Let's talk about Forrest. You can imagine him as your average next door neighbor. He finished school a few years ago and has been saving some money. He is seeing some of his friends are buying a condo/house, some are trading in stocks, some are investing in mutual funds on advice of their broker/bank.
Forrest, being a diligent one, wanted to do some research to decide what he should do with his savings. He listed down his options.
- Savings Account/Certificate of Deposit at a bank
- Bonds/Bills: These are issued by government and are considered a safe investment in most developed countries. Bonds are longer term (say 5-10 years) and Bills are shorter (say 3 months) term.
- Public Equities: This is a way to gain part ownership in an already running business. Investing in an S&P 500 Index gives one ownership to 500 biggest companies in the US.
- Commodities - Gold/Silver
- Real Estate - House
Comparing Bonds, Bills, Stocks and Gold
Forrest looked at historical returns of these instruments to learn if there is a clear winner.
Forrest came across the book "Stocks For The Long Run" by Jeremy Siegal which compares returns for Equities (S&P 500 Index), Bonds (US Treasury bonds), Bills (US Treasury Bills) & Gold over last 200 years. Here is what 1$ invested in 1800 in Stocks/Bonds/Bills/Gold grows to by 1997:
Source: Stocks For The Long Run, Jeremy Siegal
Though there would be occasional multi year periods when stocks won't perform well (apparent in the chart), it is very clear that over a long time horizon they provide the best vehicle to build wealth..
What about real estate?
Forrest also looked into real estate returns. He found a case study done by Case-Shiller which tracks inflation adjusted house prices over time. The study concluded that house prices over a very long time rise by just inflation i.e. about 2-3% over a long term. Add another 1-3% for rent income and the total return comes out to be ~4-5%, almost equivalent to returns in bonds.
The chart above shows that inflation adjusted housing prices have not changed over last 100 years, though there has been considerable volatility in the price throughout the period.
Lessons from History
In the chart from "Stocks For The Long Run" Forrest noted 2 things
- The investment in bonds and bills grows very steadily with less ups and downs whereas the investment in stocks, though growing faster, had a lot of waves (ups and downs) along the way.
- It is shocking! Over 200 years, $1 grows to ~$10k if invested in bonds and $7.5M if invested in equities. The book noted that Bonds had an average return of 4.75% over the period and stocks had a return of 8.2% over the period. But how can the end result between the two be so big, Forrest asks.
Understanding Compounding: the 8th wonder of the world
Einstein once said compounding is the 8th wonder of the world. It helped Forrest understand how $1 invested in Equities turned into millions whereas the same $1 invested in other instruments turned into a few thousands only.
Let's do some math: We use the formula Principal = Amount*(1+Rate)^Time
$1*(1+4.75%)^200 = $10,735
$1*(1+8.23%)^200 = $7,405,113
Forrest was amazed. A mere difference of ~3.5% (8.23%-4.75%) led to such a big difference over time.
He opened excel and did some math to understand this in detail. And Forrest knew he is not going to live 200 years to see his wealth grow for that long, so we wanted to see test it out on a applicable time frame (20/30/40 years). Here is a data table showing how much $100,000 will grow to after "Y" number of years if invested at "X" rate.
How about investing partly in Equities and partly in Bonds?
Forrest thought about this advice which was commonly given to him by his bank and friends sometimes. The table above shows that diluting the returns have a massive impact on the total wealth Forrest can build over time.
If Forrest invested 50%/50% in Stocks and Bonds, his expected return would be closer to 6% and he'll end up with $1.8M at the end of 50 years, whereas investing 100% in Stocks would give him closer to 8% return, which will amount to $4.7M in the same time period. For a long term investor like Forrest who doesn't need cash in the coming 3-5 years, it didn't make sense to invest even partly in bonds.
Conclusion: Forrest will invest 100% of this investable capital in Equities. A good starting point can be a low cost Equity ETF.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.