Despite tumult, the key tenets of stock market stand test of time

The more things change, the more they stay the same. Some fundamental stock-market rules and tenets have remained remarkably steady, despite all that has happened in recent years.

The past decade has thrown a lot of challenges at investors — the subprime mortgage crisis, a steep recession, a slow recovery, near-zero interest rates, wars, terrorism and more. But against this backdrop and those of prior decades — with their own booms, busts, wars, breakthroughs and other tumult — some basic investing principles have stood the test of time. The new Ibbotson SBBI 2015 Classic

Yearbook — the latest annual edition of an esoteric, numbers-crunching reference book — helps to shed light on the long-term perspective and where we stand in it. Here are some of those funda-

mental observations.

Stocks win over time: The Ibbotson Yearbook, which costs $185 and now is published by Morningstar, tracks investment returns back to the start of 1926 for several main financial-asset categories including stocks, bonds and cash (Treasury bills). The results continue to show that stocks outperform everything else, given enough time.

A hypothetical $1 invested in Treasury bills back in the mid-1920s would have grown to more than $20 by the end of 2014, assuming all yields were reinvested and ignoring taxes. That equals a compounded average annual growth rate of 3.5 percent, which would have kept T-bill buyers just slightly ahead of the 2.9 percent annual inflation average over the 89-year period.

Bonds would have done better, with $1 staked into long-term governments rising to $135, or 5.7 percent annually on average (corporate bonds fared a bit better). But $1 invested in a portfolio of large U.S. stocks, such as those in the Standard & Poor’s 500 index, would have swelled to $5,317 by the end of 2014, representing annual growth of 10.1 percent. The same $1 placed in riskier small-company stocks would have mushroomed to a sizzling $27,419, a 12.2 percent yearly pace. Clearly, high risk and high return go hand in hand.

These figures include price gains, if any, and reinvested interest or dividend income. Dividends have made a notable contribution to stock returns over time, averaging about 4 percent annually.

But they don’t do so consistently: Stocks represent ownership in companies that form the backbone of the econo- my. As the economy grows over time, corporate values do, too. But the price to be paid for investing in the stock market is an acceptance of risk — sometimes big dollops of it. While stocks have produced powerful gains over time, they don’t do so predictably.

Investors lose money almost three calendar years each decade on average, with prices bouncing around plenty in the meantime. Large stocks have posted average returns of 10.1 percent a year, but they almost never deliver that in any

particular year: Since the mid-1920s, there have been only five calendar years —1926,1959,1968,1993 and 2004 — when stocks returned 9, 10 or 11 percent.

That’s why it’s essential to take a longterm viewpoint. The more years you can

hang in there, the better the odds of at least breaking even. Large stocks gained ground in 65 of the 89 calendar years over Ibbotson’s measuring period, or 73 percent of the time. But they finished with positive returns in 86 percent of the rolling five-year periods and 95 percent of the 10-year intervals. And if you hung on for 20 years, you never would have lost money in a diversified basket of stocks (again, assuming all dividends were reinvested).

Even if you had the incredibly poor luck of investing in the weakest rolling 20-year stretch of all, that from 1929 through 1948, the 3.1 percent average annual return for stocks over that time nearly would have matched the overall returns generated by T-bills for the full 89 years.

“The effects of time diversification are clearly evident,” reads the Ibbotson

reference guide, noting that the potential for loss diminishes as investors stay put for longer periods.

Adding bonds and cash can help: It also pays to add bonds, cash instruments such as T-bills and other conservative choices to dampen the risks of a stock-market portfolio. Think of these as an anchor. They will slow your boat during balmy weather but keep it from crashing into the rocks during a storm.

Incorporating these other diversification building blocks into a stockbased portfolio doesn’t mean you must sacrifice all that much return. For example, a portfolio split 50-50 between stocks and bonds, carrying little more than half the risk of a pure-equity mix, would have returned a solid 8.4 percent annually since the mid-1920s, according to the Ibbotson yearbook. A 70-30 stock/ bond allocation, while one-third less risky than all stocks, would have delivered 9.2 percent a year on average.

These and other results cited by Ibbotson aren’t guaranteed to recur, of course, but they provide a good glimpse of the long-term pattern.

“Because stocks, bonds and cash generally do not react identically to the same economic or market stimulus, combining these assets can often produce a better risk-adjusted return,” the reference book noted.

With the stock market trading near record highs, you might view stocks as excessively expensive compared with bonds, but that’s not necessarily true. Over the past decade, from 2005 to 2014, large stocks actually underperformed their long-term averages with a yearly return of 7.7 percent. Yet long-term government bonds outperformed their historic pattern, with a near-identical average yearly return of 7.5 percent. If anything, bonds seem due to cool off.

Rebalancing keeps you on track: Most investors would be wise to split up a portfolio among stocks, bonds and cash, with the details depending on age, personal risk tolerance and other factors. Once you devise an overall asset allocation, it’s smart to reset or rebalance the mix every now and then. How often? There’s no set answer. You might decide to rebalance once a year or after your mix strays by a certain percentage from your target.

Either way, rebalancing forces you to take some chips from your hot assets and reinvest the proceeds in laggards. It’s a buy-low, sell-high approach.

Rebalancing also makes sense because stocks, like weeds in a garden, will take over the entire yard if left untended for too long. “Because stocks have outperformed bonds over the long run, it only makes sense that the proportion (in a portfolio) allocated to stocks will inevitably grow over time as well,” the Ibbotson yearbook noted. As an extreme example, a portfolio initially split 50-50 between stocks and bonds back in 1926 would have morphed into one with nearly 98 percent in stocks and just 2 percent in bonds by the end of 2014.

In other words, portfolios that aren’t rebalanced will grow riskier over time — just as most investors are becoming more conservative as they age.