Reminder: Why Do We Bother Investing In The Stock Market?

These days, a lot of people are asking themselves this very question. For most, including myself, I have a unsatisfying answer:

We don’t save enough money.

Think about it. If I had a billion dollars and my current lifestyle, I could simply build myself a Scrooge McDuck vault and just spend it gradually. No banks, no stocks, no bonds.

But I don’t. I have to try and fund both our ongoing and future expenses with our income. In order to make this more likely, I need higher returns. Unfortunately, this sometimes means investing in things that are riskier. Things that can drop 45% in less than a year!

What kind of after-inflation returns can I expect from stocks?
I explored the sources of long-term stock returns here. But as correctly pointed out they are nominal (before-inflation) returns . What about real (after-inflation) returns? Isn’t that what really matters?

Here is the adjusted equation:

Expected Real Return = Real Earnings Growth + Dividend Yield

Historically, the real earnings growth has been estimated at around 2%. At current depressed prices, the dividend yield of the US Stock Market as a whole is about 3%. Thus, this suggests that we can expect 5% real returns before expenses.

But don’t take my word for it, take it straight from Warren Buffett, in this semi-famous 1999 Fortune magazine article:

Let me summarize what I’ve been saying about the stock market: I think it’s very hard to come up with a persuasive case that equities will over the next 17 years perform anything like–anything like–they’ve performed in the past 17. If I had to pick the most probable return, from appreciation and dividends combined, that investors in aggregate–repeat, aggregate–would earn in a world of constant interest rates, 2% inflation, and those ever hurtful frictional costs, it would be 6%. If you strip out the inflation component from this nominal return (which you would need to do however inflation fluctuates), that’s 4% in real terms. And if 4% is wrong, I believe that the percentage is just as likely to be less as more.

4% real return, which was after taking out 1% in assumed management fees and commissions, again brings us back to 5% after-inflation returns from stocks. In exchange, we get a lot of volatility – big dips and peaks, and the dips can last a long time.

What if we wanted to take minimal risk?
I am nearly done with reading a book by economist Laurence Kotlikoff and financial advisor/columnist Scott Burns called Spend ‘Til the End: The Revolutionary Guide to Raising Your Living Standard–Today and When You Retire. In it, instead of recommending a portfolio of mostly stocks and adjusting from there, they start from the other direction. They believe you should start with a portfolio consisting entirely of inflation-protected bonds and see if you need more return from there.

Treasury Inflation-Protected Securities (TIPS) are bonds issued and backed by the U.S. government that promises you a total return that adjusts with inflation. Very generally, it works like this: if the stated real yield is 2% and inflation ends up at 4%, your interest payment would be 6%.

Coincidentally, the last few weeks have given us a huge surge in the real yield offered by TIPS, around 3%. This is the highest it has been in many years:

If you had enough money, such that a fixed 3% after-inflation return is adequate for your needs, then you wouldn’t have to take on very much risk. You wouldn’t have to own any stocks at all. Of course the market value of these bonds will still vary along the way, but if you hold until maturity you will get the real yield. And it is guaranteed by the government, just as much as “regular” Treasury bonds.

More thoughts…
If you invested $5,000 inflation-adjusted dollars every year for 30 years, with a 3% return you would end up with $257,000 in today’s dollars. If you invested the same amount at 5% you would have $370,000 – 44% more.

Of course, 100% stocks or 100% TIPS are at two extremes. But as you can see, either saving more (or living on less in retirement) allows us the luxury of needing to take less risk. Which means in times like these you’d be much less stressed. The question is, can we save enough money to pull this off? I don’t know, but I think I may try harder now. :)

Comments

  1. Thanks for the post Jonathan. How are TIPS different from I-Bonds? On the surface, they both seem the same since they both have real and inflationary return parts. What are the pros/cons of each vehicle?

    -Pam

  2. I invest in the stock market because i want to get free money for doing nothing ;) That, and i like volatility – much more interesting to look at than a pile of cash.

  3. Did you hear about the idea lately, that they might allow people with 401k’s to withdraw without penalty up to 10K? Of course, you have to pay taxes, but that we save people like me who use their retirement savings as an emergency fund. I would love to see this pass. I would take the 10K out of some of the bond funds I have ( I wouldn’t want to touch the stock funds, because they have sunk like rocks lately and I’m waiting for them to recover).

  4. Jonathan – does this mean you are planning to change your present bond allocation of 50/50 Treasury/TIPS more towards the TIPS side?

