We have all heard that investing in the stock market has historically averaged a return of around 9-10% per year. But why?
In trying to answer this question, we need to examine several key components. In the long run, stock prices track with the earnings of the company. Let’s take a look at the last 20 years to see if that is accurate. During this period, we have seen crazy Bull Markets and manic Bear Markets.
The average dividend yield for the past 20 years has been 1.87%. Add the return of the index plus the dividends and your total return is 9.00%.
Okay, history is fine and dandy, but we are investing for the future. Everything we see on the news is telling us that the economy is growing between 2-3% per year. How can earnings be growing at 7+% when the economy is growing so much less?
The answer lies in operational leverage. Companies have fixed costs (plants, equipment, salaries, buildings, etc.) and variable costs (commissions, materials, etc.) to produce their goods and services. Assuming the company is profitable, they have already covered their fixed costs, so any additional sales, less the variable costs, flow directly to the bottom line.
Let’s say you have a company that has $100 in revenue. They have $40 in fixed costs and $40 in variable costs. In this scenario, their earnings would be $20. If the company sells $2.50 more this year, then the costs on the additional sales would be $0 in fixed costs and $1.00 in variable costs. The earnings on the additional sales would be $1.50 for a total earnings of $21.50. So, their sales increased by 2.5% but their earnings increased by 7.5%!
The average GDP growth rate for the past 20 years has been 2.58%.
Another key component to the success of the stock market is that it is a compounding machine. When you own stock in a company, you are a part-owner in that company. As such, you get a piece of the earnings of the company. Management of the company decides how much of the earnings they are going to distribute to you in the form of dividends and how much they are going to reinvest back into the company (Build new plants, hire new people, buy better equipment, etc.). They reinvest back into the company so they can make you more future earnings.
In our above example, if the company makes $20 in earnings this year and increases its earnings on average 7.2% per year, then in 10 years the earnings will have doubled to $40. Another 10 years the earnings will be $80! Since the stock price tracks with the earnings, the value of your investment will be in the area of 4 times your original investment!
The S&P 500 Index is up almost 4 times its value from 20 years ago!
I realize that during the past 20 years, the market has had violent mood swings and there will be periods of time when prices are out of whack to the value of the earnings the companies produce. Short term volatility will be another discussion. Over time (LONG periods such as 10-15 years), prices will track the earnings.
As long as America remains entrepreneurial and innovative, this compounding machine will continue to be the place to invest for the long term.