Digital Wealth. Moore Simon

proportion of your retirement savings in stocks is a good fit. Even if you’re investing for a shorter period, such as to fund a child’s college education or to put some money away for a few years to fund a deposit on a house, the stock market can still be useful component of the portfolio, but it will typically be a smaller portion as the time until you need the money shortens and the need to balance stock exposure with fixed-income instruments increases.

      Additionally, you can construct a portfolio that may provide some insulation from the ups and downs of the stock market. Other assets can move up or decline less during bad periods for stocks, bringing more smoothness to your returns over time. This is the principle of diversification.

      The Historical Perspective

Let’s look at the evidence. Elroy Dimson and Paul Marsh have looked at stock markets from around the globe. They find that over the 1900–2014 period stock markets have delivered an actual average return after inflation of 5.2 percent. That compares with 1.9 percent for government bonds and 0.9 percent for government bills, again all numbers after inflation. Of course, these differences that may seem minor over the course of a year result in stark differences with compounding over time. A global equity portfolio would return more than seven times your initial investment over 40 years, and as I suggested at the start of this chapter, that rate of growth more than doubles your money after inflation in 15 years, whereas with bonds you’d more than double your money in 40 years, and with bills you’d earn almost a 50 percent incremental return. Also, the equity returns are robust across countries. Austria is at the low end with 0.6 percent return, and South Africa at the high end with a 7.4 percent return, but two-thirds of countries have average annual real equity returns of between 3 percent and 6 percent, consistent with the average level of growth seen across markets (see Figure 2.1).

Figure 2.1 Historical Returns by Asset Class after Inflation, 1900–2014

      Source: Elroy Dimson, Paul Marsh, and Mike Staunton, Triumph of the Optimists, Princeton University Press, 2002, and subsequent research

      Jeremy Siegel of Wharton has performed a similar analysis in the United States over two centuries and finds a real return on stocks of about 7 percent a year. Historically speaking, the United States has been at the higher end of returns relative to other markets, with only Australia and South Africa doing better within the Elroy, Dimson, and Marsh data set.

      What is important about this data is not the absolute return that stocks deliver, though it is impressive, but that stocks consistently deliver higher returns than other asset classes on a medium- or long-term view. That’s what is relevant to the portfolio construction decision. Most strikingly, looking back from 1900 to 2014 in all of the countries where there is a full run of data, stocks outperform both bonds and bills. Clearly, there are periods of underperformance of stocks relative to bonds, often for a decade or more in some countries, but in the long-term view, stocks come out ahead.

      The Logic

      In addition to just looking at the historical numbers we can also consider logically why this is the case.

      First, when an economy is growing, stocks are levered to that growth, and they receive the profit that is left after fixed costs are paid. So as an economy grows, returns to equity can grow disproportionately. This is not true of fixed-income investments, where returns over the bond’s lifetime are capped by the coupon payment of the bond but could be less. While bonds offer a steady return, but with downside risk and no major upside, equities have more of a symmetrical risk profile in terms of potential upside and downside outcomes relative to bonds, which over the long term improves potential returns considerably. In addition, consider that although a stock can fall to zero – a loss of 100 percent – gains are not capped at 100 percent, since a stock can double or triple. The other benefit of stocks comes from pricing power.

      When inflation increases, the real returns to fixed income decrease. You receive a 3 percent coupon whether inflation turns out to be 1 percent or 5 percent. However, for stocks, if inflation rises to 5 percent, companies have an opportunity to raise prices 5 percent. Clearly not all will and not all can due to the actions of customers, regulators, or competitors, but generally stocks have some defense against rising inflation, whereas bonds are more exposed to it. However, inflation is hardly plain sailing for stock investors, as we’ll discuss in the next chapter.