In this book the author considers mutual funds and ETFs synonymous because they are both collections of many different stocks. When I refer to stocks I always mean ETFs or mutual funds and never individual stocks.
Stocks represent ownership in companies. It is not an abstract concept. If you own one share of Disney common stock, you own a part of Disney itself. We all know that in this country real wealth is created by business ownership. That is how capitalism should work and in the United States we see it in action. Business ownership is the key to lasting wealth.
“Owner of vs. lender to”
If you start a business you may take out a loan. Similarly, you will likely take out a loan to buy your house. For this argument we will consider the entrepreneur and homebuyer as the same, “one who borrows”.
On the other side of the transaction is the lender.
The entrepreneur takes on much more risk than the lender. If the entrepreneur fails she could lose the entire business and all of her assets. Meanwhile the lender, who has secured collateral, only takes the risk that the collateral won't be enough to cover the debt.
the lender also has no chance to share in the upside if the business is very successful. For the lender, the reality is less risk and less reward.
Using the example of purchasing a home we can see that the home buyer takes out a mortgage and also takes on the risk of housing market undulations and maintenance costs. Appropriately, the home buyer receives all of the home appreciation. The lender simply gets his principal back and a fixed rate of interest. Again, less risk and less reward.
Applying this understanding to stocks we must now consider just how much more risk we will take (vs. bonds) and for how much more return.
It is impossible to know the future and certainty does not exist.
This investing theory will use historical data, of which there is nearly a hundred years of, and that allows us 'reasonable probability' when we look to the future.
Before I tell you the compound annual rate of return of stocks and bonds since 1926 I'll list many of the global crises that the markets have weathered. This should demonstrate the extreme resilience of the public markets and put in perspective the Covid-19 pandemic.
Beginning in the late 1920s...
The greatest stock market bubble followed by the biggest crash in history, The Great Depression, World War II, communism, the threat of nuclear war, The Korean War, The Vietnam War, the assassination of JFK and Martin Luther King. Then RFK and the violence associated with the fight for civil rights. The Oil crisis of the 1970s, stagflation followed by high inflation, Russia invaded Afghanistan, American diplomats held hostage in Iran during a revolution there, the fall of communism, the bursting of the dotcom bubble, 9/11, wars in Iraq and Afghanistan, the subprime mortgage crisis and the near-collapse of the world financial system.
During all these ups and downs large cap stocks returned 10% annualized while government bonds returned between 5-6% annualized.
Therefore, owning stocks returned nearly double that of bonds during a sample size of a hundred years. This time horizon is long and the events above demonstrate that during our historical sample there were many significant crises which occurred.
It is my opinion that the factual evidence of the past allows me to theorize, with reasonable probability, that average annualized returns will not be significantly affected by the current Coronavirus pandemic when considered as part of a long-term time sample. (Long-term time horizons are generally considered 10 years or longer for investing purposes)
I've quoted you annualized returns which do not take into account inflation and we now must do that. During our 100 year time sample inflation averaged 3% per year so we will subtract 3% from our returns. Therefore, large cap stocks have returned 7% annualized and bonds about 3% annualized. When you take into account inflation, the return you are left with is called the real return, and it's the only type of return that matters.
Now note the business (stock) owner got paid more than twice as much as the lender (bond holder) every year when considered in average annualized terms. If you compound this increase over many years the amounts are astounding.
Therefore bonds do not build long-term wealth. (We'll talk about some of their key functions later. Remember building wealth is not one of them.)
Put another way "...bonds have historically had virtually no net return at all after inflation and taxes."
And the author puts it best when he says:
"The (bondholder) set the world endurance record for treading water."
Hopefully you can accept now that business owners/stockholders do better than those who lend to businesses/bondholders. This is because the stockholder takes on more risk than the bondholder.
In the next article we will discuss understanding risk.