Stocks for the Long Run

1. Stocks outperform other assets over the long term

Over the 210 years I have examined stock returns, the real return on a broadly diversified portfolio of stocks has averaged 6.6 percent per year.

Historical evidence is clear. Stocks have consistently outperformed bonds, bills, gold, and cash over long periods. This outperformance holds true across different countries and time periods, even accounting for major economic crises and world wars. The power of compound returns makes this difference substantial over time.

Why stocks outperform:

• Represent ownership in real, productive assets
• Benefit from economic growth and innovation
• Provide a hedge against inflation
• Higher risk premium compared to "safer" assets

While short-term volatility can be high, stocks have never delivered negative real returns over periods lasting 17 years or more, making them the safest long-term investment for preserving purchasing power.

2. Market timing is futile; long-term investing wins

If Fed Chairman Alan Greenspan were to whisper to me what his monetary policy was going to be over the next two years, it wouldn't change one thing I do.

Predicting short-term market movements is virtually impossible. Even professional economists and market forecasters have a poor track record of anticipating recessions, market peaks, and troughs. Attempts to time the market often lead to buying high and selling low, eroding returns.

Key reasons market timing fails:

• Markets efficiently price in known information
• Unexpected events drive short-term moves
• Emotional biases cloud judgment
• Transaction costs and taxes eat into gains

Instead, focus on maintaining a consistent, long-term investment strategy aligned with your goals and risk tolerance. Regular investing through dollar-cost averaging can help overcome the temptation to time the market.

3. Diversification is key to managing risk and returns

As long as two assets are not perfectly correlated, i.e., their correlation coefficient is less than 1, then combining these assets will lower the risk of your portfolio for a given return or, alternatively, raise the return for a given risk.

Diversification reduces portfolio risk without necessarily sacrificing returns. By spreading investments across different asset classes, sectors, and geographies, investors can smooth out the impact of poor performance in any single area. This is particularly important as correlations between asset classes can change over time.

Effective diversification strategies:

• Mix stocks, bonds, and other asset classes
• Include both domestic and international investments
• Consider small-cap and value stocks alongside large-cap growth
• Rebalance periodically to maintain target allocations

Modern portfolio theory provides a framework for optimizing the risk-return tradeoff through diversification. However, it's important to note that diversification doesn't eliminate all risk, particularly during systemic market crises.

4. Valuation matters: Price-to-earnings ratios predict future returns

A median P/E ratio of approximately 15 for the U.S. market means the median earnings yield is 1/15, or 6.67 percent, a value that is strikingly close to the long-run real return on stocks.

Valuation metrics provide insight into future returns. Price-to-earnings (P/E) ratios, in particular, have shown a strong inverse relationship with subsequent stock market performance. When P/E ratios are low, future returns tend to be higher, and vice versa.

Key valuation considerations:

• CAPE ratio (cyclically adjusted P/E) smooths out short-term earnings fluctuations
• Dividend yields also correlate with future returns
• Valuation metrics should be compared to historical averages and interest rates
• Extreme valuations often revert to the mean over time

While valuation is a poor short-term timing tool, it can help investors set realistic expectations for long-term returns and adjust their asset allocations accordingly.

5. Small-cap and value stocks tend to outperform

The lowest-dividend-yielding stocks not only had the lowest return but also the highest beta. The annual return of the 100 highest dividend yielders in the S&P 500 Index since the index was founded in 1957 was 3.42 percentage points per year above what would have been predicted by the efficient market model, while the return of the 100 lowest dividend yielders would have had a return that was 2.58 percentage points per year lower.

Historical data reveals persistent outperformance. Small-cap stocks and value stocks (those with low price-to-book or price-to-earnings ratios) have generated higher returns than the overall market over long periods. This outperformance persists even after accounting for higher risk.

Factors driving small-cap and value outperformance:

• Greater growth potential for small companies
• Undervaluation due to neglect or temporary issues
• Higher risk premium demanded by investors
• Potential behavioral biases in pricing these stocks

While these effects can disappear for extended periods, they have tended to reassert themselves over time. Investors should consider allocating a portion of their portfolio to small-cap and value stocks to potentially enhance long-term returns.

