Why consider investing in stocks?
Stocks have outperformed most asset classes over time.
We all need to grow our savings. To do this we can invest in any kind of asset but Long Game Financial ("LGF") prefers stocks for their historically attractive long-term risk-adjusted return profile, which results from the ability of companies to reinvest cash flows.
Over time, stocks have returned significantly more than most asset classes. From 1928 through 2016, the S&P 500 stock market index delivered a +9.5% per year compounded total return (see chart below) (source: NYU professor Aswath Damodaran – link).
The return on stocks handily surpassed the return on government bonds during that timeframe. From 1928-2016, 10-year U.S. Treasury bonds delivered +4.9% per year compounded (4.6% less per year than the S&P 500) while 3-month U.S. Treasury bills delivered +3.4% per year compounded (6.1% less than the S&P 500).
These differences are substantial: if we had invested $100 in the S&P 500 in 1928, by 2016 our savings would have grown to $328,584. By comparison, if we had invested our $100 in 10-year and 3-month U.S. Treasury bonds and bills we would have ended up with far less: $7,111 and $1,988, respectively.
Caveat #1: the stock market is volatile.
The stock market’s path, fortunately or unfortunately, is not smooth and occasionally suffers protracted periods of volatility and decline, especially heading into recessions. Moreover, we cannot simply skip bear markets because market gyrations are difficult to predict.
LGF argues that the best we can hope to do is stomach the bad times while we participate in the longer-term rising trend of the market. We accept stock market price volatility as an unpleasant but unavoidable by-product of the stock market’s historically (and arguably prospectively) superior long-term return profile.
Furthermore, shorter-term price volatility can create longer-term opportunities. LGF requires price volatility to execute our strategy of buying an interest in a business or entity at a discount to what it is worth.
Caveat #2: humans are psychologically ill-equipped to adapt to volatility.
The unpleasant psychological impact of stock market price volatility often prompts investors to buy and sell at inopportune times. Humans are mentally hard-wired to buy high and sell low, even though we all know we are supposed to buy low and sell high.
The chart below illustrates this phenomenon: inflows and outflows from individual investors tend to correlate positively with the stock market’s trailing 1-year total return, often to the detriment of prospective returns (source: Investment Company Institute – link).
Price volatility notwithstanding, stocks (and, more generally, equity claims on assets) are an essential tool for the long-term compounding of savings in excess of inflation.
Which would you prefer: (i) price volatility with the potential for long-term returns meaningfully in excess of inflation or (ii) limited price volatility with little-to-no potential for long-term returns in excess of inflation?
Here's an illustrative example:
Simply put, out-earning inflation (the goal of saving and investing) is difficult to do without an allocation to stocks.
Our strategy: emphasize short-term resilience while focusing on the long game.
If we wish to compound our savings in excess of inflation over time, LGF posits that it makes sense to allocate appropriately to stocks - and when it comes to the stock market LGF acknowledges and accepts the “bad” (price volatility) because it produces the opportunity for a far greater “good” (the potential for higher returns over time).
With respect to our stock allocations we must accept that stock prices fluctuate, prepare for downturns, and seek to counteract sensibly our instinct to buy high and sell when prices decline. Historically, periods of market pessimism have presented the most compelling buying opportunities.