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Principles of Finance

12.4 Historical Picture of Returns to Stocks

Principles of Finance12.4 Historical Picture of Returns to Stocks

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Table of contents
  1. Preface
  2. 1 Introduction to Finance
    1. Why It Matters
    2. 1.1 What Is Finance?
    3. 1.2 The Role of Finance in an Organization
    4. 1.3 Importance of Data and Technology
    5. 1.4 Careers in Finance
    6. 1.5 Markets and Participants
    7. 1.6 Microeconomic and Macroeconomic Matters
    8. 1.7 Financial Instruments
    9. 1.8 Concepts of Time and Value
    10. Summary
    11. Key Terms
    12. Multiple Choice
    13. Review Questions
    14. Video Activity
  3. 2 Corporate Structure and Governance
    1. Why It Matters
    2. 2.1 Business Structures
    3. 2.2 Relationship between Shareholders and Company Management
    4. 2.3 Role of the Board of Directors
    5. 2.4 Agency Issues: Shareholders and Corporate Boards
    6. 2.5 Interacting with Investors, Intermediaries, and Other Market Participants
    7. 2.6 Companies in Domestic and Global Markets
    8. Summary
    9. Key Terms
    10. CFA Institute
    11. Multiple Choice
    12. Review Questions
    13. Video Activity
  4. 3 Economic Foundations: Money and Rates
    1. Why It Matters
    2. 3.1 Microeconomics
    3. 3.2 Macroeconomics
    4. 3.3 Business Cycles and Economic Activity
    5. 3.4 Interest Rates
    6. 3.5 Foreign Exchange Rates
    7. 3.6 Sources and Characteristics of Economic Data
    8. Summary
    9. Key Terms
    10. CFA Institute
    11. Multiple Choice
    12. Review Questions
    13. Problems
    14. Video Activity
  5. 4 Accrual Accounting Process
    1. Why It Matters
    2. 4.1 Cash versus Accrual Accounting
    3. 4.2 Economic Basis for Accrual Accounting
    4. 4.3 How Does a Company Recognize a Sale and an Expense?
    5. 4.4 When Should a Company Capitalize or Expense an Item?
    6. 4.5 What Is “Profit” versus “Loss” for the Company?
    7. Summary
    8. Key Terms
    9. Multiple Choice
    10. Review Questions
    11. Problems
    12. Video Activity
  6. 5 Financial Statements
    1. Why It Matters
    2. 5.1 The Income Statement
    3. 5.2 The Balance Sheet
    4. 5.3 The Relationship between the Balance Sheet and the Income Statement
    5. 5.4 The Statement of Owner’s Equity
    6. 5.5 The Statement of Cash Flows
    7. 5.6 Operating Cash Flow and Free Cash Flow to the Firm (FCFF)
    8. 5.7 Common-Size Statements
    9. 5.8 Reporting Financial Activity
    10. Summary
    11. Key Terms
    12. CFA Institute
    13. Multiple Choice
    14. Review Questions
    15. Problems
    16. Video Activity
  7. 6 Measures of Financial Health
    1. Why It Matters
    2. 6.1 Ratios: Condensing Information into Smaller Pieces
    3. 6.2 Operating Efficiency Ratios
    4. 6.3 Liquidity Ratios
    5. 6.4 Solvency Ratios
    6. 6.5 Market Value Ratios
    7. 6.6 Profitability Ratios and the DuPont Method
    8. Summary
    9. Key Terms
    10. CFA Institute
    11. Multiple Choice
    12. Review Questions
    13. Problems
    14. Video Activity
  8. 7 Time Value of Money I: Single Payment Value
    1. Why It Matters
    2. 7.1 Now versus Later Concepts
    3. 7.2 Time Value of Money (TVM) Basics
    4. 7.3 Methods for Solving Time Value of Money Problems
    5. 7.4 Applications of TVM in Finance
    6. Summary
    7. Key Terms
    8. CFA Institute
    9. Multiple Choice
    10. Review Questions
    11. Problems
    12. Video Activity
  9. 8 Time Value of Money II: Equal Multiple Payments
    1. Why It Matters
    2. 8.1 Perpetuities
    3. 8.2 Annuities
    4. 8.3 Loan Amortization
    5. 8.4 Stated versus Effective Rates
    6. 8.5 Equal Payments with a Financial Calculator and Excel
    7. Summary
    8. Key Terms
    9. CFA Institute
    10. Multiple Choice
    11. Problems
    12. Video Activity
  10. 9 Time Value of Money III: Unequal Multiple Payment Values
    1. Why It Matters
    2. 9.1 Timing of Cash Flows
    3. 9.2 Unequal Payments Using a Financial Calculator or Microsoft Excel
    4. Summary
    5. Key Terms
    6. CFA Institute
    7. Multiple Choice
    8. Review Questions
    9. Problems
    10. Video Activity
  11. 10 Bonds and Bond Valuation
    1. Why It Matters
    2. 10.1 Characteristics of Bonds
    3. 10.2 Bond Valuation
    4. 10.3 Using the Yield Curve
    5. 10.4 Risks of Interest Rates and Default
    6. 10.5 Using Spreadsheets to Solve Bond Problems
