Investing For Dummies - Eric Tyson

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returns

      When you buy a bond, you lend your money to the issuer of that bond (borrower), which is generally a government or a corporation, for a specific period of time. When you buy a bond, you expect to earn a higher yield than you can with a money market or savings account. You’re taking more risk, after all. Companies can and do go bankrupt, in which case you may lose some or all of your investment.

      Generally, you can expect to earn a higher yield when you buy bonds that

       Are issued for a longer term: The bond issuer is tying up your money at a fixed rate for a longer period of time.

       Have lower credit quality: The bond issuer may not be able to repay the principal.

      Note that although the rate of inflation has increased since the Great Depression, bond returns haven’t increased over the decades. Long-term bonds maintained slightly higher returns in recent years than short-term bonds. The bottom line: Bond investors typically earn about 4 to 5 percent per year.

Bar chart depicting the historical performance of bonds and stocks back in 1802; inflation has eroded bond returns more in recent decades.

      © John Wiley & Sons, Inc.

      FIGURE 2-4: A historical view of bond performance: Inflation has eroded bond returns more in recent decades.

      Stock returns

      Investors expect a fair return on their stock investments. If one investment doesn’t offer a seemingly high enough potential rate of return, investors can choose to move their money into other investments that they believe will perform better. Instead of buying a diversified basket of stocks and holding, some investors frequently buy and sell, hoping to cash in on the latest hot investment. This tactic seldom works in the long run.

      

Unfortunately, some of these investors use a rearview mirror when they purchase their stocks, chasing after investments that have recently performed strongly on the assumption (and the hope) that those investments will continue to earn good returns. But chasing after the strongest performing investments can be dangerous if you catch the stock at its peak, ready to begin a downward spiral. You may have heard that the goal of investing is to buy low and sell high. Chasing high-flying investments can lead you to buy high, with the prospect of having to sell low if the stock runs out of steam. Even though stocks as a whole have proved to be a good long-term investment, picking individual stocks is a risky endeavor. See Chapters 5 and 6 for my advice on making sound stock investment decisions.

      

A tremendous amount of data exists regarding stock market returns. In fact, in the U.S. markets, data going back more than two centuries document the fact that stocks have been a terrific long-term investment. The long-term returns from stocks that investors have enjoyed, and continue to enjoy, have been remarkably constant from one generation to the next.

Bar chart depicting how the U.S. stock market returns have consistently and substantially beaten the rate of inflation over the years from 1802-1870, 1871-1925, and since 1926.

      © John Wiley & Sons, Inc.

      FIGURE 2-5: History shows that stocks have been a consistent long-term winner.

      In addition to enabling U.S. investors to diversify, investing overseas has proved to be profitable. The investment banking firm Morgan Stanley tracks the performance of stocks in both economically established countries and so-called emerging economies. As the name suggests, countries with emerging economies (for example, Brazil, China, India, Malaysia, Mexico, Russia, and Taiwan) are “behind” economically but show high growth and progress rates.

      Stocks are the best long-term performers, but they have more volatility than bonds and Treasury bills. A balanced portfolio gets you most of the long-term returns of stocks without much of the volatility.

Pie chart presenting the total value of stocks worldwide: Emerging markets 9%; Unitted States 52%; Europe 20%; Japan, Australia, and Far East 19%.

      © John Wiley & Sons, Inc.

      Real estate returns

      

Over the years, real estate has proved to be about as lucrative as investing in the stock market. Whenever the U.S. has a real estate downturn, folks question this historic fact (see Chapter 11 for details). However, just as stock prices have down periods, so, too, do real estate markets.

      The fact that real estate offers solid long-term returns makes sense because growth in the economy, in jobs, and in population ultimately fuels the demand for real estate.

      Consider what has happened to the U.S. population over the past two centuries. In 1800, a mere 5 million people lived within U.S. borders. In 1900, that figure grew to 76.1 million, and today, it’s more than 330 million. All these people need places to live, and as long as jobs exist, the income from jobs largely fuels the demand for housing.

      Businesses and people have an understandable tendency to cluster in major cities and suburban towns. Although some people commute, most people and businesses locate near major highways, airports, and so on. Thus, real estate prices in and near major metropolises and suburbs generally appreciate the most. Consider the areas of the world that have some of the most expensive real estate prices: Singapore, Hong Kong, Vancouver, San Francisco, Los Angeles, New York, and Boston. What these areas have in common are lots of businesses and people and limited land.

      ARE SMALLER-COMPANY STOCK RETURNS HIGHER?

      Stocks are generally classified by the size of the company. Small-company

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