By Brian Hepp Market Matters
INVESTORS KNOW THAT STOCKS AND bonds are two of the most basic investment vehicles available. And anyone who has invested in stocks knows that they can play a key role in a successful wealth-building strategy over time. While stocks are favored by day traders and others looking to make quick profits on short-term price movements, long-term investors should also realize that investing in stocks offers many advantages.
For starters, stocks have historically outperformed other long-term financial assets. In addition, stocks have typically outpaced inflation, which helps investors counteract its detrimental effects on their portfolios. To illustrate these points, the results of a recent study provide empirical data to support what investors have long suspected.* A recent analysis compared the results of investing $1 in each of several different asset classes — common stocks, long-term corporate bonds, long-term government bonds, and Treasury bills — on the last day of 1919 and holding the investment (with associated returns) until the end of 2006. All proceeds were reinvested, which means dividends received were used to purchase additional shares of stock and interest payments from bonds were used to buy more bonds.
Investors likely won’t be surprised to find that over the course of the 87 years studied, stocks significantly outperformed several fixed-income investments. But what may be eye-opening is the extent to which they exceed the return on bonds. While an initial investment of just $1 in Treasury bills would have grown to approximately $29, the same investment in long-term government bonds would have grown to approximately $87 and a similar investment in long-term corporate bonds would have grown to more than $162. That initial $1 invested in common stocks, on the other hand, gives the investor a portfolio valued at more than $4,889 at the end of 2006.
The numbers alone show stocks winning this contest by a large margin. But what’s interesting is just how such dramatic growth is achieved. Capital appreciation alone causes the $1 investment in stocks to grow to $137 by the end of the period. The other $4,752 comes from collecting the dividends paid over the years, using them to purchase more shares of stock, and enjoying the benefits of compounding growth as well. As these numbers show, patient investors who buy stocks that pay dividends — especially growing dividends — and reinvest those dividends in more shares of stock have the opportunity to significantly outperform fixed-income investors.
Beyond just the growth of the different investments, the effects inflation has on each of the assets mentioned need to be taken into consideration as well. Using an average annual inflation rate of 2.5 percent over this time frame, the average inflation-adjusted returns were: 1.38 percent for Treasury bills, 2.66 percent for long-term government bonds, 3.40 percent for long-term corporate bonds, and 7.52 percent for common stocks. While past performance does not guarantee future results, as you can see, the stock investor was the only one who was able to generate meaningful returns to combat the eroding effects of inflation.
In addition to the returns stock investing can provide, investors should also consider the tax benefits of buying stocks. When a stock is sold, the owner is subject to capital gains taxes on any earnings from the sale. Because of recent legislative decisions in the past several years, tax-advantaged investments have become even more important. In 2006, the law reduced the top tax rate for long-term capital gains from 20 percent to 15 percent, until the year 2011. Under the same legislation, taxpayers in the 10 percent and 15 percent brackets will be taxed at only 5 percent on long-term capital gains realized before January 1, 2008.
These are just a few of the many reasons to consider investing in stocks. Take a look at your holdings and decide whether stocks might be welcome in your portfolio. *Source: Jack W. Wilson and Charles P. Jones, North Carolina Sate University BRIAN HEPP is a financial consultant and (310) 453-0077.
Originally published in the Santa Monica Daily Press print edition on July 25, 2007. Read the original PDF.