Friday, August 20, 2010

Are stocks still a good investment?

(Money CNN) Should investors expect superior gains from stocks in the future? Or has something changed that suggests equities won't be as dominant?

Stocks are going to outperform bonds long-term.

That's almost assured. Yes, we've had a decade where the stock market underperformed, actually had negative returns, but that was very unusual. You have to go back to the 1930s before you had another negative return for a decade in the stock market.

It makes sense, though, that we have some periods of negative returns because the whole key to getting higher returns in the long run is that stocks are risky. People have to be afraid to take the risk of investing in stocks for them to deliver superior returns going forward.

Now, future stock returns might be lower than the near 10% historical average. We think maybe 8% or so, although others say they could be even lower because they don't see strong economic growth for the next decade.

But the equity risk premium, or the extra return you get from stocks vs. less risky investments, isn't much different than it was historically. What is unusual about the last 30 years, though, is that the bond market often outperformed the stock market over long periods. You won't get that again.

Why not?

You started in 1980 with double-digit yields, which provided high income, and those yields then dropped, creating capital gains. [Bond prices and yields move in opposing directions.] That combination made it a great period for bonds. But today yields are 3% to 4%. So we're starting out with a low yield that, if anything, is more likely to rise than fall, which means you won't get any capital gains. So the bond market will not repeat its performance.

The stock market can repeat, and the kind of returns you got over the last 30 or 40 years might be indicative of future returns. But they'll come with up and down periods that can be very disheartening.

Disheartened is how many investors feel about stocks today. What makes you so confident? Is there something inherent about stocks that makes them likely to outperform?

What's inherent about stocks is that they're risky. And we don't like risk. So every time something bad happens, we're really wary of the stock market. Of course, we were especially wary in March 2009 after the market had fallen well over 50%, but that turned out to be a great time to buy stocks. It's when you're most afraid of stocks that they have the most potential.

But to get this risk premium, don't you have to be correctly pricing in the risk?
Some would argue that recent prices don't reflect stocks' true risk, that price/earnings ratios are too high.

P/Es are hard to measure coming out of the recession because earnings are changing quickly, and P/Es from trailing earnings are much different than estimated P/Es from forward earnings.

The stock market surged in the early stages of the recovery not because companies increased their revenues but because they cut their costs. Now if they can start increasing their revenues, they can improve their bottom lines a lot. If that happens, stocks will turn out to have been rather attractively priced now.

You've recently started managing two mutual funds -- American Beacon Zebra Large Cap and Small Cap -- that will invest in less liquid stocks, those that trade less frequently. Why, at a time when investors are wary, would you want to focus on shares that would seem riskier?

There are gradations of liquidity. These stocks trade every day. But research shows that the stocks that are more liquid historically have lower returns, while those that are less liquid have higher returns. We're buying companies that have strong fundamentals but are relatively less liquid, companies that there's less interest in, the ones not talked about in your magazine. Effectively, you get an out-of-favor stock, and if it ever comes into favor, you get a big kick-up in the returns.

Roger Ibbotson is a money manager and Yale finance professor.


yauwenchin said...

Perhaps we should have a mantra like Mr Ho Chin Soon for property, Location, Timing & Branding. For stocks, Blue Chips (strong fundamental stocks), Timing & Branding (Strong Management track records).

whitney said...

Excellent stuff with wonderful information! I'm new here and loving the post! Thanks for sharing this great info.


whitney said...

Excellent stuff with wonderful information! I'm new here and loving the post! Thanks for sharing this great info.