Many investors believe step one in dialing down their portfolio’s risk should be reducing equity exposure. Yes, stocks are riskier than bonds, but that’s an oversimplification that can result in some misguided moves. First, stocks provide a greater return than bonds over the long term According to Standard & Poor’s, the S&P 500 Index has had an average annual return of 9.9 percent annually from 1926 to 2010. Over the past 50 years, it’s returned 9.8 percent, and over the past 25 years, the return has been 9.9 percent. According to Ibbotson Associates, long-term government bonds have averaged 5.5 percent, 7.1 percent, and 8.9 percent during these same three time periods.
Stocks are also a better hedge against inflation. On an inflation-adjusted basis, the S&P 500 Index has provided average annual returns of 6.7 percent from 1926 to 2010, 5.4 percent over the past 50 years, and 6.9 percent over the past 25 years. There were a total of 10 rolling-year periods when the S&P 500 Index did not keep up with inflation. While long-term government bonds provided inflation-adjusted returns of 2.4 percent, 2.9 percent, and 5.9 percent over those same three periods, there were 33 rolling-year periods when long-term government bonds did not keep up with inflation. One factor influencing the gap between stocks and bonds is that, even in difficult markets, companies can increase their prices to remain competitive.
If you want another reason to invest in equities, consider this prediction by Professor Sylla, a financial historian at New York University’s Stern School of Business who has studied market behavior all the way back to 1790. A recent Wall Street Journal article–A Long-Term Case for Stocks–reported his view that if the market sticks to its long-term pattern, the Dow Jones Industrial Average could climb to 20250 by the end of 2020, up 84% from its recent 10992. Additionally, he says the Standard & Poor’s 500-stock index might hit 2300, up 99% from its recent close of 1154.23.
Using 10-year averages of annual market returns, including dividends and adjusting for inflation, Prof. Sylla found when 10-year-average annual returns drop below 5% as they did in 2008 and 2009, markets tend to transition to recovery.
Of course, we all know that past results cannot be used to guarantee future returns…
The real lesson in this research is that investors are best served when they take a long-term view of the market and think in terms of decades and years, not quarters.