“When the weather changes, nobody believes the laws of physics have changed. Similarly, I don’t believe that when the stock market goes into terrible gyrations its rules have changed.” Benoit Mandelbrot
This brilliant mathematician speaks to the reality that the price of common stocks goes up and down. If you want the possibility of a high return, you need to take some risk.
Across the web there’s been talk about the death of equity investing.
Why? My guess is because investors have short term memories and believe since stock market returns’ under performed their historical averages during the first decade of the new millennium, they will continue to under perform.
Ironically, and the end of the 1990’s there was a similar belief, only in reverse. The media was filled with discussions about how we had moved into a new world of investing and the old rules didn’t apply. In 1999 after a decade of historical out performance of the equity markets, investors believed that the “new normal” would be stock returns in the double digit range.
Well, that didn’t quite pan out.
What happened in the first decade of this millennium is a reversion to the mean. After large out performance of stock investments, the equity markets under performed which moved long term returns closer to their historical averages.
Does that mean the future equity returns will now be lower than historical averages?
I guarantee that no one knows what the future holds!
What is the relationship between investing return and risk?
Understand the relationship between risk and reward and become a smarter investor. There is an unavoidable trade off between risk and reward. Investors demand to be compensated for taking risks and investing in equities is risky.
A risky investment must compensate the investor with a higher return than a safer investment. If the returns were the same, you would always choose the less risky investment!
The reward from investing is the possibility of a high return on your investment dollars.
The real risk in investing is the possibility that your payback won’t be what you expected, but less than you expected. After all no one is unhappy if their return is greater than planned.
How to get a reward from investing?
Empirical research supports the out performance of buying a few low cost diversified index funds in an asset allocation in line with your risk tolerance and holding for the long term. You might buy an international stock index fund, a diversified USA or other country specific diversified fund, and a cash or bond fund.
Rebalance once a year based on your predetermined asset allocation and hold for the long term.
Over the last 80 years, U.S. stocks returned a bit over 9%/year. If history is any guide, your long term returns from stock investments will beat those of cash investments.
But don’t put money into stock investments that you need in the next five to ten years. Due to the volatility, short term returns are quite unpredictable. Long term, you are likely to experience the out performance benefits of investing in a risky asset.
What is the risk?
Stock investments go up and down in price. The risk is almost certain that during a 10-20 year period your investment returns will be negative some years. If history is any guide, over the long term, you will earn more money by investing in stocks than if you kept the money in a bank money market account.
What if you don’t want any risk in your investment dollars?
If you cannot tolerate any fluctuation in investment returns, then put all of your money in the bank or in government bonds. The only problem with that strategy is that inflation will likely eat into the true purchasing power of your cash.
The only way to hold on to your principal purchasing power is with a US government Treasury Inflation Protected Security (TIP) or Government I (inflation) Bond (for USA investors). Those investments will protect your money from inflation risk but offer no possibility of beating the return of inflation.
Why take the risk?
In investing, the greater the potential reward, the greater the risk. Common stocks have the potential to offer high returns over the long term. In the short term equity values move up and down so much that it is impossible to predict whether your return will be positive or negative.
If you want a way to finance long term goals such as retirement, home renovations, down payment on a home, and college expenses for your child, then stock index mutual funds are an excellent vehicle. However, you must be prepared for the ups and downs in the investment markets. Understanding the historical returns of stocks can help you stay the course during the down years.
Where are you putting your investment dollars these days?