All good things, except IP owned by Disney, must come to an end. Which brings us to our Why Do We Own Stocks series. In Part 1 we reviewed the history of investing instruments, starting with lending in ancient Mesopotamia, government bonds in Venice, and finally, the first publicly traded company with the Dutch East India Company.

In Part 2 we took another trip in our time machine to cover the history of retirement planning. Starting in the 19th Century, people began living longer than they physically could or wanted to work. Pension plans were one way people met the gap between retirement and their expiration date, but pensions have been largely replaced with company 401Ks and other investment accounts. Now that investors are responsible for their retirement planning, what should they be investing in?

The Time Value of Money

Our first step on this journey is minding the gap between where we are and where we want to be. When planning for retirement, you want the value of your investment portfolio and future contributions to meet the future value of your cash flow needs. In fact, you want a surplus of your future needs to protect yourself from unexpected events ranging from illness to retiring and drawing from your portfolio during a market downturn.

To keep things simple though, let’s say we know exactly how much money you need from retirement until death, and it totals to $2,000,000. You have 30 years until retirement and no savings. Let’s plug those variables into our future value formula.

The next step is determining the Rate of Return we want to use. Our rate of return will help us figure out how much we need to contribute each year to get to our $2,000,000 future value. We’ll use the historical returns for US stocks and bonds which are 10% and 4% respectively.

As you can see in our example, the dollar amount needed to achieve a portfolio value of $2,000,000 over 30 years is $23,502 less annually when we use stock market returns compared to bond returns. Which is drastically different. We should all prefer to hit our objectives with the most efficient method. I for one, prefer to use less money to achieve the same goal. But why do stocks generate a higher return?

Risk and Reward

The reason stocks generate higher returns than bonds is straightforward. If you recall, bonds are effectively a loan. During a new bond issue, you can buy a $1,000 bond. Then the government or company that issued the bond takes that $1,000 and uses it for something productive, and in return they pay you interest for however many years and the $1,000 back at the bond’s maturity date. Since the interest you receive, the bond’s duration, and the amount you get back is known beforehand, bonds are considered “safe” depending on the issuer.

US government treasuries are considered the safest investment on the planet and therefore serve as the risk-free rate in any investment analysis. Risk-free rate is a technical way of saying the expected rate of return assuming zero risk. Companies and governments are rated for credit quality based on their financial situation. Much like a credit score. If they have a low rating, they need to pay higher interest rates than US government treasuries to reflect the risk an investor has of not getting their money back.

Stocks are a different story. Instead of an IOU like bonds, stocks represent ownership in a company which has an unknown future value. We hope the company’s value goes up but that doesn’t always happen. Companies go out of business, decline, or have lost decades. A “lost decade” example would be Microsoft. Even with a great company you can overpay and have years of unrealized value. Because of this uncertainty, investors demand a higher expected return for stocks than bonds.

Individual Stocks Can be Scary, Diversification is Not.

Individual companies can fail or fall from grace. No one is talking about the original Chewy, Pets.com, and I’d be surprised if GE ever reaches its all-time highs in my lifetime. Dominance, competence, fair value, and even survival is never guaranteed.

To get around this risk we turn to diversification. Diversification or “never put all your eggs in one basket,” has been part of human psychology since the dawn of time, but the math nerds didn’t get ahold of it for stock market analysis until the 1950s. Harry Markowitz would gain fame for studying how you can reduce individual company risk in an investment portfolio. Markowitz noticed that the prices of different companies moved differently day to day compared to other companies. By owning enough companies that moved at different variations, one could reduce or eliminate the risk of an individual company’s poor performance harming the entire portfolio.

This would shortly lead to the idea of Beta or how much a company or group of companies move compared to the entire market. A Beta of 1 means the portfolio moves alongside the market. A 10% rise in the market means a 10% rise in the portfolio. A Beta of 1.1 translates to a 10% rise in the market leading to an 11% rise in the portfolio or a 10% decline in the market leading to an 11% decline in the portfolio.

Eventually investors realized that consistently beating the market is a task most fund managers were and still are, incapable of doing, so indexing, which is owning a mutual fund or ETF that tries to match the S&P 500, 1500 or some other index, was developed.

This means if you own a diversified portfolio of stocks, mutual funds or ETFs, you can tune out a lot of the noise in the financial media. Earnings season doesn’t matter because you have little exposure to any one company. Even the ebbs and flow of the economy matter little if you are an investor for the long-run. We only need to care whether the population is growing, productivity is increasing, and people are still demanding goods/services. I don’t see that changing any time this century. A diversified portfolio should eliminate individual company risk and provide an investor with the peace of mind that they can beat the returns of bonds and grow their investments over time.

All that said, bonds can still have a place in an investment portfolio, but the amount in the portfolio should be determined by how soon one needs to take money out of the portfolio and not simply the safety factor of bonds. A young investor with 30-40 years until retirement may be invested 100% in stocks as they have a long runway until retirement for the market to recover. Then as they get closer to retirement their allocation may shift to a more conservative portfolio with a mix of stocks and bonds that meet their plan’s objectives.

So, Why Do We Own Stocks?

For the past 150 years we have been blessed with increasing lifespans but not increasing health spans. While traditional savings, family help, pensions, and government programs could cover the gap from retirement at 65 to death at 70, they are inadequate for the task of supporting someone from 65 to 90.

Therefore, new tools, the tax advantaged accounts (401Ks, IRAs, and Roths), were developed to allow investors to harness the power of a 500-year-old invention: publicly traded companies. The returns generated by investing in stocks (publicly traded companies) allow us to have a tolerable savings rate throughout our lives compared to the savings rate needed if we only invested in bonds.

Then, to mitigate the inherent risk of stocks, portfolio diversification and indexing were developed to capture the return premium of stocks over bonds while reducing the likelihood of an investor suffering a permanent loss from the failing of any single company. The development of these tools and ideas was not straightforward, but they serve as the greatest generators of wealth and prosperity the world has ever seen.