stock market involves taking the third option. If I preferred £1,000 in cash, I probably wouldn’t invest in anything and if I thought the second option was best, I’d invest in bonds.
Stock market investing
Investing in the stock market involves buying shares in businesses. Some of those distribute the money they make to their shareholders in the form of dividends, or share buybacks.
The trouble is, there’s no way of knowing with certainty how much money a company will make. That’s why the amount an investor will make in passive income by owning stocks is unspecified.
There’s also no way of knowing how long the company will keep paying dividends for, or what the share price will be 10 years from now. Future share prices are arguably even harder to predict than dividends.
It’s therefore difficult to choose the unspecified return over the £34.50 (what I’d get from a 10-year UK government bond at today’s prices). So why would anyone looking for passive income invest in stocks?
Risk and uncertainty
The main reason is because I don’t think the future is completely uncertain. It’s impossible to be 100% sure about what the return on a stock will be, but it’s possible to know something.
For example, take Rightmove. I own this stock in my portfolio because I think I know enough about the company to be confident its shares will be a better investment over the next 10 years than a bond.
I have this view because I know certain things about the business. I know how it generates cash, what its costs are, how much debt it has, and what makes it difficult for competitors to disrupt.
None of this guarantees that investing in Rightmove shares will turn out better than a bond. Investing in shares is always risky, but I think there’s reason to believe buying the stock is a good idea.
How to invest in shares
When I invest in the stock market, it’s really important to stick to companies I can understand. Otherwise, I’m buying something with an unspecified return that might be better or worse than a bond.
As an example, I don’t have a good idea about how to estimate the prospects for pharmaceutical drugs. As such, I’m not buying shares in AstraZeneca or GSK at today’s prices.
I wouldn’t rule out doing so in the future – something might happen that means these stocks are obviously good investments. But I don’t think I’m in a position to judge this accurately enough right now.
Passive income in the stock market is never guaranteed. But there are sometimes opportunities for investors like me to spot better returns than bonds are offering. And this is the time to buy stocks.
This post was originally published on Motley Fool
