Stocks for the Long Run

by: Richard A. Anderson

Over the past few weeks most of our posts have focused on putting the recent stock market volatility in perspective and subduing concerns about the strength of the U.S. economy.

One of the important points we have stressed is the importance of remaining disciplined to your investment strategy because capital markets have rewarded long-term investors. One of the graphics we often show to illustrate this point is the chart included below. This chart shows the growth of $1 from January 1, 1926 through December 31, 2018 had you invested in US small cap stocks, US large cap stocks, long term corporate bonds, long term government bonds, and cash.

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As you can see, stocks have historically been the best vehicle for long-term wealth creation. But, investing in stocks is also accompanied by greater risk and periods of short-term losses. The tables below show rolling monthly returns for US large cap stocks, long-term government bonds, and a balanced portfolio of 60% US large cap stocks and 40% long-term government bonds since January 1, 1926 by time horizon.

Over rolling 1-year periods, both US large cap stocks, long-term government bonds, and the balanced portfolio are positive roughly 75% of the time. While US large cap stocks have doubled the average return of long-term government bonds, this has come with the potential for much greater losses. The balanced portfolio captures most of the return of US large cap stocks while smoothing out the potential for big gains or losses.

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Over rolling 5-year periods, US large cap stocks are positive 88% of the time, long term government bonds are positive 95% of the time, and the balanced portfolio is positive 94% of the time.

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Over rolling 10-year periods, US large cap stocks are positive 95% of the time and long-term government bonds and the balanced portfolio are positive nearly 100% of the time. There has never been a 10-year period where the balanced portfolio posted negative returns.

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Over rolling 20-year periods, US large cap stocks, long-term government bonds, and the balanced portfolio are all positive 100% of the time. There has never been a 20-year period where US large cap stocks have posted negative returns. However, roughly 40% of rolling 20-year periods have produced returns that are below the long-term annual compounded return of 10% for US large cap stocks.

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Over rolling 40-year periods, US large cap stocks, long-term government bonds, and the balanced portfolio are all positive. Additionally, the lowest return over 40-years for US large cap stocks of 8% is only 2% below its long-term average.

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The point of all these numbers and data is to show that over the long-term stocks do generate returns that are greater than investing in bonds or a balanced portfolio. Stocks are the best way for investors to build wealth. The wealth creating power of investing in stocks is further enhanced by the benefits of compounding.

Yet, you are not guaranteed to experience the wealth creation associated with investing in stocks over short periods of time. As you extend your time horizon, the probability of loss is significantly decreased, as is the potential range of returns. But over shorter periods of time, a balanced portfolio allowed you to capture much of the positive returns of stocks while reducing the chance of experiencing bone-crushing losses. This has provided a smoother investing experience and decreased the urge to make an emotional response to market highs and lows.

This is even further exemplified by looking at the 40-year period from January 1, 1969 through December 31, 2018. US large cap stocks had a cumulative return of 10,603%, or 9.8% per year. The balanced portfolio had a cumulative return of 9,328%, or 9.5%. Long-term government bonds had a cumulative return of 4,265%, or 7.9%. On the surface, this was a great time to be invested in US large cap stocks. However, the chart below shows that all of the outperformance of US large cap stocks relative to the balanced portfolio and long-term government bonds has come in the last 10-years. For the first 30-years of this period, both bonds and the balanced portfolio produced a higher return with much less risk.

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This further serves to highlight the importance of diversification. Diversification doesn’t work all the time, but it does work over time. More importantly though, it highlights the benefits of letting capital markets reward you for long-term discipline.