Stock market outperforms other investments long term?

April 4, 2008 7:19 PM

Stock market - do you believe that over 20 years it really outperforms other investments?

I've been invesing for about 10 years now. I know lots of people's portfolios are down right now, and most of my loss is due to one bad investment I made when I was young. So now that I'm in almost all "safe" mutual funds, is my coast clear, do you think?

posted by Penelope to Work & Money (13 answers total)

There are tomes of data dealing with this question.

Here are some quotes from David Swensen, who runs Yale's endowment:

"Domestic stocks play a central role in investment portolios for theoretical and practical reasons. The expected return characteristics of equity instruments match nicely the needs of investors to generate substantial portfolio growth over a number of years. To the extent that history provides a guide, the long-term returns for stocks encourage investors to own stocks. Jeremy Siegel's two hundred years of data show U.S. stocks earning 8.3 percent per annum, while Roger Ibbotson's seventy-eight years of data show stocks earning 10.4 percent per annum. No other asset class possesses such an impressive record of long-term performance."

The above quote represents the generally-accepted wisdom on the subject. However, Swenson makes the point:

"The more or less uninterrupted operation of the U.S. stock market in the nineteenth and twentieth centuries contributed to superior results. Jorion and Goetzmann find that the U.S. market produced 4.3 percent annualized real capital appreciation from 1921 to 1996. In contrast, the other [39 countries studied], many of which experienced economic and military trauma, posted a median real appreciation of only 0.8 percent per year. Thoughtful market observers place the exceptional experience of the U.S. equity markets in a broader, less compelling context."

By "real" appreciation, he's taking inflation into account. The data cited in the previous quote does not do so. These quotes are from his excellent book, Unconventinal Success.

There is also some good data out there that looks backwards at 20-year investment periods and shows that, while the results are generally good, there are definitely periods when equities were mediocre investments. I'll see if I can find a good reference.

And we haven't even started on the topic of return degradation from unnecessary mutual fund fees, tax distributions and transaction costs.
posted by mullacc at 7:55 PM on April 4, 2008 [1 favorite]

I think the rule is that there is no 20 year period in the history of the US where the stock market didn't grow. As I remember it, anyway. Terry Savage is the person I've heard saying it.

Smart investors can make money in all kinds of markets and all kinds of business cycles. I think it depends far more on the skill of the investor.
posted by gjc at 7:58 PM on April 4, 2008

Get Rich Slowly recently had a post about long-term compound interest -- it simplifies the growth of the stock market to an annual average, but the point in me mentioning it is that if you go with something with less growth and less risk, you really lose out over the long term.

I'm redoing my investing right now and still sticking with the stock market for most growth, even though I know the next five years are going to suck.
posted by mathowie at 8:09 PM on April 4, 2008

"The stock market outperforms other investments" seems to me to be one of those statements that is not supposed to be absolutely true; it's supposed to be mostly true. For the purpose of this question, I take investing in "The Stock Market" as a proxy for a diverse portfolio of individual stocks that cover most of the major sectors of the market.

Of course, there are investments that outperform the stock market. But, the concept of "The Stock Market" as an investment vehicle seems to me to be used to encapsulate some other pieces of conventional wisdom for the smaller investor. Those being:

1) If you are not an expert, do not try to "time the market" by looking for patterns and shifting things in and out of different sectors of the market, or pull out your cash and sit around waiting for a "low" to buy in. Over the years, the trend has always been upward, and inflation has been the rule, so you will do better with your money invested in securites 100% of the time as opposed to less than 100% of the time.

2) Diversify your investments.

3) Do not pay other people large commissions for fancy investments-- often these commissions will negate many (if not all) of the advantages of the expertise involved. (for an interesting article about simulating hedge funds, James Suroweicki makes a tangential point that hedge funds do actually generate "alpha", or returns that are not correlated to the market as a whole, but not after the management fees are taken out). You can often do reasonably well with a no-load no-fee index fund.

4) The smaller investor should not be concerned terribly much about hedging across different currencies. The smaller investor should invest in the home-field currency, because that is the currency they will be buying with when they draw down their savings in retirement.

These are all decent pieces of advice, but all definitely subject to caveats, and more intended to be "lower-risk, moderate gain" than anything else.
posted by Maxwell_Smart at 8:09 PM on April 4, 2008

As I was saying about historic 20-year periods...

This paper [PDF] by Brad Delong finds the following:

One margin such an investor must consider is the choice between:
(1) investing in a diversified portfolio of equities, reinvesting payouts and rebalancing periodically to maintain diversification;
(2) investing in short-term safe bills, rolling the portfolio over into similar short-term debt instruments as pieces of it mature.

The marginal investor must expect that their marginal dollars would be equally attractively employed in each of these strategies.

Figure 1 [in the PDF] plots the cumulative return distribution for the relative returns for these two twenty-year portfolio strategies starting in each year since the start of the twentieth century. The average geometric return differential since 1901 is some 4.9 percent per year. When the portfolios are cashed in after twenty years, investments in diversified stock portfolios are on average 2.67 times as large as an investment in short-term Treasury bills after twenty years. Stock investors more than double their relative wealth 60 percent of the time, more than quadruple their relative wealth 30 percent of the time, and have a 17 percent chance of a more than seven-fold multiplication of relative wealth. The downside is small: the empirical CDF finds that stocks do worse than bills less than 9percent of the time. The very worst case observed is the 20 years starting in 1965, when investing in stocks yields a relative cumulative wealth loss of 17 percent compared to investing in bills.

