Volatility in the stock market has increased. Recently we actually hit some down days of -3.6% and -4% in the stock market. That shakes people up. But remember why you bought stocks.
The basic axiom of investing in the stock market is that you deliberately looked for an asset class that was volatile. After all, if you don't own an asset class that's going to be volatile, why are you entitled to 10% long-term total return in the stock market? You're not.
The equity risk premium, a concept in modern financial theory illustrated here, quantifies the premium stocks annually averaged in the 20 years ended June 30, 2022. Stocks, as measured by the Standard & Poor’s 500, averaged a +9.1% annual return in the 20 years -- nearly seven times the +1.2% annual return on the risk-free 90-day U.S Treasury Bill.
Backed by the full faith and credit of the U.S. Government, T-Bills are considered a riskless investment. In contrast, the value of the S&P 500 index is subject to ups and downs, and, in theory, if all 500 of blue-chip companies in the S&P 500 index go bust, your entire investment could be lost.
Subtracting the return on T- Bills from the return on stocks, the resulting +7.9% is the premium paid for taking the risk of owning U.S. stocks over the 20years.
To be clear, investing in America’s 500 largest publicly-held companies earned an average of +7.9% more annually than a risk-free investment in the past 20 years.
This 20-year period encompassed four frightening bear markets -- the tech crash of 2002, the financial crisis of 2008, the Covid downturn of early 2020 and the current bear market.
Past performance is no guarantee of your future results and that, paradoxically, is precisely why investors are paid a premium for owning stocks. Yes, stocks are risky and past performance is no guarantee of your future results! Be glad for it!
It is precisely why stocks have returned 7.9% more annually than U.S. Government-guaranteed investments through four bear markets and financial crises of the past 20 years.
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