One of the fundamental principles of the Money Boss philosophy is that your profit (or savings, if you prefer) ought to be invested for long-term growth. You should use the magic of compounding to create a wealth snowball.
Naturally, you want put your money into an investment that offers a reasonable return and acceptable risk. But which investment is best? I believe — as do most financial experts — that you’re most likely to achieve high returns by investing in the stock market.
How Much Does the Stock Market Return?
In Stocks for the Long Run, Jeremy Siegel analyzed the historical performance of several types of investments. Siegel’s research showed that for the period between 1926 and 2006 (when he wrote the book):
- Stocks produced an average real return of 6.8%. “Real return” means return after inflation. Before factoring inflation, stocks returned about 10% annually.
- Long-term government bonds yielded an average real return of 2.4%. Before adjusting for inflation, they had a return of about 5%.
- Gold had a real return of 1.2%. “In the long run, gold offers investors protection against inflation,” writes Siegel, “but little else.”
My own calculations — and those of Consumer Reports magazine — show that real estate does worse than gold over the long term. (I come up with a real return of just under one percent.)
Siegel found that stocks have been returning a long-term average of about seven percent for 200 years. If
you’d purchased one dollar of stocks in 1802, it would have grown to more than $750,000 in 2006. If you’d instead put a dollar into bonds, you’d have just $1,083. And if you’d put that money in gold? Well, it’d be worth almost two bucks — after inflation.
Siegel’s findings aren’t unique. In fact, every book on investing shows the same thing. Over the long term, the stock market produces an average annual return of about 10%.
Note: As much as I love Dave Ramsey’s advice on getting out of debt, he’s notorious for providing misinformation on investment returns. He argues that you can expect to earn 12% in the stock market. This makes a lot of people — including me — tense. You can’t count on earning a 12% return from stocks. You’re going to earn more like 7% after inflation, and I’d argue that in order to give yourself a margin of safety it’s better to assume 5% instead.
Average Is Not Normal
Over the past 200 years, stocks have outperformed every other kind of investment. But before you rush out and sink your savings into the stock market, you need to understand a couple of things.
First up, it’s important to grasp that average market performance is not normal.
In the short term, investment returns fluctuate. The price of a stock might be $90 per share one day and $85 per share the next. A week later, the price could soar to $120 per share. Bond prices fluctuate too, albeit more slowly. And yes, even the returns you earn on your savings account change with time.
Just a few years ago, high-interest savings accounts yielded five percent annually in the U.S.; today, the best accounts yield about one percent.
While it’s true that stocks average a 10% annual return, it’s rare that the stock market produces a return close to that average in any given year. Recent history is typical. The following table shows the annual return for the S&P 500 over the past fifteen years (not including dividends):
The S&P 500 earned an average annualized return of 4.24% for the fifteen-year period ending in 2014. But only two years — 2005 and 2007 — generated stock market returns close to the average for that time span. (Note: This fifteen-year period has one of the lowest rates of return on record.)
Short-term market movements aren’t an accurate indicator of long-term performance. What a stock or fund did last year doesn’t tell you much about what it’ll do during the next decade.
Because of their volatility, stocks outperform bonds during only 60% of one-year periods. But over ten-year periods, that number jumps to 80%. And over thirty years, stocks almost always win.
Stocks for the Long Run
The best way to build your wealth snowball is to invest in the stock market. Doing so is likely to offer you the highest rate of return on your money. And the best way to approach stock-market investing is to take the long view. Forget about what the market does today or tomorrow. Focus on the future.
In The Random Walk Guide to Investing, financial guru Burton Malkiel writes:
It turns out that the longer you hold your stocks, the more you can reduce the risk you assume from investing in common stocks. The chart below makes the point convincingly. From 1950 through 2002, common stocks provided investors with an average annual return of a bit more than 10 percent…
Even during the worst 25-year period you would have earned a rate of return of almost 8 percent — a quite generous return and one that was larger than the long-run average return from relatively safe bonds.
The following chart from William Bernstein’s excellent The Four Pillars of Investing offers another way to visualize long-term returns.
Each bar represents the 30-year annualized real return on U.S. stocks. So, the first bar shows that for the period between 1901 and 1930, the market returned an average of nearly 4% annually after inflation. For the period between 1971 and 2000, the market returned an average of over 7% per year.
The bottom line: Investing is a game of years, not months.
Don’t let wild market movements make you nervous. And don’t let them make you irrationally exuberant either. What your investments did this year is far less important than what they’ll do over the next decade (or two, or three). Don’t let one year panic you, and don’t chase after the latest hot investments. Stick to your long-term plan.