NEW YORK (MONEY Magazine) -
So many investors -- maybe even you -- bought into some wild notions about stocks in the headiest days of the bull market. Today, perhaps a bit poorer, you're certainly wiser.
Yet in your newfound realism, you find plenty of cause for optimism about your investing future. You know that the market will zig and zag, but that in the long term equities will produce annual returns of 8, maybe 10 percent.
You also know that while the U.S. economy will suffer recessions, its vitality virtually assures that over 20 years, you can't help but make money in stocks.
No Internet-bubble hype for you. Your expectations are grounded in history. They're at the core of responsible financial planning, and you've found confirmation of them in financial magazines on many occasions.
But what if all you knew was just flat-out wrong?
Some of the smartest minds in finance are taking a hard look at today's cherished beliefs about stock market risks and returns, and the answers they're coming up with are, frankly, disquieting.
Much of what passes for unassailable historical truth turns out to rest upon shaky assumptions. Stocks haven't returned what you thought they did. Investors never saw anything close to the market rate of return. And the market's future looks a lot bumpier and perhaps a lot less lucrative than you likely expect.
But not all the news is bad. To the contrary, you almost certainly can do better going forward than nearly anyone ever did in the days of supposedly high returns and truly high costs.
In this story, you'll learn why it's crucial that you look at the cracks in the foundation of much of what you "know" about stocks. You'll come away with a strategy for building wealth even if the market delivers the most modest of returns.
Adjust your thinking
History doesn't owe you 10 percent a year
What have stocks returned in the past? For many years the standard answer has been 8 to 10 percent. Where did that number come from?
| || |
|Annualized return ||10.4% |
|Minus inflation ||7.4% |
|Minus brokerage and management fees ||5.9% |
|Minus bad market timing ||4.6% |
|Minus taxes ||2.4% |
| Sources: James Garland, Journal of Investing; Ibbotson Associates; MONEY research. |
In part from the pioneering work of finance professor Roger Ibbotson of Yale, who assembled a regularly updated database of stock prices from 1926 to the present. According to Ibbotson, stocks returned 10.4 percent before inflation from 1926 through 2003.
In "Stocks for the Long Run," a book whose very title evokes the halcyon days of the '90s boom, Wharton professor Jeremy Siegel took the story back to the first Thomas Jefferson administration. According to Siegel, stocks have delivered returns of 6.8 percent annually, above and beyond the rate of inflation, from 1802 to the present. Add a little for inflation, and you're back to the 8 to 10 percent range.
Trouble is, this vision of history is too selective. Critics say Siegel's 19th-century numbers are full of holes. Not only was the stock market a radically different beast back then, but Siegel's data are corrupted by "survivor bias."
That is, of all the stocks trading in the turbulent early years of the U.S. markets, he focused on the winners and ignored the flops. Siegel concedes that survivor bias knocked down his returns a bit, but he says the stocks he looked at represented a bigger slice of the market than it might appear.
| ||The old picture|
|The new picture|
|Increase in price-to-earnings ratio ||1.1% ||? |
|Dividend yield ||4.3% ||1.7% |
|Earnings growth ||1.6% ||2.0% |
|Inflation ||3.0% ||3.0% |
|Other ||0.4% ||n/a |
|TOTAL ||10.4% ||Unknown |
| Note: Annualized returns. |
| Sources: Ibbotson Associates, MONEY research.|
More important, the notion of a manifest destiny of 10 percent returns rests solely on our own history, during that extraordinary period in which the United States transformed itself from a struggling new nation into the world's only superpower.
Broaden your perspective. Three scholars at the London Business School -- Elroy Dimson, Paul Marsh and Mike Staunton -- recently compared stock returns in the United States with those in 15 other developed countries.
Since 1900, they concluded, the worldwide return on equities has been only 5 percent a year after inflation. Markets in Germany, Italy and Belgium returned less than 3 percent a year. It wasn't called the American Century for nothing.
Few before you ever earned 10 percent anyway
And whatever the market returned, most investors didn't see anything close to that. For most of the past century, retail investors couldn't assemble a diversified stock portfolio without spending a small fortune on brokerage commissions.
The advent of the mutual fund brought costs down, but even today the typical fund investor loses 1 to 2 percent or more to fees as the magic of compounding returns fights a never-ending battle with the black magic of compounding costs.
