Where Do Market Returns Come From?

The following excerpt is from our ebook “12 Principles of Intelligent Investors,” which you can download hereWhere Do Market Returns Come From?.

Want to get better at investing? Are you looking for simple, approachable ways to deepen your knowledge of the keys that create financial success? Using academic research and expert advice, this resource offers twelve principles for building wise, sustainable wealth.

Principle 7: Know the Basics About Market Returns

Now that we’ve seen the benefits of diversifying your portfolio to mitigate unnecessary risks, manage the ones you can’t avoid, and ride out market volatility, the next step is understanding how best to capture expected returns. To do this effectively, investors need a working knowledge of where those returns originate.

What Are Market Returns?

The answer is simple, if often overlooked. Investors provide the financial capital that makes all business enterprises possible, from the mom who buys the lemons for her second-grader’s lemonade stand, to shareholders of global companies. Market returns simply compensate investors for providing the capital.   

Investing is not just giving your money away; when you purchase a stock or bond, you generate capital for business or agencies. The big idea is that when they’ve achieved success, companies return your capital to you, plus some additional compensation.

Where Do Market Returns Come From?

Investor Returns

Let’s take a look at the relationship between company profits and investor returns. It might seem logical to assume a successful company should always pay out generous returns to its investors. In reality, however, an investor’s returns are affected by a number of factors – not just the company’s success. Investors shouldn’t necessarily expect to reap huge benefits simply by buying stock in a booming business. By the time a company is known to be successful, it will already have higher share prices and less room for growth.

Stocks and Bonds: The Facts About Market Returns

Investing in already-successful companies does not always guarantee higher returns, so let’s talk about what will improve your chances. Of the myriad of important factors,  market risk is one of the most potent. We talked earlier about the importance of diversifying away avoidable, concentrated risks, but investors who are willing to accept the market risks that remain after diversification can expect to be compensated for their higher risk tolerance.  

Stocks (equities) and bonds (fixed income) are two of the broadest market factors, and most investors start by deciding how much of their portfolio they’ll allocate to stocks and how much to bonds. It turns out those allocations matter significantly. Let’s take a closer look at stocks and bonds to find out why.

If you invest in a bond, you’re simply acting as lender. The business or agency that sold the bond borrows your capital and pays you interest. That interest is the return on your “loan.” With bonds, you do not acquire an ownership stake, but you are more likely to be paid back with any remaining capital in the event of bankruptcy or default.

Stocks are different. Purchasing a stock makes you a co-owner in the business and gives you the right to vote at shareholder meetings. Increased dividends or share prices are the source of your returns, and if the company goes bankrupt, you are near the end of the line of those waiting to be repaid.

Because of all this, stocks involve more risk. Investors might not get the returns they anticipated or lose their investment altogether. As a rule, however, stocks generally deliver better returns over the long term.

When stocks outperform bonds, it’s known as the “equity premium.” It’s not easy to predict exactly how much premium will be returned or how long it will take. Research on long-term stock-versus-bond performance demonstrates that stock returns eventually do pull ahead of bonds. This data also shows that stocks experience more ups and downs. Investors willing to tolerate exposure to risk are eventually rewarded with higher returns.  

Where Do Market Returns Come From?

In US dollars. Indices are not available for direct investment. Their performance does not reflect the expenses associated with the management of an actual portfolio. Past performance is no guarantee of future results. US Small Cap Index is the CRSP 6–10 Index; US Large Cap Index is the S&P 500 Index; Long-Term Government Bonds Index is 20-year US government bonds; Treasury Bills are One-Month US Treasury bills; Inflation is the Consumer Price Index. CRSP data provided by the Center for Research in Security Prices, The S&P data are provided by Standard & Poor’s Index Services Group. University of Chicago. Bonds, T-bills, and inflation data © Stocks, Bonds, Bills, and Inflation Yearbook™, Ibbotson Associates, Chicago (annually updated work by Roger G. Ibbotson and Rex A. Sinquefield).

The Bottom Line

Historic data links higher risk with better returns, but academic research also suggests other factors contribute to stronger outcomes. Next, we’ll look at these additional factors and examine why our evidence-based approach is so useful for navigating them.

Download the rest of the ebook “12 Principles of Intelligent Investors” by clicking here.

 

McLean Asset Management Corporation (MAMC) is a SEC registered investment adviser. The content of this publication reflects the views of McLean Asset Management Corporation (MAMC) and sources deemed by MAMC to be reliable. There are many different interpretations of investment statistics and many different ideas about how to best use them. Past performance is not indicative of future performance. The information provided is for educational purposes only and does not constitute an offer to sell or a solicitation of an offer to buy or sell securities. There are no warranties, expressed or implied, as to accuracy, completeness, or results obtained from any information on this presentation. Indexes are not available for direct investment. All investments involve risk.

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