Are Stocks the Best Long Term Investment?

It has often been suggested that investments in the stock market are better than any other investments over the long term. During the stock market mania of the late 1990's, this was the mantra that was repeated over and over in order to sell mutual funds to inexperienced investors. But is it true? Are shares in publicly listed companies better than any other type of investment in the long run? And if so, what exactly is the long run?

Many economists certainly seem to believe in the stock market. They are able to show statistics that support their case and have developed elaborate theories that seem to prove the point. This hasn't always been the case. In the early eighties, for example, the same theories that are now used to support the stock market, were used by economists to support the case that commodities would produce the same long term yield as common stocks. And based on historical price statistics, that certainly seemed to be the case. We all know what has happened with commodity prices since then.

So what are the economists' arguments? Basically, there are two different arguments - one theoretical and one statistical. The theoretical argument is usually some variation of a capital market model, usually the famous CAPM model. Although, CAPM is a very elegant model, it is in our opinion not applicable to real capital markets. The assumptions underlying the model are simply not correct. The CAPM model will be discussed more in depth in another essay at this site. We will not reprise it here. Suffice it to say that CAPM was the model that was used to suggest investors should buy commodities in the early eighties.

At first sight, the statistical argument is much more convincing. When looking back at historical stock market returns over any extended period it seems that the stock market returns are much higher than returns from any other investment. Admittedly, the long term has been long, and in some cases way exceeding a life time. Nevertheless, stock market investments seem to have been very profitable. There are several fundamental flaws in this line of reasoning, however. These will be discussed below.

The first flaw is a mathematical error made by those using past performance to predict the future. When using all of the statistical cook-book methods, a fundamental assumption is that the data points used as input to the method are chosen at random from the set of data points which you study. What does this mean? In a typical study, the set of data points are all daily stock market returns of the past as well as the future. A random selection would include future as well as historical returns. Of course, past returns we know, but we can't possible know what future returns will be. Essentially, you can't use the statistical cook-book methods to say anything about the future using historical data.

Other mathematical errors are often made by economists as well, including assumptions that daily returns are independent, or equally distributed or that they have finite variance. These assumptions may or may not be true, but they can't be made without justification simply because they make calculations easier. Using statistics like this is not science, but more like alchemy. I won't discuss these issues further, as they have been extensively discussed elsewhere.

There is another fundamental flaw in the statistical argument that is rarely discussed. When studying the historical price data it is common to concentrate only on the best performing stock markets. For example, long term studies using price data from the Russian stock market are never done. After the communist revolution, the Russian stock market effectively went to zero. In fact almost all of the world's stock markets have underperformed the US market in the last century or so. Today, it seems natural to study the US stock market, but for an 19th century investor, some of the most interesting growth regions of the world were Russia and South America. The United States were a poorly developed country plagued by civil war.

Using hindsight when selecting markets to study is usually not an intentional error. It is natural for economists to study the stock markets in their own country, and most economists work in the economically successful countries. Many of the less fortunate countries of the world don't even have a stock market to study anymore. There is a natural tendency to ignore the markets that have failed.

When looking at historical stock market returns, it makes sense to think about why returns have been as high as they have. In the really long term, stock investments can't grow faster than the profits of the companies invested in. Over the long run, profits tend to be relatively stable as a fraction of revenue, and in any case, the profit level will always be bounded by the total revenue of the company. This means that in the long term, profits can't consistently grow faster than revenue. What we have seen in the last century, however, is that stock prices have increased much faster than revenues and profits. This is something that can't continue. Maybe the current PE ratios are more correct than those of the 19th century - maybe they are not. But the trend of higher PE ratios cannot continue indefinitely. The fact is that higher valuations have contributed a lot to the over-performance of the stock markets of the last century. This is clearly unsustainable.

There are other factors that have also been beneficial to the stock market over the last century or so. These include a higher pace of invention and faster growth than at any other time in history. They also include the fact that the world has become a much more safe, stable and peaceful place to live. Wars used to be much more common than they are today. Maybe this development is sustainable - maybe it isn't.

While conditions have been favorable for stocks in the last century, they have been most unfavorable for alternative investments - particularly for bonds. This has to do with the advent of central banking and fiat money. Since the inception of the Federal Reserve system in the United States, the dollar has lost 95 percent of its purchasing power. Before the 20th century, the British pound had a fixed value in relation to silver and later to gold for hundreds of years (with a few brief interruptions). Although the purchasing power of the pound varied with the price of precious metals, over the long term, the purchasing power remained fairly constant until the time of devaluations and easy money in the 20th century. Since then, the pound has lost most of its former value.

While inflation has been rampant, interest rates have been kept artificially low. The policy of the 20th century has been the stimulation of demand, where-as the policies of earlier periods have been to stimulate production. The demand policy has resulted in growth, but at the cost of rapidly rising debt levels.

Some of the greatest fortunes in history have been made by investments in debt instruments. In the 20th century, great fortunes have been lost in bonds. The last one hundred years are clearly not representative of previous time periods. It seems likely that they will not be representative of the future either.

In my opinion, most of the arguments are supposed to prove that the stock market provide superior returns can be easily dismissed. They simply don't hold up to scrutiny. That doesn't necessarily mean that the conclusion is wrong, though. Maybe the stock market does produce superior results. Most investors certainly believe so - or rather, they are convinced that it does. The stock market has a tendency to discount what most investors believe, though. If the stock market believes that the companies in a broad, market weighted stock market index grow faster than interest on a risk free investment, then maybe that ought to have been discounted in the price of the stock market index.

Do we have an answer to our questions? Sadly, no. While there is no evidence that the stock market has superior returns, there is also no conclusive evidence it does not. My personal belief is that there is no simple way to make money in capital markets. Just putting all your money in a mutual fund is no safe way to get rich, even in the long run. If it were that easy, we would all do it, and soon enough, no-one would have to work anymore. Investing in shares of stock at the right price will always be a way to make money, but I believe that the price relative to fundamentals is a critical determinant of success or failure in stocks, just as in any other investment. While stock markets have had an amazing run for the last century and a half, that is certainly no guarantee that they will in the future.