Excessive trading and market timing: Another type of wishful thinking occurs when folks would like to believe that they can jump into and out of the market at the right times to participate in moves higher and to sidestep downturns.
IS HIGHER ECONOMIC GROWTH BETTER FOR STOCK PRICES?
Stocks for the Long Run (McGraw-Hill) author Jeremy Siegel makes a surprising statement in his book: “… economic growth has nowhere near as big an impact on stock returns as most investors believe.” Siegel presents a long-term analysis going back to 1900, which shows that a country’s real GDP growth (that is, growth above the rate of inflation) is negatively correlated with stock market returns.
This surprising finding means that those economies experiencing higher rates of growth actually tend to produce lower long-term stock market returns. Siegel’s analysis shows that this fact is even more pronounced in developing countries. China is a recent example of a country that has enjoyed high rates of growth but relatively low stock market returns.
In explaining how this reality could possibly be, Siegel points out that the primary determinants of stock prices are earnings per share and dividends per share. Economic growth doesn’t necessarily boost earnings and dividends per share because growth requires higher capital expenditures, and as Siegel points out, this capital does not come freely. “The added interest costs in the case of debt financing and the dilution of earnings in the case of equity financing reduce the growth of earnings per share,” says Siegel.
Chapter 8 goes into detail on stocks, explaining how to invest in them successfully and not lose your shirt.
Real estate returns
Just before, during, and for some time after the financial crisis of 2008 and associated severe recession, most types of real estate in most parts of the country declined in value. Thus, you may think that real estate isn’t a good investment, but you’d be incorrect.
Real estate is a solid long-term investment. Real estate, as an investment, has produced returns comparable to those of investing in the stock market. Both stocks and real estate have down periods but have historically produced attractive long-term returns. Overall, real estate prices in most parts of the United States now have bounced back to record high levels.
Real estate does well in the long run because of growth in the economy, in jobs, and in population. Real estate prices in and near major metropolises and suburbs generally appreciate the most because people and businesses tend to cluster in those areas.
Small-business returns
When we think of the “American dream,” one image that comes to the minds of many folks is owning their own business and possibly making it big by doing so.
You have numerous choices for tapping into the rewards of the small-business world. If you have the drive and determination, you can start your own small business. Or perhaps you have what it takes to buy an existing small business. If you obtain the necessary capital and skills to assess opportunities and risk, you can invest in someone else’s small business. None of these avenues is easy. In fact, all these routes require drive, determination, and some skills and money (more on this in Chapter 14).
By starting a small business and retaining a major ownership stake, you can potentially earn high effective returns. Unlike with the stock market, for which plenty of historic rate-of-return data exists, no specific data exists on the returns that small-time investors have had from investing in small private companies. (We do know that successful venture capital firms, which invest in small businesses with large potential, earn generous returns for the general partners.)
While the financial rewards can be attractive, there are other rewards from investing in small businesses. In my small-business ventures, for example, I’ve enjoyed designing and running businesses that provide useful and valued services. I also enjoy having flexible work hours and not feeling like I’m punching a time clock to satisfy a boss.
Compounding Your Returns
If you’ve read this chapter up to this point, you see that I’ve discussed the historic investment returns on common investments. To summarize: During the past century, stocks and investment real estate returned around 9 percent per year, bonds around 5 percent, and savings accounts about 3 percent.
In case you’re curious about some alternative investments like gold and currencies, here are those numbers. Gold has just kept investors up with inflation with a tiny bit to spare — returning an average of about 0.5 percent per year after inflation. Currencies like the U.S. dollar have depreciated about 1.5 percent per year adjusting for inflation. (There’s no reason to think that cryptocurrencies as a group will fair any better over time. See Chapter 15 for more information.)
This section illustrates how compounding seemingly modest investment returns can help you accumulate a substantial sum of money to help you accomplish your personal and financial goals.
The value of getting a few extra percent
As I discuss in Chapter 1, investing in the stock market (and real estate) can be risky, which logically raises the question of whether investing in stocks and real estate is worth the anxiety and potential losses. Why bother for a few extra percent per year?
Here’s a good answer to that sensible question: Over many years, a few extra percent per year will increase your nest egg dramatically. The more years you have to invest, the greater the difference a few percent makes in your returns (see Table 3-1).
TABLE 3-1 How Compounding Grows Your Investment Dollars
| For Every $1,000 Invested at This Return | In 25 Years | In 40 Years |
|---|---|---|
| 1% | $1,282 | $1,489 |
| 2% | $1,641 | $2,208 |
| 3% | $2,094 | $3,262 |
| 4% | $2,666 | $4,801 |
| 5% | $3,386 | $7,040 |
| 6% |