    7. Summary
    8. Key Terms
    9. CFA Institute
    10. Multiple Choice
    11. Review Questions
    12. Problems
    13. Video Activity
  12. 11 Stocks and Stock Valuation
    1. Why It Matters
    2. 11.1 Multiple Approaches to Stock Valuation
    3. 11.2 Dividend Discount Models (DDMs)
    4. 11.3 Discounted Cash Flow (DCF) Model
    5. 11.4 Preferred Stock
    6. 11.5 Efficient Markets
    7. Summary
    8. Key Terms
    9. CFA Institute
    10. Multiple Choice
    11. Review Questions
    12. Problems
    13. Video Activity
  13. 12 Historical Performance of US Markets
    1. Why It Matters
    2. 12.1 Overview of US Financial Markets
    3. 12.2 Historical Picture of Inflation
    4. 12.3 Historical Picture of Returns to Bonds
    5. 12.4 Historical Picture of Returns to Stocks
    6. Summary
    7. Key Terms
    8. Multiple Choice
    9. Review Questions
    10. Video Activity
  14. 13 Statistical Analysis in Finance
    1. Why It Matters
    2. 13.1 Measures of Center
    3. 13.2 Measures of Spread
    4. 13.3 Measures of Position
    5. 13.4 Statistical Distributions
    6. 13.5 Probability Distributions
    7. 13.6 Data Visualization and Graphical Displays
    8. 13.7 The R Statistical Analysis Tool
    9. Summary
    10. Key Terms
    11. CFA Institute
    12. Multiple Choice
    13. Review Questions
    14. Problems
    15. Video Activity
  15. 14 Regression Analysis in Finance
    1. Why It Matters
    2. 14.1 Correlation Analysis
    3. 14.2 Linear Regression Analysis
    4. 14.3 Best-Fit Linear Model
    5. 14.4 Regression Applications in Finance
    6. 14.5 Predictions and Prediction Intervals
    7. 14.6 Use of R Statistical Analysis Tool for Regression Analysis
    8. Summary
    9. Key Terms
    10. Multiple Choice
    11. Review Questions
    12. Problems
    13. Video Activity
  16. 15 How to Think about Investing
    1. Why It Matters
    2. 15.1 Risk and Return to an Individual Asset
    3. 15.2 Risk and Return to Multiple Assets
    4. 15.3 The Capital Asset Pricing Model (CAPM)
    5. 15.4 Applications in Performance Measurement
    6. 15.5 Using Excel to Make Investment Decisions
    7. Summary
    8. Key Terms
    9. CFA Institute
    10. Multiple Choice
    11. Review Questions
    12. Problems
    13. Video Activity
  17. 16 How Companies Think about Investing
    1. Why It Matters
    2. 16.1 Payback Period Method
    3. 16.2 Net Present Value (NPV) Method
    4. 16.3 Internal Rate of Return (IRR) Method
    5. 16.4 Alternative Methods
    6. 16.5 Choosing between Projects
    7. 16.6 Using Excel to Make Company Investment Decisions
    8. Summary
    9. Key Terms
    10. CFA Institute
    11. Multiple Choice
    12. Review Questions
    13. Problems
    14. Video Activity
  18. 17 How Firms Raise Capital
    1. Why It Matters
    2. 17.1 The Concept of Capital Structure
    3. 17.2 The Costs of Debt and Equity Capital
    4. 17.3 Calculating the Weighted Average Cost of Capital
    5. 17.4 Capital Structure Choices
    6. 17.5 Optimal Capital Structure
    7. 17.6 Alternative Sources of Funds
    8. Summary
    9. Key Terms
    10. CFA Institute
    11. Multiple Choice
    12. Review Questions
    13. Problems
    14. Video Activity
  19. 18 Financial Forecasting
    1. Why It Matters
    2. 18.1 The Importance of Forecasting
    3. 18.2 Forecasting Sales
    4. 18.3 Pro Forma Financials
    5. 18.4 Generating the Complete Forecast
    6. 18.5 Forecasting Cash Flow and Assessing the Value of Growth
    7. 18.6 Using Excel to Create the Long-Term Forecast
    8. Summary
    9. Key Terms
    10. Multiple Choice
    11. Review Questions
    12. Problems
    13. Video Activity
  20. 19 The Importance of Trade Credit and Working Capital in Planning
    1. Why It Matters
    2. 19.1 What Is Working Capital?
    3. 19.2 What Is Trade Credit?
    4. 19.3 Cash Management
    5. 19.4 Receivables Management
    6. 19.5 Inventory Management
    7. 19.6 Using Excel to Create the Short-Term Plan
    8. Summary
    9. Key Terms
    10. Multiple Choice
    11. Review Questions
    12. Video Activity
  21. 20 Risk Management and the Financial Manager
    1. Why It Matters
    2. 20.1 The Importance of Risk Management
    3. 20.2 Commodity Price Risk
    4. 20.3 Exchange Rates and Risk
    5. 20.4 Interest Rate Risk
    6. Summary
    7. Key Terms
    8. CFA Institute
    9. Multiple Choice
    10. Review Questions
    11. Problems
    12. Video Activity
  22. Index

