Tuesday, June 21, 2011

investing our savings .... the case for stocks over bonds and cash

A new study (Come On Gen X, Take Some Chances) reveals that younger people between the ages of 18-34 (mean age of 31) are now more conservative when making investment choices than the oldsters (65+). Preserving principal and generating income are more important to them than growing assets or increasing their portfolio value as much as possible.

While perhaps understandable in the present anxious if not fearful state of today, the survey results were somewhat surprising to me and continuing to follow along this path will definitely not be in the long term best interests of the young.

Let's summarize how this investing stuff really works.
(1) Cash and cash equivalents (money market funds, CDs, etc.) won't maintain purchasing power and will result in decreased purchasing power over time.
(2) Because of the stream of interest payments during the life of the bond, fixed income instruments may retain purchasing power and even perhaps result in modest "real" income, although the principal amount returned at the time of maturity will have declined in purchasing power due to inflation.
( 3) Common stocks or equities will return income in the form of increasing cash dividends, and the price of these holdings will likely also appreciate in real value over time. Thus, stocks represent the highest return and least risky investment, albeit the most volatile, of the three under consideration. Stocks both preserve and enhance purchasing power.

If we assume a 3% annual rate of inflation and another 6% real return from stocks due to the risk reward factor, that results in the historical average nominal annual return of ~9% for stocks. Thus, stocks over time earn more than 6% in real terms, and represent the only legitimate choice to beat inflation and enhance purchasing power. Bonds may result in real income gains, especially during the early years, but the purchasing power of the principal will decline due to inflation over the life of the bond. In last place is cash which will be lucky to keep pace with inflation and is most likely to diminish in real value.

Over long periods of time, stocks (we're considering only common stocks herein) will realize a real rate of return approximately double that of bonds. (We will not address commodities or currencies, since these are not viewed as appropriate long term investments. Neither will we consider real estate as an appropriate investment vehicle. Homes should be lived in and not considered as investments.)

The long term case for stocks is uniquely compelling due to several factors, not the least of which is their long term historical performance. That long term performance is largely due to a very simple fact which is often neglected when people decide how to invest their savings ...... the relationship of risk and reward in our market based capitalist system of ownership.

Stocks involve ownership and ownership involves risk. While risk is admittedly a scary word for some, it's really just another word. That's because decisions to invest or not to invest involve risk. All non-decisions likewise involve risk. Risk is everywhere and all the time, whether we acknowledge its presence or not. Risk is.

Accordingly, in our capitalist system stocks not only will, but in fact must, earn a premium to bonds and cash over time. That's the only way our free market ownership system and American way of life will survive. Investors will both demand and receive a higher return from equities than from bonds, simply because stocks involve greater risks than bonds.

Bonds represent legally enforceable contracts whereas stocks promise nothing other than a piece of the rock .... ownership. Hence, unless investors have faith in the future, they won't invest in stocks. Therefore, stocks must generate higher returns in order to compensate for the higher risks assumed by the stock investor. For those of us who believe in the American way of life, in the long run there is no better place for our savings than stocks.

The historical record is that inflation of 2.5% plus a plus a historical risk premium for stocks of more than 6.5% equals an average annual nominal return of greater than 9%. Comparatively, bonds generally yield between 4% and 5%, or ~2% greater than inflation. Cash earns at roughly the rate of inflation.

In future postings we'll go into greater detail but for now suffice it to say that a basket of diversified but strong stocks should be the overwhelming investment of choice for the long term investor. We need to get comfortable with that thought and capable of ignoring the short term volatile twists and turns of equity prices.

American capitalism is not going away, at least not anytime soon. Accordingly, it's a most appropriate time to invest in our great American free market system by owning a piece of the future earnings of our strongest American companies.

Thanks. Bob.

1 comment:

  1. Looking forward to hearing more of your views on this topic. I'm following perfectly so far.