About a decade ago, Jeremy Siegel, a finance professor at the Wharton School of Business (my alma mater), wrote his best-selling Stocks for the Long Run. In that book, he argued that long-term investors should invest in a diversified portfolio of stocks (as opposed to money market securities, corporate, or government bonds).
If you follow the markets at all, you already know that stocks have historically provided higher average annual returns than other investment alternatives. If you’d held a portfolio of large company stocks for the last 30 years, your average annual return would have been about 15 percent per year, and you’d have earned an average of 21 percent per year on a portfolio of small company stocks. Compare that to less than 10 percent on long-term corporate and government bond portfolios and 6 percent for low-risk Treasury bills.
Of course, you’d only have achieved those results if you’d bought and held through the entire 30 years, something that few investors ever do. That means holding onto your losers through the crashes and your winners through the booms. Individual investors are notorious for jumping in and out of the markets at exactly the wrong times-selling when the market is down and buying when the market is up. If you had done that, your stock portfolio would have earned substantially lower returns.
The reason individual investors have trouble staying the course is that return on investment is only half the story. The other half is risk-the ups and downs in prices over time that are inevitable when you invest in the stock market. If you own a money market mutual fund, your long-run returns won’t be much better than what you could earn on a bank savings account. But you would be exposed to virtually zero risk of losing your money. In contrast, if you invest in stocks, you run the risk of losing all of your money if the company goes out of business. Bonds are less risky than stocks because they pay you regular interest each year and are also first in line to get paid back in the event of bankruptcy.
Given the recent performance of the stock market, you may wonder whether "stocks for the long run" is still good advice. Although we seem to have recovered from the crash precipitated by the technology bust a few years back, 2006 has not been very kind to stock investors. In his new book "The Future for Investors," Siegel suggests that the choice of which stocks to invest in is also important. He provides evidence that the portfolios of "tried and true" company stocks perform better than growth stocks over time.
The lesson to take from both books is that it’s the long term that counts. The prices of stocks and stock mutual funds are very sensitive to economic conditions, here and abroad. The war in Iraq, interest-rate increases precipitated by Federal Reserve policy decisions, the rising trade deficit, and the depreciation of the dollar are all factors that influence the value of shares of stock and stock mutual funds. This type of information changes from day to day, so you can expect to see the prices of stocks rise and fall as investors reevaluate what it all means for the prospects of particular companies. The trick for stock investors is to have the nerve to hold on through the inevitable ups and downs.
Diversification of your portfolio across other asset classes can reduce your exposure to these risks. In the long run, this lower risk will also imply lower average returns. But it might help you sleep better at night.
Vickie Bajtelsmit, Professor of Finance, Colorado State University College of Business, firstname.lastname@example.org