September 2024
In a recent meeting, an investor asked me if I thought they should have more liquidity in the form of stocks.
This brought up the question, “Should stocks be considered liquid?” While you can buy or sell stocks with literally the click of a button, should you? More than any other asset class, stocks are a paradox. They are often viewed as a short-term trading instrument when they really should be used as a long-term builder of wealth.
News headlines and stock “experts" (or influencers) tend to promote the viewpoint that stocks are short-term investments. With flashing prices running across the bottom of your screen, it's easy to think of a stock as something that is regularly bought or sold. However, those trying to build wealth over the long term know better. They acknowledge that stocks are volatile and are willing to sit tight through the inevitable ups and downs.
So that poses the question: what is long term?
How long should you be committed to holding on to your stocks with the confidence that their value will appreciate despite any short-term bumps along the way? I recently polled a number of people with this question and the most common answer was 10 years with 5 years being the runner up. One friend said, “I don’t mind the volatility of stocks from one year to the next, because as long as I hold the stocks for 10 years, I’ll be fine.”
I then asked him what he means by “fine.” What annual return should he expect? His answer was around 10% since he guessed that’s what stocks have returned over their history. Well, lo and behold, he was right. Looking at data going back to 1926, stocks have in fact returned an average of 10.3% per year. This friend concluded that since the long-term return on stocks has been roughly 10%, his long-term (10 years in his case) return expectation should also be around 10%. Or, even in a disappointing scenario, stocks should at least make mid-to-high single digits.
I then asked whether his view would change if stocks were flat over the next 10 years. He was skeptical that this was even possible but acknowledged that this would in fact change his outlook on stocks. Since this friend is a data junkie, I elected to pull out my book of long-term returns on stocks to show him the actual “long-term” paths of stock returns.
What the data shows is that you can split the last 100 years of data into three 30-ish year buckets and that each of these buckets share similar patterns of stock returns. Within each of these generational, 30-year timeframes, about 20 of the years exhibit very strong returns, while the other stretch of 10 years shows very poor returns. Specifically, here is what the data shows:
In all three periods above, stocks were flat and actually negative on an inflation-adjusted basis. The 1966–1974 period was particularly rough since inflation averaged 5.6% during that timeframe. In fact, it took 16 years, from 1966 to 1982, for stocks to break even with inflation.
What can we learn from these three timeframes?
At Morton Wealth, we often talk about stock valuations being the most important determinant of long-term stock returns. A good measure of a stock’s value is its price-to-earnings (P/E) ratio, which compares the price of a company’s stock to the earnings the company generates. When stocks are cheap (low P/E ratio), future returns on stocks tend to be robust. Not surprisingly, the mirror image of this holds as well. When stocks are expensive, future stock returns historically have disappointed.
In 1929, stocks reached a then all-time-high P/E of 20. After the stock market crash that year, stocks floundered for the next 14 years, bottoming at a P/E ratio of 8. Even though 1943 was likely a scary time to buy stocks given the backdrop of World War II, this cheap P/E ratio meant that stocks did incredibly well in the decades that followed.
Then stocks hit a high P/E ratio of 18 in 1966, resulting in a poor decade for stocks leading into the 1970s. They bottomed at an 8 P/E ratio in the early 1980s, which we now know was an incredible time to jump into the stock market.
Finally, the 2000 dot-com bubble peaked at an outrageous P/E ratio of 34, which resulted in a market crash and flat returns over the ensuing decade.
The natural next question is where are stock valuations today?
The challenging answer is that they are expensive, trading at a 23 P/E ratio, higher than any other time in history outside of the late 1990s dot-com mania. To be clear, this is not a prediction that the stock market is about to turn over and that the next decade will result in 0% stock returns. Stocks can certainly get more expensive from here. The takeaway is simply that valuations do matter to long-term stock returns and disciplined investors should increase their allocation to stocks when they are cheap and trim them when they are expensive.
The other takeaway is that investors should redefine their definition of “long term” when it comes to stocks. Ten years is simply not a long enough timeframe to rely on stocks to meet your financial goals. Stocks should be viewed as a 15- to 20-year asset and sized accordingly based on your age and risk tolerance.
This exercise also illustrates why we are so passionate about diversifying into other asset classes within client portfolios. Stocks have their place in a portfolio, but since they are currently expensive, we choose to underweight them. Alternatively, we are also on the hunt for more attractive asset classes that we can allocate to, and the opportunities we continue to find in the private lending realm fit this description.
Sample portfolio is provided for informational purposes and does not consider the specific needs of the recipient. Portfolio contains private investment opportunities that may only be available to eligible clients.
When looking for attractive private lending strategies, we try to identify those with the potential for equity-like returns without taking on the same level of equity risk. But tying back to this article, how does the volatility of private lending compare to stocks? Can we envision decade-long periods where private lending results in flat to negative returns? That would be shocking to put it mildly. The consistency and predictability of returns in the lending space is a key attribute that should not be underestimated, both for practical reasons as well as psychological ones.
On the practical side of things, it’s incredibly valuable to have investments that are reliable and spill off consistent income that you can either live off of or reinvest back into your portfolio. On the psychological side of things, the consistency of returns leads to a healthy investment mindset as well. Stock market swings result in most investors being whipsawed between fear and greed, which results in poor investment decisions and sleepless nights. The alternative of resilient and stable returns that many of our cash-flowing opportunities should afford, gives investors peace of mind and allows them to focus on more important things than the daily swings of their portfolio. Nothing is more rewarding than when a Morton Wealth client tells their advisor that they don’t often look or even think about their portfolio balance because they know it’s constructed to be stable and resilient. Instead of logging on to their portal to regularly check on their portfolio value, they can focus on other, more fulfilling obsessions, from travel to time with family to pursuing a new hobby. Music to my ears!
*Performance of “Stocks” refers to the performance of the S&P 500 Index. The S&P 500 Index tracks the performance of the 500 largest US public companies and is regarded as one of the best gauges of US equities’ performance and the stock market overall.
Disclosure: Information presented is for educational purposes only and should not be relied on for investment recommendations. References to specific investments are for illustrative purposes only and should not be interpreted as recommendations to purchase or sell such securities.
The private investment opportunities discussed herein involve a high degree of risk. They are only available to eligible clients and can only be made after careful review and completion of the applicable Offering Documents.
Targets or other forecasts contained herein are based upon subjective estimates and assumptions about circumstances and events that may not yet have taken place and may never take place. Forecasts should not be construed as providing any assurance as to the results that may be realized in the future from investments. Many factors affect performance including changes in market conditions and interest rates and changes in response to other economic, political, or financial developments. There is no guarantee that the investment objective will be achieved.
Past performance is no guarantee of future results. All investments involve risk including the loss of principal.
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