Asset No. 1: Stocks

STOCKS WERE A GREAT investment over the past century, but miserable performers between early 2000 and early 2009. What can we expect in future? Nobody knows. But for stock investors, there’s reason for both optimism and caution.

Stocks are riskier than bonds, so they should be priced to deliver higher returns. When you buy a stock, you become an owner, with the prospect of endless gains if things go well and the possibility of losing everything if they don’t. Meanwhile, as a bond investor, you are merely a lender, with limited upside—represented by the yield—but also less risk. If a company gets into difficulty, its bondholders will be paid off before stock investors receive anything. The bottom line: If stocks didn’t hold out the prospect of higher returns, people would be crazy to buy them.

But it isn’t just that investors demand a higher return when they buy a risky asset like stocks. Corporations should also supply it. As the economy grows, corporate earnings ought to climb, and shareholders may also collect dividends. By contrast, with bonds, overall yields shouldn’t be greater than the growth rate of nominal gross domestic product. That suggests bond investors will earn modest long-run returns, plus they’ll suffer tumbling bond prices during periods of rising interest rates.

While the long-term outlook may be brighter for stocks than for bonds, there’s one caveat and one wildcard. The caveat: The full benefit of economic growth won’t necessarily flow through to shareholders. Earnings per share may not match the economic growth rate, which means share price gains could lag behind GDP. And then there’s the wildcard: What value will investors put on corporate earnings and dividends? The fact is, U.S. stocks are expensive by historical standards.

Next: Inflation

Previous: Today’s Valuations

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1 year ago

I was taken aback by the opening sentence, that stocks were miserable performers between early 2000 and early 2009, so I looked it up, using the S&P 500 as a proxy, and “miserable” is in fact an accurate assessment. Left unsaid, however, is that if the timeframe is moved just 2 years later, to early 2011 (which I entered initially by mistake), then that same metric goes from down roughly -29% to +9.8%. So what I take away is that investing in stocks really is a long term game, and that the game may take longer than 10 years to “win”, but over that long (or longer) term the odds of success more more and more towards the buy and hold investor.

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