Further dragging down returns is our tendency to buy high and sell low, pouring more money into the market when it's up and selling when things look dire.
| ||What it was|
|What could be|
|The investor ||41% ||91% |
|Wall Street ||12% ||3% |
|Uncle Sam ||47% ||6% |
| Note: For earlier period, outcome based on S&P 500 annual return of 12.2%, 1% management fee, 80% portfolio turnover rate, taxation at prevailing rates. For later period, outcome based on hypothetical 6% average annual return on $50,000 portfolio of 50 largest stocks in S&P 500, purchased from online broker for $29.95 per stock and held continuously for 25 years. No realized capital gains; dividends taxed at 15%. |
| Sources: James Garland, Journal of Investing; Joel Dickson, the Vanguard Group.|
A sobering new study by Ilia Dichev at the University of Michigan found that investors in the New York and American stock exchanges saw their returns lag the markets by 1.3 percentage points annually from 1926 to 2002. Investors in the Nasdaq did even worse: Their returns lagged the Nasdaq overall by 5.3 percentage points annually from 1973 to 2002.
"Nasdaq investors, as a whole," says Dichev, "darted in and out so much that they would have done just as well keeping all their money in T-bills."
A 2002 study conducted by MONEY's Jason Zweig and three finance experts found something similar. The study looked at money moving in and out of 6,900 U.S. stock funds from 1998 through 2001 and found that while the average fund returned an annualized 5.7 percent, the average fund investor earned a measly 1 percent a year by buying and selling at the wrong time.
The damage was compounded in tech funds. While Firsthand Technology Value produced a solid 16 percent annualized return, investors in the fund lost money. Yikes!
Even over the long run, stocks are risky
It was certainly a seductive notion: Stocks -- not bonds -- are the safest bet of all. Over the two centuries of U.S. market history covered in "Stocks for the Long Run," Siegel notes, stocks always beat inflation over holding periods of at least 20 years, while bonds have often lagged inflation over long stretches.
But as Dimson and his colleagues at the London Business School note, only three markets besides the U.S. have never seen a 20-year stretch in which the return on stocks fell behind inflation.
In six of the 16 stock markets that the London researchers looked at worldwide, investors would have had to wait a full 50 years to be assured of a positive real return. The seeming safety of American stocks owes a lot to their better-than-average returns.
If you expect the 5 percent real (after inflation) rate of return that world markets have delivered and assume the same sort of volatility the U.S. market has shown in the past, Dimson calculates that you face a 14 percent chance of losing money after inflation over 20 years; if your portfolio isn't diversified, you face a 15 percent chance of a shortfall over 40 years.
The future for stocks doesn't look so hot
History does tend to repeat itself. Based on past sunrises, it would be unreasonable to expect dawn to arrive in the western sky tomorrow, and the weather this September really should resemble the weather of Septembers past.
Yet the stock market of today doesn't look much like its past. Bear market notwithstanding, by historical standards stocks today are anything but cheap, and that may make tomorrow's gains harder to come by.
John Bogle, founder of the Vanguard funds, explains that stock gains come from two sources: the "investment return" (dividends plus earnings growth) and the "speculative return" (how eagerly investors bid stocks up -- or down -- over time). Both of those factors have changed dramatically.
Let's take the investment return first. For starters, dividends have plummeted. The long-run average dividend yield, notes Yale's Ibbotson, was 4.3 percent annually. But today it's just 1.7 percent.
That wouldn't be a problem if companies invested the earnings they retained wisely, boosting their earnings growth. Instead, too often that money goes into foolish acquisitions or is spent on stock buybacks to offset the high number of shares that end up on the market via stock option grants.
That means, says Robert Arnott, editor of the Financial Analysts Journal, that companies are de facto transferring dividends to the honchos that run them instead of to you.
The second part of the investment return is earnings growth. That has averaged about 2 percent annually, after inflation, over time. Add that to today's dividend yield, and the expected long-run investment return on stocks looks like 3.5 percent to 4 percent annually after inflation, not 7 percent. The difference between 4 percent and 7 percent is $77,000 if you invest $500 a month for 20 years.
Stocks, of course, could do better than 4 percent, but only if the speculative return shoots up. How likely is that?
