Total Real Returns
The focus of every long-term investor should be the growth of purchasing power - monetary wealth adjusted for the effect of inflation.
The growth of purchasing power in equities not only dominates all other assets but also shows remarkable long-term stability. Despite extraordinary changes in the economic, social, and political environments over the past two centuries, stocks have yielded between 6.6 and 7.0% per year after inflation in all major subperiods.
The long-term perspective radically changes one's view of the risk of stocks. The short-term fluctuations in the stock market, which loom so large to investors when they occur, are insignificant when compared with the upward movement of equity values over time.
Risk and Holding Period
For many investors, the most meaningful way to describe risk is by portraying a worst-case scenario.
Stocks unquestionably are riskier than bonds or bills in the short run.
- In every 5-year period since 1802, the worst performance in stocks, at -11% per year, has been only slightly worse than the worst performance in bonds or bills.
- For 10-year holding periods, the worst stock performance actually has been BETTER than that for bonds or bills.
- For 20-year holding periods, stocks have never fallen behind inflation, whereas bonds and bills once fell as much as 3% per year behind the rate of inflation.
- For 30-year periods, the worst annual stock performance remained comfortably ahead of inflation by 2.6% per year, which is just below the average 30-year return on fixed-income assets.
It is very significant that stocks, in contrast to bonds or bills, have never offered investors a negative real holding period return yield over periods of 17 years or more. Although it might appear to be riskier to accumulate wealth in stocks rather than in bonds over long periods of time, precisely the opposite is true. The safest long-term investment for the preservation of purchasing power clearly has been a diversified portfolio of equities.
As the holding period increases, the probability that stocks will outperform fixed-income assets increases dramatically.
- For 10-year horizons, stocks bea bonds and bills about 80% of the time.
- For 20-year horizons, it is over 90% of the time, and
- For 30-year horizons, it is virtually 100% of the time.
Although the dominance of stocks over bonds is really apparent in the long run, it is more important to note that over 1- and even 2-year periods, stocks outperform bonds or bills only about 3 out of 5 years. This means that in nearly 2 out of every 5 years a stockholder will fall behind the return on Treasury bills or bank certificates. The high probability in the short run of underperforming bonds and bank accounts is the primary reason why it is so hard for many investors to stay in stocks.
Investor Holding Periods
Some investors question whether holding periods of 10 or 20 or more years are relevant to their planning horizon. Yet these long horizons are far more relevant than most investors recognize. One of the greatest mistakes that investors make is to underestimate their holding period. This is so because many investors think about the holding periods of A PARTICULAR stock, bond, or mutual fund. But the holding period that is relevant for portfolio allocation is the length of time the investors hold ANY stocks or bonds, no matter how many changes are made among the individual issues in their portfolio.
Average Investor Holding Period
Let us study the average length of time that investors hold financial assets based on gender and the age at which they BEGIN purchasing such assets. It is assumed:
- That individuals accumulate savings during their working years in order to build sufficient assets to fund their retirement, which normally occurs at age 65.
- After age 65, retirees live off the funds derived from both the returns and sale of their assets. It is also assumed that investors either plan to exhaust all their assets by the end of their expected life span or plan to retain one-half of their retirement assets at the end of their expected life span as a safety margin or for bequests.
Under either assumption:
- Individuals who begin accumulating assets in their 30s will hold financial assets for 40 years and more.
- Even investors who begin accumulating assets near retirement will have a holding period of up to 20 years or more. It should be noted that the life expectancy for males is now about 82 years; for females, more than 86 years; and for either spouse, about 90 years.
- Many retirees will be holding assets for 20 years or longer. In addition, if the investor works beyond age 65 , which is increasingly common, or plans to leave a large percentage of assets as a bequest, the average holding period is even longer than those indicated.
Conclusion
No one denies that in the short run stocks are riskier than fixed-income assets. In the long run, however, history has shown that this is not the case.
There is still much uncertainty about what a dollar will be worth two or three decades from now.
Historical evidence indicates that we can be more certain of the purchasing poer of a diversified portfolio of common stocks 30 years hence than we can of the final payment on a 30-year U.S. government bond.
