The Lessons of Market History for Novice Investors

Past performance is no guarantee of future results. Every mutual fund you own says something to that effect in its literature. And yet, ignoring the past--in investing or in any other field--is rarely a wise move. I don't mean you should be a performance-chasing hound. Buying funds that sport the gaudiest one- and three-year returns, for example, can easily lead you astray. However, knowing something about stock market history can help you set expectations for your investments. That can be extremely useful for novice investors who have little experience navigating the turbulence of the markets.

The Historical Performance of Stocks
First, let's review some stock market history with Professor Jeremy Siegel, who is famous for advocating in his book Stocks for the Long Run that stocks are the best long-term investment. Siegel argues that, despite their short-term price gyrations, stocks become less risky over longer periods of time, especially in relation to inflation. Inflation, of course, is the phenomenon of money becoming less valuable over time or purchasing less over time, mostly because the government tends to print a lot of it. So stocks fluctuate much more than bonds, for example, over shorter periods of time, but their superior long-term returns help investors maintain their purchasing power over longer time periods better than other investments.

So what exactly have stocks returned? Siegel shows that stocks have returned about 10.2% per year from 1926 through 2001. Siegel also breaks that number down into 3.1% inflation, 4.1% dividends, and real capital appreciation of 2.7%. Adding these components will give you an approximation (9.9%) of the return. This return assumes the reinvestment of dividends and capital gains and not paying taxes.

Does this mean that stocks have returned 10% per year in most years? Hardly. The volatility of stocks is legendary. Over the past five years, the S&P 500 Index (which we'll use as a proxy for "stocks" or the stock market) has returned something close to its historical average only once--10.8% in 2004. In this short time frame, the index has plummeted as much as 22% in a year (2002) and surged as much as 29% (2003). Additionally, going back to 1988, the index's total return (appreciation plus dividends) was between 8% and 12% only one other time (10.1% in 1993). This wide disparity of returns makes holding stocks for long periods of time a better idea than holding them for short periods.

The Stability of Bonds
If you're interested in steadier, more predictable returns, let's take a look at bonds, which tend to fluctuate less than stocks. From 1926 through 2001, bonds have returned about 5.3% per year, according to Siegel's research. So clearly you give up return for the relatively smoother ride that bonds provide. Also, although bonds can provide wonderful ballast to a portfolio, they do experience periods of decline when interest rates are increasing. Still, these periods are generally shorter lived and less severe than the declines stocks can experience.

However, bonds don't protect you against inflation as well as stocks do. The 5.3% that bonds have typically returned every year may sound perfectly fine, especially if you don't like how stock prices bounce around so much, but it sounds less impressive when you consider that inflation has pushed prices up, on average, about 3% per year. So it's important to think of not only what returns your investments are giving you every year, but how well your returns stack up against the invisible but corrosive force of inflation. The occasional gyrations of stocks might be easier to take when you realize how much further ahead of inflation stocks can get you over the long run when compared with bonds.

We don't mean to scare investors away from bonds, which make lots of sense for retirees seeking income from their capital. The point is that the farther away you are from your goal, the more stocks make sense.

What the Future may Hold
So now that we have some history under our belts, can we extrapolate what we've learned about the past onto the future? Can we expect that 10% per year from stocks over the next 20 years? That may not be so prudent. First of all, the dividend yield of the S&P 500 Index is now less than half of what it was 20 years ago, and as Siegel tells us, dividends have been a significant part of the index's return. With a significantly lower dividends, growth will have to exceed its past rates in order for total returns to match their historical levels. Second, some pretty talented investors like Warren Buffett, bond guru Bill Gross, and Gross's colleague Robert Arnott have cautioned against high expectations for stocks. All three see average nominal stock returns in the mid- to high-single digit range for the foreseeable future (perhaps 6% to 8%) and bond returns lower than that. Of course, it's difficult even for legendary investors like Buffett and Gross to know what entire asset classes will do over a given time frame in the future, and smaller investors generally shouldn't organize their portfolios around such pronouncements.

The Lessons of History
Armed with our knowledge of history, we can, however, reach a few helpful conclusions.

1. For long-term money, stocks likely remain the best investment. They may not return what they have in the past, but another asset class that can keep pace with inflation as well as stocks has not presented itself. Because of their volatility, however, stocks remain bad investments for short-term money (cash that you'll use for a down payment on a house in six months, for example). In fact, Siegel says that stocks are inappropriate investments for money that you're planning to spend within five years.

2. Knowing history can help you manage your emotions, which may be the most important part of investing. Just when you want to throw in the towel after a period of stock market decline, those stocks may bounce back. Also, just when you're likely to feel most confident in them is when they're prone to disappoint. Keeping a long-term perspective and trying to focus more on your time frame than on the daily and yearly fluctuations can make you a better investor.

3. Broad-based mutual funds, including index funds that track the S&P 500 or Wilshire 5000 indexes, give individual investors a good chance to capture much of the market's return over time. Stick to these kinds of investments with the bulk of your assets, and try not to pay attention to various sectors that may be running hard for short periods of time. It's easy to feel like a dolt at a cocktail party when you don't own the latest high-flying sector, but armed with history you'll realize that periods of unusually strong performance can't continue for the market as a whole or for an individual sector.

4. Fees matter. Because beating inflation, especially for bonds, is difficult, paying a large expense ratio on your mutual funds is effectively asking you to fight with one hand tied behind your back. Look for low-fee mutual funds. Our  Analyst Picks lists are filled with them.