While the stock market gyrates, it seems a good time to talk about investment returns.
Investing in stocks:
- has outperformed both bonds and cash.
- is volatile.
- is much less volatile with a long-term horizon.
Since 1926, the average annual total returns for all three asset classes have been:
- Stocks: 10%
- Bonds: 6%
- Cash: 3%
Volatility is abstract so I’ll make it more concrete by presenting three different perspectives.
First, let’s look at the range of stock returns for different time periods:
- The worst year for stocks was a loss of 43% and the best year was a gain of 54%.
- Over any 20-year horizon the range is much more narrow — the worst result was an average gain of 1% per year and the best was 16%.
Bonds are less turbulent:
- The worst year for bonds was a loss of 8% and the best year was a gain of 43%.
- Over any 20-year horizon, the range was 1% to 12%.
A second way to understand volatility is to see how often the returns are negative:
- Stocks have lost money 1 out of every 4 years.
- Bonds have lost money 1 out of every 5 years.
And for you math nerds, a third way to understand volatility is to look at the standard deviation of returns.
- With a one-year horizon, stocks returns have a standard deviation of 20%.
- With a 20-year horizon, stock returns have a standard deviation of just 3%.
Again, bonds are less turbulent as their standard deviations for these two periods are 8% and 3%.
Roughly speaking, you can think of the standard deviation as the range (up and down from the average) within which the returns should fall about two-thirds of the time. In other words, if the average returns are 10%, then the returns should fall between -10% and 30% in two out of every three years.
In all three ways of thinking about volatility, you can see that with longer time horizons, volatility is considerably dampened. This point is crucial to recognize.
Why does anyone invest in bonds if stocks have higher returns and minimal volatility over long time horizons? This “equity premium” has puzzled economists for a long time especially given that the difference between 6% and 10% returns are large. For example, averaging 10% returns instead of 6% will give you double the money after 20 years.
Part of the answer is that we humans are risk-averse and want to sleep well every night, rather than just averaging a good night’s sleep over 20 years. Also, not all investors have long-term horizons. But it does remain a mystery why investors don’t opt for a greater concentration of stocks in their long-term investment portfolios.
If you can tolerate the short-term turbulence of the stock market, your older self will almost certainly be financially better off 20 years from now.
Finally, if the stock market remains at this level for the rest of the year, 2018 will be the tenth year in a row of positive stock market returns. If so, that would be the first time the stock market went up ten years in a row, dating back to 1926.
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