If there's a venerable rule of thumb in the world of investing, it's that over the long haul you can expect to earn about 7 percent a year in stocks, beating bonds and just about any other asset class most folks would dare to invest in. That's 7 percent in "real" (inflation-adjusted) total return—the capital appreciation of the stock plus whatever it generates in dividends.
Of course, we all know that past performance doesn't guarantee future results, especially when that hole in your portfolio has all the hallmarks of a paradigm shift. Seven percent may have been a reasonable expectation during the American Century of chickens in every pot and a pre-casino financial system, but is it reasonable going forward?
After a dismal decade or so for U.S. equity markets, the 7-percent expectation now strikes many as a curious artifact of a halcyon market vaporized in the extinction event of 2008. After all, the S&P 500 remains 9 percent or so below even its 2000 peak, having generated an annualized total return of 1 percent in nominal terms and a 1.3 percent decline in real terms so far this millennium.
Stoking doubts about the long-term prospect of stocks, bond king Bill Gross recently declared that "the cult of equities is dying" and that investors must adapt to a "new normal" of meager growth and longer working lives. Gross writes in his latest newsletter that the "Siegel constant of 6.6% real appreciation" for the past century—after Wharton School finance professor Jeremy Siegel—"is an historical freak, a mutation likely never to be seen again as far as we mortals are concerned."
Why did 7 percent ever become the benchmark it has? Maybe because it happens to be about the rate at which an investment doubles in 10 years. (To be more precise, the actual rate is 7.177 percent.)
There's also the little matter of market history. Since 1926, the S&P 500 has produced an annualized total return (including capital gains and reinvested dividends) of 6.6 percent, after inflation. Those 86 years include the 1929-32 free-fall (when the Dow lost about 90 percent), the years just before World War II (when it fell by half), and the doldrums of 1966-81, when stocks were essentially flat.
You're thinking the 20th Century was some sort of aberration? Maybe, but Dr. Siegel, in his widely read book Stocks for the Long Run, finds similar returns for the past two centuries—a compounded, inflation-adjusted 6.8 percent, in fact, for the period 1801-2006. For that matter, according to Morningstar, there is no single rolling 20-year period going back to 1926 when the S&P did not produce a positive annualized return, net of inflation. It got pretty meager at times—0.84 percent for 1962-81—but the average 20-year return is 7.25 percent.
If stocks could generate 6.6 percent a year for over two centuries that included a couple of world wars, a U.S. civil war, a Great Depression, and too many financial panics to count, why would you expect lower returns in the future?
You shouldn't, says Mark Matson, founder and CEO of Cincinnati-based advisory firm Matson Money, which manages more than $3.2 billion. "I know they've taken a beating lately in the media, but equities are the greatest long-term wealth-creation tool on the planet," says Matson, noting that since the unpleasantness of 2008-09, stocks have more than doubled (for a real, annualized total return of about 19 percent on the S&P).
Matson says there's no reason to believe that, over the long term, 7-percent returns are less obtainable now than they've ever been. That's stocks across the board. You can expect to do even better, he says, in micro-caps and value stocks. (Matson is not saying you will do better, only that it's not an unreasonable expectation.)
Sure, the average investor is pessimistic after a long, grim chapter symbolized by AIG and Bernie Madoff. It can be hard to remember, but there's a reason financial professionals say that the most dangerous four words in investing are "this time is different"—that is, this time the market really won't come back (or won't stop rising). There have been lots of occasions over the decades when investors were arguably more justified than they are now in giving up on equities. Imagine how you'd have felt in the summer of 1932, when the major indexes had just posted a three-year annualized return of minus 46 percent.