Let Markets Work for You

The financial markets have rewarded long-term investors. People expect a positive return on the capital they supply, and historically, the equity and bond markets have provided growth of wealth that has more than offset inflation.

Most people look to the financial markets as their main investment avenue—and the good news is that the capital markets have rewarded long-term investors. The markets represent capitalism at work in the economy—and historically, free markets have provided a long-term return that has offset inflation.

This is documented in the growth of wealth graph above, which shows monthly performance of various indices and inflation since 1926. These indices represent different areas of the US financial markets, such as stocks and bonds. The data illustrates the beneficial role of stocks in creating real wealth over time. T-bills have barely covered inflation, while longer-term bonds have provided higher returns over inflation. US stock returns have far exceeded inflation and significantly outperformed bonds.

Another key point is that not all stocks or bonds are the same. For example, consider the performance of US small cap stocks vs. US large cap stocks over this time period. A dollar invested in small cap stocks in 1926 would be worth considerably more today than a dollar invested in large cap stocks.

Keep in mind that there is risk and uncertainty in the markets. Historical results may not be repeated in the future. Nevertheless, the market is constantly pricing securities to reflect a positive expected return going forward. Otherwise, people would not invest their capital.

Confidence that liquid markets price securities fairly has important implications for investors. If current market prices offer the best estimate of real value, investors should regard stock mispricing as a rare and temporary condition. Equally essential, they should avoid spending time and effort trying to identify and exploit mispricing that might occur as prices seek equilibrium.

If professionals with vast resources cannot apply research and analysis to pick winning stocks, it is even less likely that individuals can outperform the market. The futility of speculation is good news for the investor. It means that prices for public securities are fair and that differences in expected returns are explained by differences in expected risk. It is certainly possible to outperform markets, but not without accepting increased risk.

Investors who believe that markets are fair choose a different path to building wealth. Rather than trying to outguess the capital markets, they let the markets work for them by continuously and efficiently targeting the dimensions of higher expected returns.