Learning Outcomes

By the end of this section, you will be able to:

  • Explain overall equity market behavior over various historical periods.
  • Explain different equity style and size behavior over various historical periods.
  • Extract various equity market performance results from plots and charts.

Using Graphs and Charts to Plot Equity Market Behavior Stock Size Considerations

The Dow Jones Industrial Average (DJIA), also known as the Dow 30) and the S&P 500 Index are the most frequently quoted stock market indices among scholars, businesses, and the public in general. Both indices track the change in value of a group of large capitalization stocks. The changes in the two indices are highly correlated.

It may be fair to question if either index is a good representation of the value of equity and the changes in value in the market because there are over 6,000 publicly traded companies listed on organized exchanges and thousands of additional companies that trade only over the counter. As of year-end 2020, the S&P 500 firms had a combined market capitalization of $33.4 trillion, about 66% of the estimated US equity market capitalization of $50.8 trillion.20 It is widely agreed that the performance of the S&P 500 is a good representation of the broader market and more specifically of large capitalization firms.

Figure 12.13 provides a visualization of how S&P 500 stock returns have stacked up since 1900. This figure makes it clear that equity returns roughly follow a bell curve, or normal distribution. Thus, we are able to measure risk with standard deviation. A lower standard deviation of returns suggests less uncertainty of returns and therefore less risk.

