The Long Run Superiority of Stocks
In the short run, it is incredibly difficult to predict the direction that an individual stock will go. In the long-run however, it becomes far more plausible to anticipate. This is because in the long run stocks tend to revert to the mean, and this mean is based on the fundamentals of the underlying company.
While predicting the future of an individual company requires an extensive amount of buisness and financial knowledge (and even then there is significant margin of error), predicting the trend of the overall stock market in the long run is a relatively manageable task.
In the long run GDP growth has averaged around 2-3% in Canada and the US, and as long as populations continue to increase, we can expect this rate of GDP growth to remain steady. The average dividend rate has been around 4%, giving an overall average return from stocks at roughly 6.6%.
As can be seen from the above graph of average returns over the 200 year period from 1802-2002, this average has far outpaced that of all other investment vehicles.
It is important to note however that in the short run, any of these asset classes could provide the greatest returns from investment. In the next section we will examine over what time frame it becomes reasonable to assume that stocks will be the best investment vehicle, in what instances bonds will outperform stocks, and recommended portfolio allocations under different circumstances.
Stock, Bonds, and Portfolio Allocation
It is clear from the above figures that in the short run, stocks provide not only the greatest return but also the greatest risk. As we expand are time horizon, the returns from stocks continues to outperform that of bonds and T-bills, while the risk of loss actually become lower than that of Bonds and T-bills starting at 10 years.
What does this mean for you? Well, if you are in your 20’s or 30’s and are beginning to save for your retirement, then a 100% stock allocation could be recommended as long as you are able to stomach the possibility of significant short term losses .
That being said, in shorter time horizons it is not unusual for bonds to outperform stocks. If you are a risk averse individual, then a higher proportion of bonds can serve to greatly stabilize your portfolio.
If you are approaching retirement and thus have a shorter time horizon, or if you are in need of income from your investments, then a higher proportion of bonds would also be advantageous.
The above figure serves as a general guideline for allocating your savings.
Stocks are the only hedge for inflation
The last thing worth mentioning is that stocks provide the best mechanism for shielding against inflation. Although inflation rates have been low in the recent past, there is no guarantee that this will continue going forward. In times of inflation, the principal value of bonds is quickly eroded, while the market value of stocks tends to adjust for inflation.
Also noteworthy is the fact that in times of deflation (negative inflation) bonds tend to outperform stocks, as the principal value of the bonds is enhanced due to deflation while the market value of stocks is discounted accordingly.
This being said, while there are situations in which central banks would try to stimulate the economy or payback debt by printing money, thus creating inflation, there is no logical reason for a central bank to pursue a policy of deflation.
Therefore the possibility of future deflation remains far less likely than that of an increase in the current inflation rate.
If you are an investment novice in your 20’s or 30’s are looking to start saving for your retirement, there are two ways you can take advantage of the long run advantages of stocks.
The First is to invest in a low cost index fund (The method I would highly recommend), the second is by investing in a mutual fund.
To find out why investing in an index fund is a far superior method than investing in mutual funds, stay tuned for my next article.