- Stocks produce attractive returns over the long run in comparison to bonds.
- The longer the holding period, the less the expected volatility.
This article sets out to provide evidence-based reasoning as to why equities should be the primary vehicle of investment for a long-term investor.
Before we begin, I want to preface this article with a warning of a sort. Everyone has unique financial goals. The key to successful investing is identifying your goals and executing a plan to achieve those goals. Depending on your investing timeframe and need of capital, a more diverse allocation may be most appropriate. However, for the long-term investor, with a timeframe of 10, 15, 20 or more years to invest, I present the case for a strong allocation towards equities.
Equities and their attractive long-term results
To understand the long-term results of investing in the stock market, we will compare a hypothetical investment of $100 in the S&P500 compared to a similar $100 investment in 10-year Treasury Bonds.
Dating back to 1928, the average annual return of stocks, as measured through the S&P500, comes in at roughly 10.50%. For Treasury Bonds, the annual returns yielded 5.76%. Historically, the annual return for stocks has been nearly 5% higher than that of bonds.
Data adapted from stern.nyu.edu
Analyzing this effect in nominal amounts, we can see the magnified effects of the compound growth over the 88 years.
Dating back to 1928, a $100 investment in the S&P500 would be worth $328,645.87 in 2016. In contrast, the same $100 investment in 1928 in 10-year Treasury Bonds would have become worth $7,110.65 in 2016. The difference is truly life changing - the returns from an investment in stocks would have returned nearly 47 times more than an investment in bonds over the same time period.
Reward is not without risk
When looking into the variances in return per year, we see that the known trade off between risk and reward proves true.
Annual returns from the S&P500 range from roughly -43% to 52%, while the Treasury bonds have a tighter range of roughly -11% to 33%. Right off the bat, we can see bonds are much more stable and provide better downside protection versus stocks.
The following is a graphical representation of the S&P500 annual returns from 1928 to 2016, helpful in visualizing the volatility.
Graph from macrotrends.net
Any given year stocks may vary significantly in value, whether it higher or lower. As an investor keeping a careful eye on his investments, this may be worrisome. Fortunately, there is a way to mitigate this volatility.
Mitigating risk with time
As we saw above, stocks have experienced more positive years than negative years. Leveraging this positive skew, an investor can lower the risk of investing in stocks by holding for longer period of years.
The following graphs show annualized returns for various holding periods. In other words, each bar represents the average return per year of an investment if it was held for the previous so many years.
The one year holding period shows the same volatile returns we had seen previously. The 5 year holding period shows the total returns of holding an investment over the previous 5 years, divided by 5; similarly for the 10, 20 and 30 year graphs. As you can see from the trend, average annual returns become much more stable as the holding period increases.
Another study, presented in Burton Malkiel's The Random Walk Guide to Investing, found similar results.
This graph shows that over the period of 1950-2002, investing in common stocks for any period of 25 years would have resulted in annual returns between 7.94% and 17.24%. In comparison, an investment held for 1 year in this period appears to be more of a gamble, ranging from -26.47% to 52.62%.
Although history doesn't guarantee future results, it gives a strong anchor from which to compare. Over the long term, stocks have historically averaged over 10% returns per year. Treasury Bonds, which tend to be less volatile, have averaged 5.76%. Although bonds are particularly helpful in moderating portfolio volatility, the stability comes at a cost. As we saw, the compounded annual growth can lead to significantly different outcomes.
Bonds are not the only way to mitigate volatility. Holding an investment in stocks for a longer period of time reduces risk by averaging out volatility from any single year. The volatility, or stability, of equity investments over time should be considered by any investor in setting his financial goals.
For young and/or long-term investors who intend to hold equities for many years to come, history shows equities to be a very compelling, if not the, investment vehicle.