Why we bet on stocks

NEW YORK (Money) -- Question: Is historical performance the only reason for believing that stocks will always outperform other asset classes in the long run or is there a more solid basis for expecting that stocks will generate superior long-term returns? - Sachin, Hagerstown, Maryland

Answer: The way you hear the past performance of stocks parroted so often in the financial press you could easily get the impression that the mere fact that stocks have done so well in the past gives them some sort of edge in the future.

That's not the case. But there is a logical explanation for why stocks have delivered the highest long-term returns and are likely (although hardly guaranteed) to continue doing so in the future. And, when you come down to it, the explanation is pretty simple.

Let's say you're trying to decide between two investments selling for the same price. One pays a 5 percent return every year and guarantees that you'll get all your money back in 10 years. The other also pays 5 percent a year, but offers no assurance you'll get all your money back.

Which would you choose? Well, unless you're into financial self-flagellation, you'd choose the first investment. I mean, why take the second and settle for the same return when you're taking on more risk? That wouldn't make sense.

But what if the second investment were priced so that it had the potential for higher returns. What if it could pay up to 10 percent a year? Or what if it paid 5 percent a year but might return double or triple your money in 10 years? Well, in that case you might consider taking on the higher risk and uncertainty for a shot at those higher returns.

And that, essentially, is why stocks overall generally have higher long-term returns than, say Treasury bonds. In both cases, you are investing money today for cash flows in the future. With Treasuries, you're buying interest payments and the eventual return of your principal.

With stocks, the cash flow is more complicated, but it essentially boils down to companies' future earnings power, which is paid out in the form of dividends, if the company pays them, and a higher share price down the road. But while the Treasury cash flows regular and certain - you know the U.S. Treasury Department will make interest payments and repay the face value of the bond at the end of its term - the cash flows from stocks are anything but.

The stock might pay dividends. Or it might not. The stock price might rise. Or it might not. So if there were a Treasury bond and a stock that were expected to make the same future payments to investors, investors would pay less for the stock cash flows because they're less certain.

Paying less for the same cash flow translates to a higher return. Which is another way of saying that the only way investors will put their money into stocks is if they believe they have a reasonable chance of being compensated for the uncertainty and possibility of loss with a larger payoff. I've oversimplified things here. After all, Treasury bonds have risks too. If interest rates go up after you buy a Treasury bond and you then sell it, you have a loss.

Corporate bonds not only have interest-rate risk, but the possibility of default as well. But the basic idea is that all other things being equal, people won't buy a riskier investment unless it has the realistic potential for higher returns. Now, this higher return for a riskier asset isn't guaranteed. And, indeed, one of the things stocks' higher returns depend on is people being wary of taking on that risk. If people for some reason begin to believe stocks' higher returns are a sure thing, they'll pay more for stocks.

And the more they pay, the lower the potential return (unless you believe that a company will be able to generate higher earnings just because people are willing to pay more for its shares). So although it may sound kind of screwy, the less fearful people are about investing in stocks - or, to put it another way, the more comfortable they feel with stocks - the less money they're likely to make in them.

When you think about it, though, this makes sense. At the end of the roaring '90s, the prevailing notion was that stock returns were a sure thing. Only idiots or wimps would waste their money on bonds. The putative smart investors bought tech stocks and dot-com stocks, even if they didn't have any earnings. As a result, stock prices got bid up well beyond their capacity to generate future earnings that would be high enough to justify their prices.

People who bought at those inflated prices sat on losses for many years and are still sitting on lackluster returns. It was only earlier this year that the Standard & Poor's 500 index regained its March, 2000 high, while the Nasdaq, the hottest benchmark of the go-go '90s, is still roughly 50 percent below where it stood more than seven years ago. By contrast, people who buy when everyone hates and fears stocks - like back in the late '70s and early '80s when many investors had simply given up on equities or, for that matter, in 2002, when stocks hit bottom after the '90s frenzy - earn the highest returns because they're getting stocks at the lowest prices.

Okay, so what does all this mean for individual investors wondering how to invest their money for retirement or other goals? Well, to my mind, there are three key lessons.

One: Never put everything into one asset - diversify. Looking back on stocks' history and the underlying rationale for why stocks should generate superior long-term returns, you might be tempted to just throw all your money in stocks. After all, if you're a long-term investor doesn't that assure the biggest pile of money down the road?

I have two problems with the 100 percent stocks approach. One is that nothing in the future is absolutely guaranteed. So I think it's always smart to hedge a bit. If for some unlikely and unforeseen event stocks don't deliver the highest returns, you've got some money in other assets as well. There's also the much more likely possibility that stocks will outperform, but not by as big a margin in the past. Either way, it makes sense to hedge your bets.

The other problem I have with the idea that long-term investors should put all their dough in stocks is that it's based on what I think is a false premise - namely, that investors will maintain a long-term view even when stocks suffer major setbacks. Many people claim their nerves are so steely they won't panic and flee stocks during market meltdowns. But they usually say this while the market is going up.

When things start falling apart - I mean really falling apart, like losses of 50 percent - they usually end up selling, often just at the time when stock prices may have reached their nadir and equities are thus the best values. Diversifying into bonds as well as among different types of stocks can help you avoid bailing out at the worst time and sabotaging your efforts.

Generally, the younger you are and the less nervous you get when stock prices slide, the more of your money you can afford to invest in stocks. For guidelines on how to divvy up your portfolio, check out our Asset Allocator tool.

Two: Don't get too giddy in good times - or too gloomy during rough patches. It's human nature to get swept up in the excitement of a bull market -and to shun stocks with the rest of the crowd when the market heads south. But following that impulse can be dangerous. In heady times, it can lead to overpaying for stocks and during bear markets it may make you more apt to sell at a trough or less likely to invest new money in stocks.

Diversifying is the first defense against investing in too emotional a manner. But the second, equally important, defense is rebalancing - that is, once a year or so bringing your portfolio's mix of stocks and bonds back to its original proportions. You can do this by selling off some shares of winning assets and plowing the proceeds into losers. Or you can restore your portfolio to its proper balance by funneling new money into investments that have lagged. Either way, the end result is that rebalancing prevents your portfolio from getting too concentrated in whatever assets are riding the tops of the performance charts. And as this excellent piece on rebalancing shows, regularly whipping your portfolio back into shape can sometimes even lower risk and increase your return.

Three: Keep the fees down. Whether it's stocks that are leading the pack or bonds or some other asset, this much is clear: the less you pay out in fees, the more of the gross returns will go into your pocket. Of course, you can't control what fund managers and other investment pros charge for their services. But you can control what you pay by homing in on funds with low annual operating expenses.

On that score, I recommend index funds and, assuming you're investing large chunks of money, exchange-traded funds, or ETFs. (As much as I like broad-based ETFs that let you invest in a large segment of the market, I'm not a fan of the growing number of gimmicky ETFs that seem more like marketing ploys or speculative plays than investment strategies. A Global Vaccine Index ETF? Please.)

The razor thin fees of index funds and ETFs mean you keep more of the gains the markets generate. You can find the index funds and ETFs that I think are worth a look, as well as low-cost actively managed funds, by checking out our MONEY 70. Of course, just as there's no absolute guarantee that stocks will always outperform, I can't promise that following the advice in my three little lessons will lead to superior performance. But the way I see it, there's only so much you can do, and if you do the right things, the things that make sense, you'll increase the odds that in the long-run things will work out in your favor.