In my recent post, “3 Reasons Why Stocks are Up”, I discussed the unprecedented times we’re experiencing. The stock market is at record levels. Simultaneously, unemployment is high, and the nation continues to face cultural clashes and extreme income disparities.
Despite the S&P 500 topping $3,490 on August 28, 2020, there are wide swaths of the market that aren’t faring too well. Yet, stocks remain an important asset class for those attempting to grow their wealth for the future.
5 Year S&P 500 Price Chart
The recent S&P 500 market expansion is driven by a handful of stocks. While many stock prices are treading water, the FAANG stocks – Facebook, Amazon, Apple, Netflix, and Google (Alphabet) – contribute to approximately 25% of the S&P 500 market capitalization (the average share price X the number of outstanding shares), highlighting their impressive performance.
This recent market rally has a lot of investors worried that there is a major disconnect between the stock market and the economy. If the economy is still fragile, why should stocks be up like they are? Especially during an election year?
As I stated before, the stock market is forward-looking, meaning that they trade based on the probability of likely outcomes. Plus, with the trillions of economic stimulus dollars we have seen, it is no wonder why the markets have rallied as they have. But, are stocks reaching bubble levels? Are prices reasonable? Maybe or maybe not. It depends on which of the infinite outcomes occur.
Yet, even if prices are irrational, “The markets can remain irrational longer than you can remain solvent,” said famous economist John Maynard Keynes. In other words, the market might be overvalued, but that doesn’t mean that there will be a market correction this year or next.
With confusing economic information including historically low-interest rates, market valuations priced for perfection, and the highest unemployment rate in decades, investing for many is more difficult than usual.
Anyone with investment savvy understands that asset prices are volatile and uncertainty is simply a part of the game. Yet, when returns are lofty, and the economy is struggling, there’s an underlying worry among some that maybe it’s time to flee the markets (this, of course, is not the right answer). A lot of people have a lot of stress on their shoulders and worrying about stocks is one worry they can manage. And some of these people are even asking, “why should I invest in stocks at all?”
In this article, I will delve into the issue of why one should invest in stocks at all and elaborate upon the resiliency of the stock market.
This is a must-read for those of all persuasions, the worriers who want to cut back on stocks, as well as those who ponder whether they have enough money in the market.
The Stock Market is Resilient
Over the long term, stock market returns are positive. Even after severe declines, the markets tend to rebound. Sometimes the rebound takes longer than others, but in general, it’s difficult to find a better vehicle for financial growth than the US and global stock markets.
S&P 500 Total Return
Yes, the stock market is very volatile. There are periods where the stock market has crashed. In fact, it is a certainty that the stock market will continue to see crashes and bear markets going forward. Yet, since 1928, the S&P 500 average annual return is 9.71%. The trick when investing in stocks is to ignore the day-to-day noise and to keep a long-term mindset.
Another point to keep in mind is that many companies pay out dividends to their shareholders, even during downturns.
S&P 500 Dividend Yield
The average dividend yield since 1870 was 4.32% with a minimum yield of 1.11% in 2000 and a maximum of 13.84% in June 1932. So if investors held on and didn’t sell during a market decline, the dividend payments mediated the pain of the declines in stock prices.
Today, most investors are reasonably diversified – in line with their risk tolerance, goals, and other factors. So even in a worst-case scenario, most investors own bonds, cash, real estate, and other assets to balance out the stock market volatility.
To examine the data another way, let’s examine rolling returns for various periods between 1872 and 2018. Since investing is best for long term investors, this approach makes a lot of sense when looking at the benefits of stock investing.
One, Five, Ten, and Twenty Rolling Year Stock Market Returns 1872-2018
During any 20-year rolling period, there have been no negative returns. Most of the 10-year rolling periods produced positive returns. The maximum 10-year return was 17.6% and the worst losing period was -4.1%, while the average annual return was 6.8%.
When exploring returns of rolling five- and one-year returns, the trend is still up. Although, the down years are more frequent and volatility increases.
This data highlights the importance of only placing money in the equity markets that you won’t need for more than five years. The money you need sooner should remain in less volatile assets like short-term bond funds and liquid cash-type accounts.
You don’t want the $80,000 that you’ve saved for the down payment on a home to drop to $55,000 during a market decline in the year you were planning to buy.
The Role of Bonds in a Portfolio
Although we believe that bonds have a place in an investor’s portfolio, stocks provide greater growth prospects than bonds, now and going forward. We largely view bonds within a portfolio as a diversifier and a relatively safer asset class. It is the counterweight to a stock portfolio when volatility strikes equities. If you have a longer time horizon and a higher risk tolerance, you should have a larger allocation to stocks and vice versa.
The following graph shows the annual returns of stocks, short and long term treasuries, and corporate bonds.
50 Year Investment Returns – S&P 500, 3-month Treasury Bill, 10-year Treasury Bonds, Baa Corporate Bonds
Notice the annual returns of stocks during the last 50 years, in contrast with those of bonds. Although more volatile, stock market returns are substantially higher than those of all varieties of fixed assets including government and corporate issues.
