The exact number depends on the historical time period. The reason that stocks have historically returned approximately 6% over inflation (around 10% including dividends) is as follows (in the roughest of rounded numbers):

4% Inflation
3% Productivity Growth
3% Dividend Yield

The reason stocks should always grow more than inflation is because companies deliver efficiencies and productivity growth every year, on average. That gives you a few percent above inflation. So capital appreciation tends to reflect that earning power, and you get a yield a few percent above inflation. In addition, stocks pay out portions of their cash flows as dividends, so that adds to your yield as well.

A lot of people believe that because inflation is low now historically, and stocks pay out lower dividends on average, that the long term return on stocks going forward will be lower.

The number of studies on the long term returns of stocks are too numerous to count. You can debate the future performance of stocks, but not the past at this point. The returns differ depending on what time period you look at.

The whole point of my article above is that you should not be looking at individual stocks as a representative of the asset class. You don’t want to have your retirement portfolio in SGI. You want to have a diversified portfolio of common stocks. If you own the Vanguard Total Market index, you will have a small piece of every publicly traded company.

Adam

Can it be the study is only based on surviving companies or some other pre-conditions? What if they included every companies that ever IPOed. Would that number still be 9%?

Your strategy isn’t actually dissimilar from what a lot of index funds do. The way that funds can “double” the return of an index is by using derivatives, like futures contracts, to exaggerate moves in the index. Usually, even normal index funds do this a little because they have to maintain a certain amount of cash on hand to deal with new contributions or withdrawals. This would be a drag on their returns, so the use futures to close the gap.

My guess is, however, that the actually risk profile of the fund with double the market return is actually slightly higher than 2.0. Derivatives have a “risk-free return” built into them, similar to your cash return, so there is no free lunch. Your portfolio mix will likely return a bit more than the market on the upside and lose a bit more than the market on the downside, because my guess is that the risk averages to more than 1.0.

In addition, the expense ratio on your double-return fund is likely quite a bit higher than a normal index fun, which can be as low as 7 basis points these days.

Still, your strategy has a lot of merit in terms of providing more liquidity in your portfolio. By maintaining half the portfolio in cash, if you are regularly rebalancing, it will have the effect of buying more when the market is down.

I think if you use your mix in my example above, it will turn out even better because the Year 2 gain for stocks will be doubled for the 50% you have in that fund.

It’s worth thinking about – I wrote this article really as a basic 101 on asset allocation, so concepts like “enhanced” index funds and derivatives aren’t included.

I’m impressed you read through the whole thing!

Adam

What about using leverage in a typical portfolio? Or perhaps using it creatively?

For example, I’m trying out an investment strategy now where for my Large Cap allocation, I put 50% in an ETF designed to do 2x the performance of the S&P 500. I then put 50% in the maximum yield money market at Schwab (5%).

The result? Theoretically, my large cap allocation now has a Beta of ~1.0 since its 50% risk-free (Beta = 0) and 50% at 2x the market (Beta = 2). [Practically, of course, this theoretical result is never reached because the ETF doesn't always perform as desired -- it also tries to match daily moves in the S&P 500 rather then aggregate performance. I'm trying this out now to see what difference this makes, I suspect I can also dynamically reallocate to adjust to underperformance. ]

In either case, assuming you buy the Beta = 1.0 argument, my returns are always guaranteed to be above the S&P 500 — since, the ETF returns 2x for 50% of the money for a return equivalent to a 100% investment in the S&P500. Menawhile, the money market returns an additional 5% for 50% of the money, so 2.5% over the whole portfolio.

Subtracting fees/commissions (1%), that’s 1.5% over the S&P 500 every year — a pretty good large cap strategy ….