Capital market history demonstrates that the average return to stocks has significantly outperformed other financial security classes, such as government bonds, corporate bonds, or the money market. Table 12.4 provides the return and standard deviation of several US investment classes over the 40-year period 1981–2020. As you can see, stocks outperformed bonds, bills, and inflation. This has led many investment advisers to emphasize asset allocation first and individual security selection second. The intuition is that the decision to invest in stocks rather than bonds has a greater long-run payoff than the change in performance resulting from the selection of any individual or group of stocks.

Figure 12.14 demonstrates the growth of a $100 investment at the start of 1928. Note that the value of the large company portfolio is more than 50 times greater than the equal investment in long-term US government bonds. This supports the importance of thoughtful asset allocation.

Still, the size of a firm has a significant impact on how investors choose equity securities. Capital market history also shows that a portfolio of small company stocks has realized larger average annual returns, as well as greater variability, than a portfolio of large companies as represented by the S&P 500. Small-cap stock total returns ranged from a high of 142.9% in 1933 to a low of -58.0% in 1937.

More recently, the differential return between small and large capital stocks has not been as pronounced. From 1980 through 2020, the Wilshire US Small-Cap Index has averaged an annual compound return of 12.13% compared to the Wilshire US Large Cap Index average of 11.82% over the same period. The 31-basis point premium is much smaller than that realized in the 1926–2019 period, which saw a small-cap average annual compounded return of 11.90% versus 10.14% for the large-cap portfolio.

An illustration of The Pyramid of Equity Returns: Distribution of Annual Returns for the S&P 500 Index, 1931–2020. It displays years stacked on top of each other forming a tabular pyramid. It shows the historical returns of US stock markets over a 90-year period. The returns are listed by the number of years in each category. The figure shows that the stock market recorded a growth of 10-20% the highest number of times, while there is only one instance each of -50% to -40% growth and 50% to 60% growth respectively.
Figure 12.13 The Pyramid of Equity Returns: Distribution of Annual Returns for the S&P 500 Index, 1928–2020 (data source: Aswath Damodaran Online)
Asset Class Nominal Average
Annual Returns
1981–2020
Standard Deviation
of Returns
1981–2020
Large company stocks 12.64% 16.06%
Baa bonds 10.34% 7.67%
10-year T-bonds 8.21% 9.92%
US T-bills 3.94% 3.39%
Inflation 2.93% 1.76%
Table 12.4 Arithmetic Average Annual Returns and Standard Deviation by Asset Class, 1981–2020 (source: Aswatch Damodaran Online)
A line graph where the four lines show the growth of a $100 investment into selected asset portfolios from 1938 to 2020. The value of $100 invested in 1928 would be $1497 in 2020 when adjusted for inflation. It would be $8921 in 2020 if it had been invested in 10-year T-Bonds. It would be $53,736 in 2020 if it had been invested in Baa Bonds. It would be $592,868 in 2020 if it had been invested in the S&P 500.
Figure 12.14 Growth of a $100 Investment into Selected Asset Portfolios, 1928–2020 (data source: Aswath Damodaran Online)

Concepts In Practice

Warren Buffett

Profile picture of Warren Buffett.
Figure 12.15 Warren Buffett (credit: “Warren Buffet at the 2015 Select USA Investment Summit.” USA International Trade Administration/Wikimedia Commons, CC Public Domain Mark)

Warren Buffett has not always been one of the richest people in the world, but he has always been one of the hardest workers. An entrepreneur from an early age, Buffett’s yearbook photo caption noted that he “likes math: a future stockbroker.” Before leaving high school, Buffett had already earned thousands of dollars running a paper route and through one of his start-up businesses of installing and maintaining pinball machines in barbershops.

As they say in Nebraska, “you need to make hay while the sun shines,” and Buffett has made his share of hay, so to speak. In his career, Buffett has accumulated enough hay to be one of the wealthiest people in the world, with a net worth of over $80 billion by the end of 2020.

