Despite this excellent long-run record, stock returns are not inde-
pendent of the level of earnings. In Chapter 7 we learned that the long-
term real return on the stock market is approximated by the earnings
yield, which is the inverse of the price-to-earnings (or P-E) ratio. A 6.8
percent return is consistent with a market that sells at about 15 times es-
timated earnings.
But there is no reason why a 15 P-E ratio will always be the “right”
ratio for stock prices. Chapter 8 maintains that there are good economic
reasons why the stock market may rise to a higher P-E ratio in the future.
The decrease in transactions costs, the ability to diversify internationally,
and the greater stability of the macroeconomy may cause investors to
bid the price of stocks higher and may lead to a higher justified level of
prices, perhaps at 20 times earnings. If stocks do reach and stay at that
level, forward-looking real returns will decline to the lower earnings
yield of 5 percent per year after inflation, a return that is still consider-
ably above the yields available on bonds.- Stock returns are much more stable in the long run than in the short
run. Over time stocks, in contrast to bonds, compensate investors for
higher inflation. Therefore, as an investor’s horizon becomes longer, a
larger fraction of one’s assets should be in equities.
The percentage of your portfolio that you should hold in equities
depends on individual circumstances. But based on historical data, an
investor with a long-term horizon should keep an overwhelming por-
tion of his or her financial assets in equities. Chapter 2 showed that over
holding periods of 20 years or longer, stocks have both a higher return
and lower risk than standard corporate or government bonds.
The only long-term risk-free assets are Treasury inflation-protected
securities, or TIPS. In recent years the real yield on these bonds has ranged
between 2 and 3 percent, which is about 4 percentage points a year below
the historical returns on stocks. The difference between the returns on
stocks and the returns on bonds is called the equity premium, and histor-
ically it has favored stocks in all countries where data are available. - Invest the largest percentage of your stock portfolio in low-cost stock
index funds that span a global portfolio.
Chapter 20 showed that the broad-based indexes, such as the
Wilshire 5000 and the S&P 500 Index, have outperformed nearly two out
of three mutual funds since 1971. By matching the market year after
year, an indexed investor is likely to be near the top of the pack when the
long-term returns are tallied.
CHAPTER 21 Structuring a Portfolio for Long-Term Growth 361