  5. Great post. In the current environment, it’s easy to lose sight of the real reason to invest (and stay invested) in capitalism and the long term benefits that accrue from that investment.

  6. Good start. Now if you factor in the real inflation number rather than the bogus inflationary numbers that the fed says we have, and you have a large negitive number. TIPS are based on the fed’s inflationary numbers, which are bogus.

    Investing in the stock market is a lot harder now then it was and will continue to be questionable as best. Even if stocks go up, inflation is going to go much higher over the next few years, which will reduce your returns.

  7. What happens to the principal with TIPS when we have deflation? Do they adjust it downward?

  8. Mike Jones says:

    Another book that you might enjoy by those two others you mentioned above is “The Coming Economic Storm”. It is a very easy read and easily outlines the dangers that we are going to face from Medicade and Medicare. You may already be familiar with this, but you might finding something good in the book. They also mentions TIPS as being a good investment for a possibly very volatile future.

  9. Any time I put my brain to it, it seems like buying individual bonds is better than buying bond funds for something like TIPS, because you don’t want the price to go down just because other people are selling if the yields are fine. Am I wrong on this? Have you seen any good discussions of this?

  10. If you are considering TIPS there should be a discussion of the effects of deflation on TIPS vs. I Bonds. There are actually different rules for the two government bonds. However, your total investment in Ibonds is now restricted to $5,000 a year and the bases for determining the interest paid is different from TIPS. I would be interested in someone creating an estimation calculator to choose between them.

    Last point should be a discussion of holding TIPS on your own, or through a mutual fund.

  11. The problem with TIPS is the tax treatment. If you buy them in taxable accounts you will get nothing like 3% real returns (perhaps even negative real!). Most people don’t have enough room in tax-deferred if they have enough money that 3% real is sufficient.

  12. The reason that I invest in the stock market is simple. I can make a much better return by investing in stocks compared to mutual funds, savings account, bonds, or CD’s. I understand that stocks are more speculative, but I will take my chances because I am investing for the long term anyways.

  13. Justjoeguy says:

    Buffet said: “investors in aggregate–repeat, aggregate–would earn in a world of constant interest rates, 2% inflation, and those ever hurtful frictional costs, it would be 6%”

    This part of his statement doesn’t even make sense. It is theoretical. You don’t live in a theory. Now think about this: If Obama wins and raises taxes on what he calls rich people inflation will go through the roof, production will fall and profits and wages will decline. This strategy would produce losses. BTW, it’s not surprising that Buffet advises Obama. But Buffet isn’t following this advice. He wants you to follow it.

  14. Dividend Growth Investor- The Finance Buff tackled that very question, YTM for TIPS during deflation, at this site: http://thefinancebuff.com/2008.....ation.html

  15. SandDance,

    Thanks for the link. I will check it out!

  16. mimi….
    i thought over-spending by Joe Six-Pack and the resulting bad credit that we now need to inflate out of the economy was the problem in the first place (even though neither pres. candidate will blame anyone but wall st)…. letting people spend their 401K now seems counterproductive. We should find a way to encourage savings, not spending every last dime you have to your name. face it, most people would spend this money, rather than move it to different investments.

  17. Pam – Here is a good link on I-Bonds vs. TIPS. For a long-term investment, TIPS are much more attractive right now. I-Bonds are offering a ZERO real yield right now, and also have restrictive buying limits.

    Mimi – I don’t know. The penalties were put in place for a reason. I do tentatively support the delaying of required minimum distributions.

    Andrew – Yes, I am making some changes to my portfolio, will post tomorrow.

    Curt – Inflation can be counted in an infinite amount of ways. I agree that the gov’t tried to remove any big inflation spikes, but in general the market should adjust their expectations of real yield if they think inflation is fudged.

  18. Dividend Growth – TFB probably does explain it best. As long as you don’t have net deflation over that entire period (not just a brief contraction) there is very little to worry about.

    Mike – Yes, that is on my reading list (a bit lower now since there are many similarities).

    Heather – Well, the market price will always change due to the prevailing real yield available, regardless of if it is held in a fund or not. A bond fund primarily saves you the expense ratio, and you get to control the maturity/duration.

  19. Incidentally, how much do you think Scrooge McDuck has influenced your outlook on money in life? Personally, I think the old Barks’ tales had a huge influence on me subconsciously. I can’t think of a better way to begin one’s financial education!

