The price levels of stocks and bonds will undoubtedly fluctuate beyond your control.
You need to acquire a general methodology that will serve you well in realistically projecting long-run returns and adopting your investment program to your financial needs.
What determines the returns from stocks and bonds?
Very long run returns from common stocks are driven by two critical factors:
- The dividend yield at the time of purchase, and,
- The future growth rate of earnings and dividends.
In principle, for the buyer who holds his or her stocks forever, a share of common stock is worth the present or discounted value of its stream of future dividends.
A stock buyer purchases an ownership interest in a business and hopes to receive a growing stream of dividends.
Even if a company pays very small dividends today and retains most (or even all) of its earnings to reinvest in the business, the investor implicitly assumes that such reinvestment will lead to a more rapidly growing stream of dividends in the future or alternatively to greater earnings that can be used by the company to buy backs its stocks.
LONG RUN EQUITY RETURN = INITIAL DIVIDEND YIELD + GROWTH RATE.
From 1926 to 2010:
Common stocks provided an average annual rate of return of about 9.8%.
The dividend yield for the market as a whole on Jan 1, 1926 was about 5%.
The long-run rate of growth of earnings and dividends was also about 5%.
Adding the initial dividend yield to the growth rate gives a close approximation of the actual rate of return.
OVER SHORTER PERIODS, SUCH AS A YEAR OR EVEN SEVERAL YEARS, A THIRD FACTOR IS CRITICAL IN DETERMINING RETURNS.
This factor is the change in valuation relationships - specifically, the change in the price-dividend or price-earnings multiple. (Increases or decreases in the price-dividend multiple tend to move in the same direction as the more popularly used price-earnings multiple.)
Price-dividend and price-earnings multiples vary widely from year to year.
In times of great optimism, such as early March 2000, stocks sold at price-earnings multiples well above 30.
The price-dividend multiple was over 80.
At times of great pessimism, such as 1982, stocks sold at only 8 times earnings and 17 times dividends.
These multiples are also influenced by interest rates.
When interest rates are low, stocks, which compete with bonds for an investor's savings, tend to sell at low dividend yields and high price-earnings multiples.
When interest rates are high, stock yields rise to be more competitive and stocks tend to sell at low price-earnings multiples.