But, again, I must warn against paying too much in fees to active mutual fund managers. Look into investor-friendly passively managed index funds provided by companies such as Vangaurd. The book by Swenson that I mentioned in my previous post is an excellent one, though it will probably be challenging for a financial n00b.
posted by mullacc at 8:15 PM on April 4, 2008

IANYIR (and all that precedes that disclaimer).

There are clearly periods as long as ten years where you can come out the other side with no more than you came in with - I believe the 70s are one, but I'm too drunk/lazy to look up the data. Twenty years? I'd be surprised (but if mullacc comes up with the data, he/she gets best answer). On preview, mullacc has a paper that proves it - it's possible, but extremely unlikely, that you'd lose money versus purely safe debt instruments over any 20-year period. The paper doesn't show it, but it looks like you'd absolutely come out better than shoving it under your mattress over a 20-year period.

As others have said, you do want to be in the lowest-cost, no-load index funds you can find. If you want to juice your risk/return, throw in some small cap, international, or other niche-y things. But you don't have to. The more complex your portfolio is, the more you'll have to watch it. And the more you watch, the more angst you could have. That can lead to inopportune decisions.

One of the things I've learned is that really smart people make really poor investment decisions for lots of different reasons. Don't be scared - and don't be too quick to pull a trigger or pull out of something. Find your comfort zone, understand the risk/reward ratio for your comfort zone, and invest accordingly.

It sounds like you're doing all the right things and you're just looking for a little backup. This is your backup. *hugs*
posted by sachinag at 9:31 PM on April 4, 2008

A long time ago there was an analysis in AAII that said that a portfolio of 80% stock and 20% cash (like a money market fund) out performs the more common 60% stock, 40% bonds in terms of better performance with less volatility. it also meant that I could include emergency funds as part of my portfolio and ever needed it, I could rebalance over time.
posted by metahawk at 10:33 PM on April 4, 2008

a few points from above : i disagree totally with the "dont try and time the market" comment. with the amazing value of blue chips right now, that just seems a silly comment to me. i think it is better for the small time investor to 100% try and time the market, as they dont want to invest as a day-to-day occupation.
also, i see "diversify your investments" as a really pointless comment. only take risk where you want to and can afford to, is a better way to look at your portfolio.
from my experience over the last 5 years, i wouldnt recommend to anyone to rely on the stockmarket as the primary area of investment. i started in property and i have only won there (i am in aus).
trading is a difficult and more volatile proposal. so for me, first get settled in property, then secondarily get some solid term deposit/compound type investment, then if there is some left over, get into the stock market.
the reason i enjoy the stock market is actually because i can get involved with companies that i have and interest in, and learn about sectors deeply that i would never get to work in. so i only invest money that i am prepared to risk.
posted by edtut at 2:32 AM on April 5, 2008

Check these guys out. http://diehards.org/

They'll give you plenty of affirmation about investing in low-cost index funds. If you can bear to look at it this way, when the market sucks, everything's on sale!
posted by zackola at 7:20 AM on April 5, 2008 [1 favorite]

It's really not a matter of belief, it's a matter of measurment of past performance. Going forward, who knows? Something fundamental could change the tendency of stocks to outperform, but what? In the face of that uncertainty, assuming the future will be similar to the past is probably the safest bet.

What you don't want to to do is get caught fully invested in equities if you end up hitting retirment in the middle of bear market, so as you get older (say in your fifties) it's best to slowly allocate and incresing percentage of your portfolio to fixed income.
posted by dzot at 9:55 AM on April 5, 2008

Read widely for different views; this guy, for example. It all depends on what you are factoring in. Factor in the horrendous decline of the US dollar in recent times and all your 'growth' on the US stock market is destroyed vis-a-vis other currencies. If you hold dollars, compared to folk in the euro zone you are just getting poorer and poorer. Maybe you think you're happy in the US bubble and that doesn't matter; but maybe you think it does matter. Europeans can come over to the USA, for example, and buy assets you cannot afford. On January 1 2003 the US dollar bought 0.95 euros; 5 years later it bought 0.68 euros. A person with €100,000 on 1/1/2003 had $105,000. On 1/1/2008 he had $147,000. Now he has $157,000. Seen in these terms any "gains" from investing on the US stock market are illusory.
posted by londongeezer at 11:25 AM on April 5, 2008

Bear in mind the stockmarket depends on continued growth to deliver capital gains. The peak oil people are suggesting we will enter a stagnant or contractionary phase that will last quite a few years. If this proves to be true, being invested in the stock market in that period will suck.
posted by bystander at 4:57 AM on April 7, 2008

Seen in these terms any "gains" from investing on the US stock market are illusory.

I haven't seen great gains investing in foreign stock index funds either, so it's not that easy a problem to solve. You can invest in currency directly, but that's a crapshoot too, since the average investor knows nothing about the currency market.
posted by smackfu at 6:07 AM on April 7, 2008