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FIGURE 2-4: A historical view of bond performance: Inflation has eroded bond returns more in recent decades.
Stock returns
Investors expect a fair return on their stock investments. If one investment doesn’t offer a seemingly high enough potential rate of return, investors can choose to move their money into other investments that they believe will perform better. Instead of buying a diversified basket of stocks and holding, some investors frequently buy and sell, hoping to cash in on the latest hot investment. This tactic seldom works in the long run.
Going all the way back to 1802, the U.S. stock market has produced an annual return of 8.3 percent, while inflation has grown at 1.4 percent per year. Thus, after subtracting for inflation, stocks have appreciated about 6.9 percent faster annually than the rate of inflation. The U.S. stock market returns have consistently and substantially beaten the rate of inflation over the years (see Figure 2-5).
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FIGURE 2-5: History shows that stocks have been a consistent long-term winner.
Stocks don’t exist only in the United States, of course (see Figure 2-6). More than a few U.S. investors seem to forget this fact, as they did during the sizzling performance of the U.S. stock market during the late 1990s and 2010s. As I discuss in the earlier section “Diversify for a smoother ride,” one advantage of buying and holding overseas stocks is that they don’t always move in tandem with U.S. stocks. As a result, overseas stocks help diversify your portfolio.
In addition to enabling U.S. investors to diversify, investing overseas has proved to be profitable. The investment banking firm Morgan Stanley tracks the performance of stocks in both economically established countries and so-called emerging economies. As the name suggests, countries with emerging economies (for example, Brazil, China, India, Malaysia, Mexico, Russia, and Taiwan) are “behind” economically but show high growth and progress rates.
Stocks are the best long-term performers, but they have more volatility than bonds and Treasury bills. A balanced portfolio gets you most of the long-term returns of stocks without much of the volatility.
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FIGURE 2-6: Plenty of investing opportunities exist outside the United States.
Real estate returns
The fact that real estate offers solid long-term returns makes sense because growth in the economy, in jobs, and in population ultimately fuels the demand for real estate.
Consider what has happened to the U.S. population over the past two centuries. In 1800, a mere 5 million people lived within U.S. borders. In 1900, that figure grew to 76.1 million, and today, it’s more than 330 million. All these people need places to live, and as long as jobs exist, the income from jobs largely fuels the demand for housing.
Businesses and people have an understandable tendency to cluster in major cities and suburban towns. Although some people commute, most people and businesses locate near major highways, airports, and so on. Thus, real estate prices in and near major metropolises and suburbs generally appreciate the most. Consider the areas of the world that have some of the most expensive real estate prices: Singapore, Hong Kong, Vancouver, San Francisco, Los Angeles, New York, and Boston. What these areas have in common are lots of businesses and people and limited land.
ARE SMALLER-COMPANY STOCK RETURNS HIGHER?
Stocks are generally classified by the size of the company. Small-company stocks aren’t stocks that physically small companies issue; they’re simply stocks issued by companies that haven’t reached the size of corporate behemoths such as IBM, Walmart, or Coca-Cola. The Standard & Poor’s 500 index tracks the performance of 500 large-company stocks in the United States. The Russell 2000 index tracks the performance of 2,000 smaller-company U.S. stocks.
Small-company stocks have outperformed larger-company stocks during the past seven decades. Historically, small-company stocks have produced slightly higher compounded annual returns than large-company stocks. However, nearly all this extra performance is due to just one high-performance time period, from the mid-1970s to the early 1980s. If you eliminate this time period from the data, small stocks have had virtually identical returns to those of larger-company stocks.
Also, be aware that small-company stocks can get hammered in down markets. For example, during the Great Depression, small-company stocks plunged more than 85 percent between 1929 and 1932, while the S&P 500 fell 64 percent. In 1937, small-company stocks plummeted 58 percent, while the S&P 500 fell 35 percent. And in 1969 to 1970, small-company stocks fell 38 percent, while the S&P 500 fell just 5 percent. During the 2020 COVID-19 contraction, the S&P 500 fell about 33 percent while the small-company Russell 2000 dropped nearly 44 percent.
Contrast these areas with the many rural
