Investing All-in-One For Dummies. Eric Tyson

Investing All-in-One For Dummies

School of Business professor Jeremy Siegel has tracked the performance of bonds and stocks back to 1802. Although you may say that what happened in the 19th century has little relevance to the financial markets and economy of today, the decades since the Great Depression, which most other return data track, are a relatively small slice of time. Figure 2-4 presents the data, so if you’d like to give more emphasis to the recent numbers, you may.

Bar chart depicts a historical view of bond performance: Inflation has eroded bond returns more in recent decades.

FIGURE 2-4: A historical view of bond performance: Inflation has eroded bond returns more in recent decades.

Note that although the rate of inflation has increased since the Great Depression, bond returns haven’t increased over the decades. Long-term bonds maintained slightly higher returns in recent years than short-term bonds. The bottom line: Bond investors typically earn about 4 to 5 percent per year.

Stock returns

Investors expect a fair return on their stock investments. If one investment doesn’t offer a seemingly high enough potential rate of return, investors can choose to move their money into other investments that they believe will perform better. Instead of buying a diversified basket of stocks and holding, some investors frequently buy and sell, hoping to cash in on the latest hot investment. This tactic seldom works in the long run.

Unfortunately, some of these investors use a rearview mirror when they purchase their stocks, chasing after investments that have recently performed strongly on the assumption (and the hope) that those investments will continue to earn good returns. But chasing after the strongest performing investments can be dangerous if you catch the stock at its peak, ready to begin a downward spiral. Chasing high-flying investments can lead you to buy high, with the prospect of having to sell low if the stock runs out of steam. Even though stocks as a whole have proved to be a good long-term investment, picking individual stocks is a risky endeavor. See Book 3 for advice on making sound stock investment decisions.

A tremendous amount of data exists regarding stock market returns. In fact, in the U.S. markets, data going back more than two centuries document the fact that stocks have been a terrific long-term investment. The long-term returns from stocks that investors have enjoyed, and continue to enjoy, have been remarkably constant from one generation to the next.

Going all the way back to 1802, the U.S. stock market has produced an annual return of 8.3 percent, while inflation has grown at 1.4 percent per year. Thus, after subtracting for inflation, stocks have appreciated about 6.9 percent faster annually than the rate of inflation. The U.S. stock market returns have consistently and substantially beaten the rate of inflation over the years (see Figure 2-5).

Stocks don’t exist only in the United States, of course (see Figure 2-6). More than a few U.S. investors seem to forget this fact, as they did during the sizzling performance of the U.S. stock market during the late 1990s and 2010s. As discussed in the earlier section “Diversify for a smoother ride,” one advantage of buying and holding overseas stocks is that they don’t always move in tandem with U.S. stocks. As a result, overseas stocks help diversify your portfolio.

Bar chart shows that stocks have been a consistent long-term winner.

FIGURE 2-5: History shows that stocks have been a consistent long-term winner.

Schematic illustration of plenty of investing opportunities exist outside the United States.

FIGURE 2-6: Plenty of investing opportunities exist outside the United States.

In addition to enabling U.S. investors to diversify, investing overseas has proved to be profitable. The investment banking firm Morgan Stanley tracks the performance of stocks in both economically established countries and so-called emerging economies. As the name suggests, countries with emerging economies (for example, Brazil, China, India, Malaysia, Mexico, Russia, and Taiwan) are “behind” economically but show high growth and progress rates.

Stocks are the best long-term performers, but they have more volatility than bonds and Treasury bills. A balanced portfolio gets you most of the long-term returns of stocks without much of the volatility.

Real estate returns

Over the years, real estate has proved to be about as lucrative as investing in the stock market. Whenever the U.S. has a real estate downturn, folks question this historic fact. However, just as stock prices have down periods, so, too, do real estate markets. The fact that real estate offers solid long-term returns makes sense because growth in the economy, in jobs, and in population ultimately fuels the demand for real estate.

Consider what has happened to the U.S. population over the past two centuries. In 1800, a mere 5 million people lived within U.S. borders. In 1900, that figure grew to 76.1 million, and today, it’s more than 330 million. All these people need places to live, and as long as jobs exist, the income from jobs largely fuels the demand for housing.

Businesses and people have an understandable tendency to cluster in major cities and suburban towns. Although some people commute, most people and businesses locate near major highways, airports, and so on. Thus, real estate prices in and near major metropolises and suburbs generally appreciate the most. Consider the areas of the world that have some of the most expensive real estate prices: Singapore, Hong Kong, Vancouver, San Francisco, Los Angeles, New York, and Boston. What these areas have in common are lots of businesses and people and limited land.

Contrast these areas with the many rural parts of the United States where the price of real estate is relatively low because of the abundant supply of buildable land and the relatively lower demand for housing.

Compounding Your Returns

During the past century, stocks and investment real estate returned around 9 percent per year, bonds around 5 percent, and savings accounts about 3 percent.

In case you’re curious about some alternative investments like gold and currencies, here are those numbers. Gold has just kept investors up with inflation with a tiny bit to spare — returning an average of about 0.5 percent per year after inflation. Currencies like the U.S. dollar have depreciated about 1.5 percent per year adjusting for inflation.

This section illustrates how compounding seemingly modest investment returns can help you accumulate a substantial sum of money to help you accomplish your personal and financial goals.

The value of getting a few extra percent

As discussed earlier in this chapter, investing in the stock market (and real estate) can be risky, which logically raises the question of whether investing in stocks

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