My Two Cents

Stocks for the long run

Chris Farrell Nov 3, 2008

Brad DeLong, economist at the University of California, Berkeley and former assistant U.S. Treasury secretary during the Clinton Administration, makes a strong case for owning equities. He notes that stocks have been a terrible investment over the past decade, and that the recent 40% or so decline may not be the end of the bad news. A few highlights:

So investors are wondering: Will future decades be like the past decade? If so, shouldn’t investments in equities be shunned?

The answer is almost surely no. At a time horizon of a decade or two, the past performance of stocks and bonds is neither a reliable guarantee nor a good guide to future results. Periods like 1998-2008, in which stocks do relatively badly, are preceded by periods — like 1978-1988 and 1988-1998 — in which they do relatively well, and are in all likelihood followed by similar periods.

Do the math. At the moment, the yield-to-maturity of the 10-year US Treasury bond is 3.76 percent. Subtract 2.5 percent for inflation, and you get a benchmark expected real return of 1.26 percent.

Meanwhile, the earnings yield on the stocks that make up the S&;P composite is fluctuating around 6 percent: that is how much money the corporations that underpin the stocks are making for their shareholders.

Some of that money will be paid out in dividends. Some will be used to buy back stock — thus concentrating the equity and raising the value of the stock that is not bought back. Some will be reinvested and used to boost the company’s capital stock…. Thus, the expected fundamental real return on diversified US stock portfolios right now is in the range of 6 percent to 7 percent….

All these arguments apply only to long-term investors who can afford to wait out another 40 percent decline in values and keep their money invested until perceived risk drops. (And if perceived risk never drops than you have worse things to worry about than the performance of your portfolio.)….

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