    I’m voting for a full post about Scrooge!

  20. Why do we bother investing in the stock market? Well, there is the we don’t save enough money answer. But there’s also the we don’t live in a country that provides for the retirement of its citizens answer, or the we’ve moved to an economy where retirement is not a shared responsibility (employer/government) but an individual responsibility (which, obviously, entails much bigger risk for individuals than other retirement policy options available to governments and citizens).

  21. Well, for me getting the 10K (turning into 8K, I know once I pay taxes), would make me feel better right now – since I will turn to my retirement savings if I should lose my job for any length of time. It would save me the penalty, and that’s always nice. In the meantime, I could stick it into a Roth (I know, I should have had one already but I’m one of the those late comers to logic sometimes).

    Also, come to think of it, if so many people are now saying you’re not going to make much in the stock market over the next couple of years — and say you have other savings for emergencies, etc., — then why not take out (from bond funds, like me) the 10K and stick it on your mortgage and make 6%, versus the 2% on the bonds. If the market isn’t likely to move that much in the next 3 years, it would probably be more worth your while.

    And I agree, no one should raid their retirement to buy a big screen TV – but having better access to this money, especially in this economy could be very useful!

  22. Investing in the market has been the best for long term growth in the past simply because the value of stocks represent the value of growth in companies, which in turn is a measure of the economy. No matter what other instrument you go to, stocks present better investments because companies are the drivers of growth for most economies (for example, the rising value in your house isn’t produced from growth but a direct result of your income from the growth at work).

    But that shouldn’t mean future growth will come from the US stock market either. I think if we want returns we must seek the growth drivers outside our country or focus on US companies whose growth is coming from outside the US, or look at specific industries like alternative energy where growth is expected to occur. You want returns, follow the money – look for growth.

  23. Holy Poop…I can believe the posts I’m reading. When front covers of magazines, TV pundits, and your neighbors say “buy, the market is great” that’s the time to add to your cash. When those people, including the people posting on this board say “sell”, that’s the time to buy.

    Don’t you guys remember the books you read? Don’t you guys remember any of Jonathon’s past posts? BUY, BUY NOW!

    Brush up on the classic “The Intelligent Investor” by Graham.

    Here a quick summary
    http://www.slideshare.net/kpre.....chapter-8/

    The DOW Ind Forward PE is 12.5 … which means a yield of about 7%
    The S&P Forward PE is around 15… which means a yield of about 6.5%

    Stocks are ON SALE!

    Seriously, you guys have all been doing dollar cost averaging in your 401k, SEPs, IRA during the past bull but now that that the market is cheap, everyone’s running for the closest mattress to hide under with their pockets full of cash. The market dropped – stop crying about it!

    Ok, thanks. I just had to get that off my chest.

    Jonothan – your doing a great job reminding people about what investing means.

  24. Jon – why do I need to be worried about price fluctuations of an individual bond if I’m not buying and selling, because it’s a long-term investment and I’m a buy-and-hold investor? I guess there’s a reinvestment risk if I buy a duration that doesn’t match my time horizon, but there’s a guaranteed return of principal if I hold until maturity, right?

  25. Heather – the only things to be concerned for regarding your hold-til-maturity bonds are 1) the company going bankrupt (default risk), and 2) the effect of inflation on your real returns. The price fluctuations wouldn’t matter so long as you’re not planning to sell them before maturity. I believe the expense ratio argument for buying into bond funds becomes irrelevant if you’re plan is only to hold the bond til maturity.

    To someone concerned over the long-term inflationary effects of an economy, holding the long-term bond might not be as appealing as some “inflation-protected” securities.

  26. i have never purchased stocks on my own before. i inherited some bank stock when my mom passed away. i receive statements from ‘computershare’ regarding the bank stock. i go online to computershare to see how the stock is doing. not too well right now. but, i have been interested in purchasing some stock in walmart or coca-cola. it looks like i might be able to purchase some walmart stock through the computershare co. i think thats the way i understood what i read. but i think i have to purchase the coca cola stock through a different broker first. but since i’ve never purchased stocks on my own, i’m not sure what is the best way to purchase them to avoid spending more on administrative and brokerage fees. are online stock purchases lower in up front fees?
    i’ve been doing alot of reading and researching, but just dont understand all the legal jargon. i’m ready to try, but still afraid to take the plunge. could anyone out there give me some advice as to the best place to go to make my first purchase of stock. any advice will be welcome. thanks, jayne

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