6. Economic factors significantly impact stock performance

In the stock market, as with horse racing, money makes the mare go. Monetary conditions exert an enormous influence on stock prices.

Macroeconomic factors drive market returns. Interest rates, inflation, GDP growth, and monetary policy all play crucial roles in determining stock market performance. Understanding these relationships can help investors anticipate broad market movements and position their portfolios accordingly.

Key economic factors affecting stocks:

• Interest rates: Lower rates generally boost stock valuations
• Inflation: Moderate inflation is often positive, but high inflation can hurt stocks
• GDP growth: Strong economic growth typically supports higher corporate profits
• Monetary policy: Central bank actions influence liquidity and risk-taking

While economic data can provide context for market movements, it's important to remember that much of this information is already priced into stocks. Unexpected changes in economic conditions tend to have the largest impact on markets.

7. Market volatility is normal and often presents opportunities

Accepting risk is required for above-average returns: investors cannot make any more than the risk-free rate unless there is some possibility that they can make less.

Volatility is the price of higher returns. Stock market fluctuations are an inherent part of investing and should be expected. Short-term volatility often creates opportunities for long-term investors to buy quality assets at discounted prices.

Understanding and managing volatility:

• Volatility tends to cluster (periods of high/low volatility)
• Bear markets and recessions typically see higher volatility
• Diversification can help smooth portfolio volatility
• Having a long-term perspective helps overcome short-term fluctuations

The VIX index, which measures implied volatility in options prices, can provide insight into market sentiment and potential turning points. Extremely high VIX readings often coincide with market bottoms, while very low readings can signal complacency.

8. Exchange-traded funds (ETFs) offer efficient market exposure

Exchange-traded funds (ETFs) are the most innovative and successful new financial instruments since stock index futures contracts debuted two decades earlier.

ETFs combine the best features of mutual funds and individual stocks. They offer diversified exposure to various markets, sectors, or investment strategies while trading throughout the day on exchanges. ETFs have grown rapidly in popularity due to their low costs, tax efficiency, and flexibility.

Advantages of ETFs:

• Lower expense ratios than most mutual funds
• Intraday trading and pricing
• Tax efficiency through in-kind creation/redemption
• Ability to use options and short-selling strategies

While ETFs provide many benefits, investors should be cautious of overtrading and carefully evaluate the underlying holdings and methodology of each fund. Some niche or leveraged ETFs may not be suitable for long-term investors.

9. Dividends play a crucial role in total stock returns

Dividends not only dwarf inflation, growth, and changing valuations levels individually, but they also dwarf the combined importance of inflation, growth, and changing valuation levels.

Reinvested dividends drive long-term returns. While price appreciation often gets more attention, dividends have historically accounted for a significant portion of total stock market returns. Dividend-paying stocks have tended to outperform non-dividend payers over time.

The power of dividends:

• Provide a steady income stream
• Signal financial health and shareholder-friendly management
• Offer downside protection in bear markets
• Compound returns when reinvested

Investors should consider dividend yield and dividend growth potential when evaluating stocks. However, extremely high yields can sometimes signal distress, so it's important to assess the sustainability of dividend payments.

10. Global investing provides additional opportunities and diversification

Sticking only to U.S. equities is a risky strategy for investors. No advisor would recommend investing only in those stocks whose name begins with the letters A through F. But sticking only to U.S. equities would be just such a bet since U.S.-based equity will continue to shrink as a share of the world market.

International diversification enhances returns and reduces risk. As the global economy becomes increasingly interconnected, investors who limit themselves to domestic stocks miss out on significant opportunities. Emerging markets, in particular, offer potential for higher growth and diversification benefits.

Key considerations for global investing:

• Currency fluctuations can impact returns
• Political and economic risks vary by country
• Correlations between markets tend to increase during crises
• Valuations and growth prospects differ across regions

While home country bias is common, a globally diversified portfolio is better positioned to capture worldwide economic growth and mitigate country-specific risks. ETFs and mutual funds provide easy access to international markets for most investors.

Last updated: November 19, 2024