Stocks Over the Long Run
Compounding is an important term used in investing and it refers to the way gains are accumulated on investments. When an investment averages a 10% gain over a period of time the gains build upon themselves, or you essentially earn a higher return through increased money from previous returns. For example, say a 10% gain on an initial investment of $100 in the first period is a $10 return. But a 10% return in the second year on the beginning investment in that period of $110 (due to the prior period’s gain of $10) leads to a gain of $11. If you stretch this over many years (which we hopefully have left in our lives) then a few percentage points of return between investment types makes a huge difference.
From historical data provided by financial data firm Morningstar’s 2015 Ibbotson Yearbook we can see the compounded annual return rates across several investment types. These returns represent what investors would have received if in 1926 (when this data began to be gathered) they invested $1 in stocks of large-sized companies, long-term debt issued by companies, Treasury debt of long, intermediate, and short maturities, and a measure of general price increases over that time period. The returns are a compounded average accounting for all interest and dividends received being reinvested in more shares or bonds. This is not a picture of actual price movement of each asset (as prices were very volatile over the period and didn’t follow these patterns), but rather the change in the size of your initial investment through investing in each type of asset beginning in 1926.
Since 1926 through the end of 2014 stocks of large-sized U.S. companies have averaged a 10.1% annual compounded return through capital gains (a rise in their share prices) and dividends (quarterly cash payments, which were reinvested in more shares). In the same period, longer-term corporate bonds returned 6.1% annually. Over this significant time horizon, which contained historical events as dramatically bad as the Great Depression and World II, this 4% annual asset price differential received by investing in equities as opposed to fixed income would have created $5,316.85 in stock value versus and an ending bond value of $189.76! The long-term benefits received with taking on more risk with stocks speak for themselves! The returns for taking an additional risk by investing in small company stocks were even higher over this period providing a 12.2% annual return.
But, to be honest, the recent past has been a brutally tough period for stock investors. Combining the technology bubble in 2000 (which led to overpriced stock prices and preceded a minor recession beginning in early 2001) and the most recent housing bubble and financial meltdown (which led to the longest and deepest recession since the Great Depression) has led to weaker than average historical returns for stocks.
The S&P 500 is a popular index that tracks stock prices for the 500 of the largest U.S. companies. The index does not account for dividends paid to investors which effectively understating actual returns by about 2% each year. This also removes the compounded return investors receive by using their dividend payments to buy more shares of stock.
This is to suggest that stocks over the short term are more volatile yet over longer holding periods their returns tend to outperform fixed income. The single worst equity return in a calendar year was -43% in 1931. Yet if we look at 20-year holding periods ranging from over the past 86 year period in the Ibbotson Yearbook data the lowest 20-year return for large company stocks was +3.11% (the best was 17.88% ). If you stretch your holding period to 30 years then the lowest annual return moves to 8.5% (the best being 13.7%)!
This goes to show that over the longer time horizons that equity returns tend to revert to their long-term averages as the various economic cycles balance out with higher returns prevailing over losing years. Over this period 65 years out of 89 provided positive equity returns (73%), but over longer holding periods stock investors are rewarded for taking this short-term risk through longer-term higher returns. However, attempting to time when exactly the market will rise in the short run is perilous as many individual investors time the market incorrectly and sell after a decline and fail to buy before a market rise. This problem is solved by staying invested through all market cycles.
In the short-term, our economy and economies worldwide face tough issues like high unemployment, tight lending conditions, weak demand for goods and services, and an uncertain solution to politically important items like entitlement reform and deficit reduction.
In the long-term stocks will be driven by the “long-term bets” which we covered in the equity overview section: A company’s continued growth and success seen in their ability to reach new customers across the globe, their use of technology to improve the efficiency of their operations and to develop innovative new products, the continued growth of the global economy, and the success of globalization and capitalism.
Don’t let the negative portrayals of the current economy cloud the long-term view of the world. Make investments now, and continue to invest in equities over many years to participate in the long-term exponential growth of your investments! Focus on the long-term and invest accordingly.