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The recent market turmoil has the naybirds out in force, and they're decrying the long-term viability of stocks. I think this is nonsense. Though I try not to be dogmatic around here, today is an exception. Today I am going to sing the praises of the stock market.
Learning from the experts
When I began to turn my financial life around, I made a habit of reading books about money. The more I read, the clearer certain patterns became. I wrote about these patterns in my very first post about getting rich slowly.
I've continued to read personal finance books, including books about investing. And I've continued to detect recurring themes. One of the most prominent themes — present in most investing books and present in most conversations with real-life financial planners — is that, in the long term, stocks produce attractive returns. They may fluctuate in the short term, and may even decline by 50% in a single year, but historically, they yield an investment return of about 10%.
But I'm no financial expert. I'm just an average guy who is trying to build his wealth. Let's see what the actual experts have to say. In this post, I've included excerpts from four of my favorite books about investing.
From Yes, You Can…Achieve Financial Independence (2004)
This book by James Stowers contains some of the most complete information on investment returns that I've found. And Stowers presents it in interesting ways. Here's what he says about comparing the short term to the long term:
[A $10,000] investment made on 01 July 1932 would have realized, one year later, the worst one-year result out of 425 [periods tested]: minus 69%. Most people, if they had experienced those poor results, would have assumed that this was an indication of future performance and would have become discouraged. Many would have traded their investment back for dollars and tried to find another place to invest their money.
Had they had confidence in the long-term opportunities of the Dow and left their investment undisturbed for another 29 years (30 years total), it would have been worth $556,563. The original investment, which began with the worst one-year result, grew at an average annual compound rate of 14.34% (the best 30-year result). As you can see, it is unwise to assume that short-term investment results are an accurate indication of long-term performance.
The following charts indicate the probability of obtaining a certain return from a $10,000 one-time investment. The top line of each chart indicates the one-year probabilities. So, for example, there's an 55% chance that the S&P 500 Index will produce a 10% return over a one-year period. There's an 85% chance of obtaining that return over a decade. But, historically, there is a 100% chance of earning that return over a 30-year investment career. (Ignore “Fund A” — it's irrelevant to this discussion.)
These next three charts provide snapshots of 1-year, 15-year, and 30-year investments from January 1897 to December 2003. The “individual periods” have quarterly start dates. Each chart breaks returns into quartiles. Watch how the numbers move to the middle — at about 10%.
From Saving and Investing (2005)
Michael Fischer's slim volume remains one of the best and most under-rated finance books of the last few years. It's a shame it doesn't have a wider audience. Fortunately, Fischer's Saving and Investing channel on YouTube continues to grow. (1350+ subscribers now!) Here's his take on the impact of time on investment returns:
The impact of time (7:15)
From his book:
In order to capture positive long-term returns from a volatile asset like equities [stocks], it has been easier to predict the result when the asset is held for a long time. Over short time periods the returns are very difficult to predict, and jump around a lot. A longer time horizon significantly increases the likelihood of having a good result.
One implication of this is that when we invest in volatile assets like equities, our investment horizon should be longer to increase our chances of achieving a positive result.
Here are series of charts tracing the annualized return of the S&P 500 Index for a variety of time periods ending from 1939 to 2003. Notice how the one-year returns are all over the map. As the investment horizon increases, the returns become smoother.
From The Four Pillars of Investing (2002)
If I could recommend one book to those who want to learn about the stock market, I think it would be The Four Pillars of Investing. The author doesn't sugar-coat anything. As he describes the history of speculation, he explains that there's every possibility that the U.S. stock market's past performance could simply collapse in the future. All the same, he cannot offer a better long-term investment:
Short-term risk, occurring over periods of less than several years, is what we feel in our gut as we follow the market from day to day and month to month. It is what give investors sleepless nights. More importantly, it is what causes investors to bail out of stocks after a bad run, usually at the bottom. And yet, in the long-term, it is of trivial importance. After all, if you can obtain high long-term returns, what does it matter if you have lost and regained 50% or 80% of your principal along the way?
This, of course, is easier said than done. Even the most disciplined investors exited the markets in the 1930s, never to return…If you want to earn high returns, be prepared to suffer grievous losses from time to time. And if you want perfect safety, resign yourself to low returns…High investment returns cannot be earned without taking substantial risk. Safe investments produce low returns.
In this chart, Bernstein shows the 30-year annualized inflation-adjusted return on U.S. stocks.
from The Four Pillars of Investing by William Bernstein
From The Random Walk Guide to Investing (2003)
Finally, financial guru Burton Malkiel also makes the case for stock-market investment. Like the others, he notes that the stock market can (and does) enter prolonged periods of declining value:
Common stocks have been the big winner, providing an average annual return of about 10 percent. This 10 percent return includes both the dividends and capital gains resulting from growth over time in corporate earnings and dividends. But these generous returns have been achieved at the expense of considerable annual volatility, which is a good indicator of risk.
In some years, stocks have lost more than a quarter of their value. And sometimes there have been three years in a row of negative returns, as was the case from 2000 to 2002. In fact, equity investors have suffered through several severe bear markets over the past fifty years. The chart below shows the magnitude of the declines as well as the number of months it took the stock market to recover.
from The Random Walk Guide to Investing by Burton Malkiel
Later in the book, Malkiel writes:
It turns out that the longer you hold your stocks, the more you can reduce the risk you assume from investing in common stocks. The chart below makes the point convincingly. From 1950 through 2002, common stocks provided investors with an average annual return of a bit more than 10 percent…
Even during the worst 25-year period you would have earned a rate of return of almost 8 percent — a quite generous return and one that was larger than the long-run average return from relatively safe bonds. This is why stocks are a wholly appropriate medium for investing in long-term retirement funds.
from The Random Walk Guide to Investing by Burton Malkiel
The bottom line
All of the books say the same thing: over the long term, stocks have returned an average of about 10% per year. Obviously, there's no guarantee that they'll continue to offer these sorts of returns, but there's no reason to believe that they won't, either.
Yes, 2008 may blow a lot of these charts out of the water. But you know what? I have confidence (some might call it “faith”) that, in the years ahead, we'll see a regression toward the mean. That is, the returns will tend toward the historical norms to which we are accustomed. If you do not share this confidence (or “faith”), then I'd argue that your risk tolerance is too low, and you should consider other investments.
It's a stock-market crash at the back end of your investment life that will hurt you — if your asset allocation isn't appropriate for your age — not a crash at the front end. A crash at the front end has, historically, been a good thing. What does this mean? If you're in your twenties or thirties, the statistics would seem to indicate that your best bet right now is to buy into the stock market. That's what I intend to continue doing.