Buy and Hold? You Bet

Stock-market investors are an unhappy bunch. Standard & Poor's 500-stock index is no higher than it was 12 years ago, and over the ten years ended in May, stocks have returned a dismal -1.7% per year. So it's no surprise that investors wonder whether "buy and hold" and "stocks for the long run" are discredited concepts (see Can You Time the Market?).

The short answer is that stocks are still the best long-term investments. As bad as the past decade has been, there have been other ten-year periods during which stocks have recorded even bigger losses. Yet over periods of 20 years or longer, stocks have never lost money, even after inflation. Including the latest bear market, stock returns have averaged 7.8% per year over the past 20 years and 11% annually over the past 30.Nevertheless, the assault on buy-and-hold investing continues. Robert Arnott, of Research Affiliates, recently observed in a widely publicized article that over the past 40 years, even lowly government bonds had outperformed stocks. Just a few months later, though, events overtook that claim as stocks rallied from their March lows and bond prices skidded.

Brighter future. After periods of sluggish returns, stocks tend to regain their oomph. Stock returns over the past five and ten years have fallen to the bottom quartile when measured against all five- and ten-year periods since 1871. But history shows that after reaching such a low, stocks' average return for the next five years has been almost 9.5% annually after inflation.

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Furthermore, once stocks have plunged 50% from their highs, which they have done during the current bear market, investors have always been rewarded with winners over the next five years -- and that includes the Depression decade of the 1930s. In Dec-ember 1930, stocks were 50% off their highs of September 1929. Yet, over the next five years -- when the economy was experiencing the greatest con-traction in its history -- investors were rewarded with an annual return of 7% after inflation.

Value stocks. All the returns I've quoted reflect indexes based on market capitalization, the indexes that are used to measure market performance. But research has shown that investors would have done better if they had tilted their portfolios toward value stocks -- stocks that have higher-than-average dividend yields and lower-than-average price-earnings ratios. Even after the collapse of financial stocks over the past year (most financials fell into the value category), the Russell 3000 Value index has outperformed the capitalization-weighted index over the past five, ten, 20 and 30 years.

Evidence suggests that investors may be able to outdo the indexes by pursuing an activist strategy that shifts into or out of stocks depending on their valuation. However, this strategy requires investors to sell stocks of companies that have done well and buy shares that have done poorly -- an exercise that requires a huge (and often impossible) amount of self-control.

But now there are new indexes that rebalance stocks automatically and have outperformed both capitalization-weighted and even value indexes. These so-called fundamental indexes rank stocks by their dividends or earnings (or some other measure of a company's worth) instead of by their market value. Fundamental indexes automatically sell stocks that move up in price beyond their dividends or earnings and buy stocks whose prices lag. Dividend-weighted indexes have outperformed value indexes over the past ten, 20 and 30 years; earnings-weighted indexes have done even better.

In the long run, stocks are still the way to go. And if you want to give your returns an extra kick, value-oriented stocks and fundamental indexes may be your best bet.

Columnist Jeremy j. Siegel is a professor at the University of Pennsylvania's Wharton School and author of Stocks for the Long Run. He also advises Wisdomtree Investments, which issues low-cost, fundamentally weighted ETFs.