The easiest way to measure the speculative return is to look at the relationship between stock prices and earnings. Stocks started the 20th century with a price/earnings ratio, or P/E, of 13.55. They rose from a low P/E of 8 in 1982 to an unsustainable, in retrospect, 33 in 2000, and now trade at around 20 times earnings.
There aren't good reasons to expect the speculative return to go up from here. Much of the dramatic rise in stock valuations over the past two decades is the direct result of the democratization of finance. Stock mutual funds have enabled millions of people to assemble diversified portfolios cheaply and easily.
"You won't get that again," says Ibbotson. "That was a one-time windfall."
This new reality needn't bring you down. With an understanding of stocks that's based on solid research, not wishful thinking or best-case scenarios, you're prepared to shore up the foundation of your financial future. And the tools to do this are readily available.
Get the most out of the market
Control your costs
Today, with brokerage costs a fraction of what they were only a few years ago, and low-cost index funds available in all but the lousiest of 401(k) plans, it's possible for buy-and-hold investors to retain something close to the market rate of return, meaning you could easily make out better than most investors ever did. Just watch out for:
- Brokerage costs, which you can cut from perhaps 1 percent a year to virtually zero by trading as seldom as possible.
- Management fees, which you can slash from nearly 2 percent a year to well under 0.5 percent by favoring low-cost index mutual funds as the core of your portfolio.
- Taxes, which you can reduce from 15 to 35 percent to almost nothing by holding on to your investments.
- Your own bad behavior, the most punitive cost of all, which you can minimize by not market timing.
Invest in the world
The markets in only three countries posted better inflation-adjusted returns than the U.S. did in the past century. Elsewhere, markets delivered mostly so-so results, and some didn't survive at all.
"Just looking at all the trajectories that stock markets could take over this time period -- that's pretty sobering," notes Will Goetzmann, a professor of finance at Yale.
Indeed, those who put all their rubles in the St. Petersburg exchange in the early 1900s came to regret their lack of diversification.
The lesson here? It's dangerous to have all your money in your own country's stock market, even this country's. More than half the world's stocks are traded outside the U.S. We think it makes sense to keep at least a quarter of your stock money in foreign equities.
Not only will that help you weather any possible calamities that might hit the U.S., but it will help smooth out your overall returns as well.
Search for value
Investors who owned a half-dozen Janus funds in the 1990s might have thought they were diversified, but those funds fell together because they held the same high-flying technology stocks.
Whether you invest in funds or buy stocks directly, consider adding value stocks -- shares of companies that sell at bargain P/Es because of what legendary value investor Ben Graham called "lack of interest or unjustified popular prejudice."
Value stocks, over the long haul, have actually done better for investors than the growth stocks everyone loves. There's no guarantee that will continue, of course, but value stocks can cushion the blow when the growth stocks in your portfolio are being knocked about.
See the MONEY 100 section of this Web site for top value fund picks.
And don't forget dividends. In the latter stages of the past bull market, dividends were as unhip as Donald Trump's hair. Now (like Trump) they're staging a comeback.
You can thank the changes in income tax laws, which allow investors to keep more of the dividends they receive. While companies paying out decent dividends tend to be slow to moderate growers, MONEY's Michael Sivy argues compellingly in "Dividends Rule" that financially strong dividend payers may well return more to investors than popular growth stocks in the years ahead, and at considerably less risk.
Most investors should consider keeping a bigger chunk of their money in bonds -- if you're conservative, perhaps as much as 40 percent. With stocks seemingly poised to return less than in years past, an increased helping of bonds won't drag down your long-term returns much. And it will definitely help you sleep at night.
Rising interest rates may cause short-term losses in the bond market. But as a core holding, TIPS, U.S. Treasury bonds that are guaranteed to return more than the rate of inflation, offer what stocks never did -- virtually risk-free returns.
Finally, realize that the Big Three of diversification is not the traditional triad of stocks, bonds and cash.
A new and more helpful way to think about the Big Three is human capital (your job and career), physical capital (your house and other possessions) and financial capital (those stocks, bonds and cash).
All these components should work together. A software engineer who owns a house in Sunnyvale, Calif. and has 80 percent of his money in tech stocks could lose nearly everything when Silicon Valley suffers its next recession. And diversifying his financial assets alone would not offer him enough protection.
So hedging your risks on all three fronts -- picking up new job skills, buying a second home elsewhere, making sure your investing bets are spread out -- is the ultimate foundation for unshakable financial success.