There are only a handful of negative years when bond losses came anywhere near those of stocks. Since the turn of the century, the 10-year treasury has averaged 4.19% in contrast with the S&P 500’s annual average return of 13.44%.
It is likely that the Fed keeps interest rates low for the foreseeable future. However, this will not be forever. At some point, inflation will rise and so will rates (will the latest round of stimulus bring inflation levels higher?). When interest rates rise, bond yields increase and bond prices fall. However, there are ways to mitigate this risk within a bond portfolio.
This adds more heft to the concept that the stock market should not be ignored. Yet, retirees have frequently depended upon bond income to fund their future. Given our current economic scenario, it may be time to adjust the status quo on retirement portfolios.
Wade Pfau and Michael Kitces wrote a groundbreaking report on the idea of a reverse glide path in retirement investing. Their updated research on the topic is published here.
Their studies further underscore the resiliency of investing in the stock markets. In other words, declining stock market returns typically bounce back.
Reverse Glidepath for Retirees
“Recent research shows that despite the contrary nature of the strategy – allowing equity exposure to increase during retirement when conventional wisdom suggests it should decline as clients age – it turns out that a “rising equity glide path” actually does improve retirement outcomes!” ~Michael Kitces
Retirees have been coached over decades that they should increase their exposure to bonds and cash during retirement and to live off the dividends. As previously discussed, with interest rates in the low single digits leading to low bond interest rates, this strategy doesn’t make sense in this economic climate. The income they would receive will be extremely low. This strategy may not even make sense when interest rates begin to rise.
One of the greatest risks for retirees is the “sequence of returns risk”. This is the situation where the stock market declines during the beginning years of retirement and the retiree must begin withdrawals from their retirement assets when the valuations are lower.
To combat this type of scenario, we prepare our clients by running different “scenarios” prior to retirement. We will see how their retirement and portfolio look if a 2008 scenario impacts their portfolio, especially during the first year of retirement (typically, the most vulnerable year). If they can sustain an impact like this, then they can likely sustain most other types of shocks.
The reverse glide path concept recommends that retirees portfolios begin with a relatively conservative asset allocation, and over time increase exposure to the stock market. With the rising equity glide-path, the retiree has less equity exposure early in retirement, when most vulnerable.
Michael Finke, published another study with Wade Pfau and Duncan Williams in the Financial Planning Association Journal, touting the benefits of a stock allocation in retirement to secure more income during the later years of life.
In the long term, the retirees’ overall assets will likely be greater, as equity percentages increase. This theory holds whether there is a drop in the stock market early in retirement or not.
The Stock Market Represents Businesses
It’s heady to consider the long term positive stock market returns. It’s also normal to worry about the direction of future returns. After all, it’s your wealth that increases and decreases on a daily basis.
But realize that the stock market is not an amorphous object driven by unknown forces, but ownership in U.S. and global businesses. A business’s primary goal is to generate profit. As a shareholder in a company, you get to receive a share of those profits. There is also the possibility of companies losing money. However, we are an innovative society and humankind has an uncanny ability to overcome problems.
Furthermore, the global population will continue to grow and people will continue to need goods and services. Companies are incentivized to deliver a product or service in an efficient manner. Even if/when some companies fail and if/when industries lose favor, others will emerge as future leaders.
This is the beauty of capitalism. This process ensures the survival of the fittest and its’ result is a product that is better than it’s predecessor.
In the end, the reason why the stock market continues to outperform over time and why companies are so resilient is due to one major factor: innovation. The ability to continue to move forward, to overcome obstacles, to create better technologies and products is simply innovation. It is also a very humanistic quality we can all get behind.
Why Invest in the Stock Market – Wrap up
While some compare investing in the stock market to gambling, that is a partially correct analogy, but not a complete one. The strategy of diverting a portion of current income into growing US and global businesses is a way to stretch out your financial resources across a long life. It is difficult to realize capital growth to secure a financial future without investing in stocks. Is it possible? Yes. Does avoiding stocks make it extremely difficult? Absolutely.
Despite periodic stock declines, it’s tough to find a better asset class to grow your wealth over future decades. Regardless of current economic and cultural conditions, businesses are the foundation of a growing society. These are the vehicles that provide goods, services, and jobs for the future.
Participating in the stock market, with a sensible plan is appropriate for individuals of all risk levels. For those with less tolerance for the volatility of stock prices, a greater allocation to fixed assets including cash and bonds is appropriate. For those comfortable with wider swings in asset prices, larger stock market allocations may lead to returns going forward.
It is important to remain diversified so that the declines in one asset class will be offset by the growth in others. More importantly, it also ensures that you don’t do something foolish by selling out at market bottoms.
We are here to speak with you about your asset allocation, our approach to investing, and any concerns you might have about current and future financial conditions.