With more workers than ever depending on 401(k)s and other self-directed plans for their retirement, investors have a lot at stake when it comes to optimizing their portfolio. The conventional wisdom is that stocks offer the best chance to maximize returns over the long term, but every significant dip in the market seems to bring fresh doubts.
The so-called "lost decade" between 1998 and 2008, when U.S. stocks actually declined 0.6%, created particularly strong skepticism. If stocks - or equities, as they're often called on Wall Street - are such a smart investment, how does this happen?
Determining the real merit of an asset class requires a sense of perspective. Going back to the early 1900s, slumps of this duration are actually quite rare. Plus, over that time, stocks have averaged much stronger returns than bonds or even precious metals. So, for investors who can afford to ride out the inevitable dips along the way, stocks really are the best way to increase the growth potential of their nest egg.
Stocks Versus Bonds
When comparing stocks to bonds, it’s important to first understand the fundamental differences. A corporate bond is essentially an I.O.U. that a company gives an investor. It agrees to pay back the par value of the note in addition to a stated interest rate. And because there’s a promise attached to the security, bondholders are presumably willing to accept a lower rate of return than they’d expect from a more speculative investment.
When you buy a share of stock, however, you’re purchasing an ownership stake – small as it may be – in the business. In theory, the value of your ownership position could move infinitely in either direction based on the company's performance. The degree of risk is greater, but so too is the potential reward – or so we’re told.
So does history bear this out? When one looks over several decades of data, the answer is a resounding “yes.”
One major source of confusion for investors is cherry-picking dates when analyzing stock performance. The 1998-2008 period is a prime example. If someone put all their money into U.S. equities in 1998 and tried to sell it all in 2008, it’s true that their return would be slightly less than zero. But too much emphasis on this one particular 10-year span can be misleading.
The trouble here is that 1998 represented a temporary peak for the market – it was the first time the S&P 500 hit the 1,000 mark – and 2008 happened to be a valley. The more accurate way to evaluate different securities is to calculate at their long-term trajectory – and that requires looking back as far as possible.
When we look at the entire period between 1928 and 2011, we find that stocks appreciated by a compound average rate of 9.3% a year. Over the same span, bonds generated a 5.1% annual return on average.
So how reliable are stocks, if we use them for long-term saving? Here’s one way to look at it. If you start with the date Jan. 1, 1905, and look at the Dow Jones Industrial Average every 15 years, you’ll notice that the index rose during every interval but one (it dipped slightly between 1965 and 1980). So stocks aren't bulletproof, but over extended periods they’ve been remarkably consistent.
Of course, over shorter time periods, equities can fluctuate considerably - just ask anyone who planned to tap their stocks before the 2008 market collapse. When investing for the near term, shifting toward high-grade bonds and other relatively low-risk investments is a good way to protect one's savings should the economy take an unexpected dip.
Source: Federal Reserve Bank of St. Louis
Does Gold Measure Up?
Just as an investment vehicle can have a bad decade, it can also have a stellar one. Such was the case with gold after the dotcom bubble exploded. In 2001, the precious metal was worth $271.04 per troy ounce. By 2012, it had shot up to a staggering $1,668.98.
So has gold overtaken stocks as the best avenue to grow your portfolio? Not exactly. Here, too, we run into the problem of selectively picking dates. After all, gold has gone through rough periods, too. For instance, its price rose to $615 an ounce in 1980 before dipping over the next consecutive years. It didn’t reach $615 again until 2007, nearly three decades later.
Indeed, when we look over a long stretch of time, gold loses much of its luster. From 1928 to 2011, its price increased by an average of 5.4% annually. Interestingly, gold is historically just as volatile as stocks, so a lower return in this case does not mean less risk.
Here’s another reason to be cautious about gold, at least if you live in the United States. Long-term gains on collectibles – the investment category that gold falls under – are taxed at 28%. As of 2013, long-term gains on stocks and bonds are subject to a maximum 20% tax.
It’s not that gold can’t play a useful role in one’s portfolio, but making it the centerpiece of a long-term investment strategy has clear pitfalls.
Finding the Right Mix
If equities really do offer higher growth potential than other asset classes, what role should they play in a retirement plan? The answer is almost never 100%, even for an investor in her 20s who is just starting a career.
The fact is that stocks – even those of established, “blue chip” corporations – are significantly more fickle than assets like bonds and money market funds. Adding more stable securities to the mix has its advantages.
For example, even younger investors sometimes have to tap their 401(k)s as the result of an unexpected financial hardship. If they do so when the market is down, an over-reliance on stock only worsens the pain.
While equities typically comprise the bulk of a portfolio for those with longer time horizons, minimizing risk tends to become a bigger priority when one gets closer to retirement and other major financial needs. As such, it makes sense to gradually reduce one's stock allocation as these events draw near.
The Bottom Line
Whenever a different asset class outperforms stocks over several years, there’s a tendency to look at equities with suspicion. When evaluating securities from a historical standpoint, however, it becomes evident that stocks truly are the best way to maximize the upside potential of one’s portfolio. The key is to hold an appropriate amount and to diversify your holdings through mutual funds, index funds and ETFs.
|Watch: What Are Stocks?|