The “Oracle of Omaha,” as Buffett is known, grew his fortune through investing partnerships and most notably as the chairman, president, CEO, and largest stockholder of Berkshire Hathaway (BRK). Berkshire Hathaway was a New England textile manufacturer when Buffett and his investment partners began buying shares in the 1960s. By 1966, after a dispute with the then CEO of Berkshire, Buffett assumed control of the company and fired the CEO. Soon, Buffett’s partnerships merged into Berkshire and moved the business away from textiles; it eventually became the largest financial services company in the world, including total ownership of the Geico Insurance Company.

Buffett’s career is notable for how he developed his fortune, how he explained his philosophy, and for his current and future plans. Buffett followed the method of Benjamin Graham, famous value investor and author of Security Analysis, The Intelligent Investor. However, Buffett expanded beyond Graham’s analysis of financial statements and intrinsic value to examine the character of executive management. He applied the same criteria to hiring employees as well. Buffett once noted, “We look for three things when we hire people. We look for intelligence, we look for initiative or energy, and we look for integrity. And if they don’t have the latter, the first two will kill you, because if you’re going to get someone without integrity, you want them lazy and dumb.” When speaking of integrity, Buffett went on to say, “Only when the tide goes out do you discover who’s been swimming naked.”

Buffett’s folksy way of making his point will undoubtedly be another of his legacies. When asked repeatedly about how he managed to be such a successful investor, Buffett replied, “Never invest in a business you can’t understand.” Never was this truer than in the late 1990s and 2000, when the dot-com craze fueled the stock market with technology firms enjoying tremendous price increases without the corresponding earnings. Buffett’s value investing lagged until the bubble burst, and suddenly he was back on top. When asked about his change in fortune he replied, “In the business world, the rearview mirror is always clearer than the windshield.”

Buffett believes in long-term rather than short-term investing. He once remarked that “Someone’s sitting in the shade today because someone planted a tree a long time ago” and “If you aren’t willing to own a stock for 10 years, don’t even think about owning it for 10 minutes.”

The third aspect of Buffett’s legacy will be how his money works now and after he is gone. With Bill and Melinda Gates, Buffett started the Giving Pledge, and to date they have gathered the pledge of over 200 billionaires to give away half or more of their fortune during and after their lifetimes. Buffett states, “If you’re in the luckiest 1% of humanity, you owe it to the rest of humanity to think about the other 99%.” Buffett has begun the process to give away most of his fortune, but he has left this pearl of wisdom for his own children: “A very rich person should leave his kids enough to do anything, but not enough to do nothing.”

(Sources: Joshua Kennon. “How Warren Buffett Became One of the Wealthiest People in America.” The Balance. May 4, 2021. https://www.thebalance.com/warren-Buffett-timeline-356439; Ty Haqqi. “Five Largest Financial Services Companies in the World.” Insider Monkey. November 26, 2020. https://www.insidermonkey.com/blog/5-largest-financial-services-companies-in-the-world-891348/2/; Mohit Oberoi. “Warren Buffett: Growth Stocks Look Like Dot-Com Bubble.” Market Realist. September 4, 2020. https://marketrealist.com/2020/07/warren-buffett-growth-stocks-like-dot-com-bubble/)

Footnotes

  • 20Spencer Israel. “The Number of Companies Publicly Traded in the US Is Shrinking—Or Is It?” MarketWatch. October 30, 2020. https://www.marketwatch.com/story/the-number-of-companies-publicly-traded-in-the-us-is-shrinkingor-is-it-2020-10-30; Siblis Research. “Total Market Value of US Stock Market.” Siblis Research. https://siblisresearch.com/data/us-stock-market-value/
  • 21Karl Steiner. “Historical Returns of Global Stocks.” Mindfully Investing. July 6, 2020. https://www.mindfullyinvesting.com/historical-returns-of-global-stocks/; Elroy Dimson, Paul Marsh, and Mike Staunton. Summary Edition Credit Suisse Global Investment Returns Yearbook 2020. Credit Suisse, February 2020. https://www.credit-suisse.com/media/assets/corporate/docs/about-us/research/publications/credit-suisse-global-investment-returns-yearbook-2020-summary-edition.pdf
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