Stocks may seem risky in the short term, but they are less volatile over the long run than many people think. In fact, stocks share some characteristics with bonds, which makes them more predictable. When stock prices—or valuations—fall, future expected returns rise, much like how bond yields increase when prices drop.
Since the market bottomed in October 2023, major indices like the S&P 500 have surged over 40%, with markets in Europe, Japan, and Canada seeing similar gains. Fears of persistent inflation and high interest rates dragging down stocks have eased. Central banks have started cutting rates just as corporate profits rise, pushing many stock markets near record highs.
High Valuations and Investor Concerns
Despite this upward momentum, investors are now wondering if the good times are coming to an end. Stock prices relative to underlying profits are high, historically a sign of potential downturns. The market is also heavily concentrated, with just 10 companies making up over a third of the S&P 500’s value. Additionally, rising bond yields and increasing volatility add to the unease. Though a crash would need a trigger, various factors are already aligning to cause concern.
However, there’s a silver lining to a potential crash: it may not be as devastating as it seems. Decades of financial research show that over time, the impact of falling stock prices is less severe. Like bonds, when stock valuations drop, future returns tend to improve.
Lessons from Bonds
To understand how this works, think of bonds. In 2022, as interest rates rose, bond yields followed suit. To align older, low-interest bonds with new ones offering higher rates, their prices plummeted. This caused a significant drop in bond prices, but unless investors sold their bonds, their long-term returns remained unchanged. They would still receive all the interest payments and the principal repayment at maturity.
Though stocks don’t offer a guaranteed principal repayment like bonds, a comprehensive study in 2011 found that the ratio of profits to share prices (similar to bond yields) predicts expected stock returns, not future earnings. Even when share prices fall, investors can expect higher future returns, just like bondholders do with higher yields after prices drop.
A Crash May Benefit Younger Investors
For long-term investors, particularly younger ones, a market crash can actually be advantageous. High stock valuations have reduced the future returns that savers can expect. For example, analysts at Goldman Sachs predict that nominal returns for the S&P 500 over the next decade will be around 3%, compared to the historical average of 11%. A crash could reset prices, allowing younger investors to buy in at lower valuations, potentially improving their chances of strong returns over time.
Investing for the Long Term Reduces Risk
While short-term investors may panic during a crash, those holding stocks for the long term, such as through a retirement fund, face less risk than they may realize. Many investors imagine stock returns as a series of random outcomes, like tossing a coin. In that scenario, a bad streak doesn’t change the odds of future results. However, the reality of the stock market is different. A series of bad years makes it more likely that future returns will improve, similar to how a streak of losses in gambling can lead to a better outcome.
Although it’s hard to stay calm when stock prices are falling, long-term investors should remember that falling prices often present a buying opportunity. In the long run, those who stay the course are often rewarded with higher expected returns.
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