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I have read in many personal finance books that stocks are a great investment for the long term, because on average they go up 5-7% every year. This has been true for the last 100 years for the S&P500 index, but is there reason to believe this trend will continue indefinitely into the future?

Look at other markets. The Shanghai stock index trades much lower today than the same day 10 years ago, and the Japanese stock index has not grown for the last 20 years. Is the standard assumption of 5-7% growth true only for American stocks?

Can we expect the trend for the S&P500 to continue? The last 100 years have been a period of economic prosperity for the US, so it's no surprise that stocks have done so well, but is economic prosperity required for such stock growth?

Grade 'Eh' Bacon
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Bai Li
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  • I'm voting to close this question as off-topic because it's more about economics in general, and no one here can predict the future. – D Stanley Jun 23 '17 at 13:49
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    It's relevant to personal finance though! A lot of personal finance advice rely on the assumption that stocks will go up the future like they have been in the past. I think it would be beneficial to justify this assumption, don't you think? – Bai Li Jun 23 '17 at 13:54
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    OK, so what's the alternate assumption? That it won't? Don't mistake expectation for certainty - the market obviously has ups and downs, and preparing for those is the biggest part of personal finance (e.g. don't borrow money to invest in the market). Since we can't tell the future, all anyone can go on is past performance and hope that the causes of that performance will not change in the future. If you don't understand the underlying forces that drive the market and don't believe that is will continue to grow then don't invest in the market. – D Stanley Jun 23 '17 at 13:57
  • Don't get me wrong - I like the question and I actually had an answer drafted, but it's off-topic for a Q&A forum like this. – D Stanley Jun 23 '17 at 14:01
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    Japan is stuck in a demographic trap where the population is shrinking and aging and the economy is poised for inevitable shrinkage. The US is in a different situation, so I would expect different results. – zeta-band Jun 23 '17 at 15:46
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    +1, great question. This is something that many people wonder about, and great, well-defended answers are certainly possible. And the question is certainly related to personal finance and investing. – Ben Miller Jun 23 '17 at 18:41
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    Eventually there will not be enough matter to represent all the money, so we know for certain that the answer is "No" for a long enough term. – yters Jun 23 '17 at 19:28
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    Keep in mind that the alternatives to stocks are not 100% safe. Stocks did extremely well in Weimar Germany from 1920 to 1924, while many other investments became worthless because of hyperinflation. is economic prosperity required for such stock growth? No, e.g., the US stock market gained no value from 1959 to 1972, but that was a period of prosperity. The stock market gained 300% from 1932 to 1937, which was the height of the Great Depression. –  Jun 23 '17 at 19:31
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    @yters: Eventually there will not be enough matter to represent all the money What do you mean by "represent?" Do you mean that we won't be able to build computer chips that can store a digital representation of someone's stock income? Do you mean that we will no longer be able to cash out our stock portfolio into a fixed commodity like gold, at a fixed dollar price? The former seems wrong to me, and the latter irrelevant. –  Jun 23 '17 at 20:18
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    @BenCrowell: the stock market is not abstract, it depends on investors expectations on the real economy. Its obvious that the economy cannot grow forever, as the planet (and its resources) are finite. – Martin Argerami Jun 23 '17 at 20:50
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    @BenCrowell also the universe will end at some point, which is another limit on stock market growth. – yters Jun 23 '17 at 21:36
  • @MartinArgerami: I've made this into a question on economics.SE: https://economics.stackexchange.com/questions/17298/can-the-stock-market-show-indefinite-exponential-growth –  Jun 23 '17 at 22:36
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    @yters: also the universe will end at some point, which is another limit on stock market growth. That's actually not true in current cosmological models, although that would be more of a topic for physics.SE. There is a somewhat different question of whether an infinite computation or, equivalently, infinite energy extraction is possible. The answer can be no or yes depending on specifics of the cosmological model. There have been papers on this by Dyson and Krauss. –  Jun 23 '17 at 22:40
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    Effectively, the Universe will come to an end as there is nothing to stop the expansion of the Universe. It could be the Big Rip or the Big Freeze. – Peter Mortensen Jun 24 '17 at 13:39
  • @Bai "I think it would be beneficial to justify this assumption" Sorry, you don't understand how the personal finance industry works. You might as well expect a car salesperson to explain that you might be better off not buying a car. The function of the PFI is not to make you rich but to make its employees rich by getting you to pay them (via commission and annual fees) to look after your money for you. Of course, investing in some stocks is an excellent idea. Investing in others is not. The only hard part is guessing which ones will turn out good and which will not! – alephzero Jun 24 '17 at 14:56
  • @BenCrowell In order for the stock market to grow indefinitely, there must be some physical quantity that can grow unboundedly. As long as reality is finite the answer to the OP is "No." – yters Jun 24 '17 at 18:09
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    You have to be careful about what you compare stocks to, considering most currencies loses value over time. – CodesInChaos Jun 24 '17 at 19:11
  • The Stock market is always in competition to the housing market. Unlike the Stock market, the housing market has a safe ROI, rent's are NEVER going to be cheaper. If there's a bubble, the stocks will suffer. – antipattern Jun 26 '17 at 01:31
  • @yters "In order for the stock market to grow indefinitely, there must be some physical quantity that can grow unboundedly." Why? You can be richer with less stuff. Are you richer with 10KG of steel or one small iPhone? As for money, that's what redenomination is for. – André Paramés Jun 26 '17 at 13:45
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    @AndréParamés, any form of redenomination is upper bounded by the busy beaver function, which is not computable. Granted, it's an extremely large upper bound, but it is still a strict upper bound. The answer to the OP's question is still "No" for a sufficiently long term. – yters Jun 26 '17 at 16:43
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    @antipattern you don't think land value in Detroit was lower in 2010 than it was in 2000? – quid Jun 28 '17 at 03:53
  • @quid "Dear tennant, due to the reduced land value in your area, we have decided to cut your monthly rent payments by 5%". – antipattern Jun 28 '17 at 09:45
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    @antipattern, then your tenant leaves. Which many did. It's silly to claim real estate and rents NEVER (in caps) go down. – quid Jun 28 '17 at 16:12

10 Answers10

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Does it make sense for stocks to earn a premium indefinitely?

Yes. There is good reason to think that the stock market will make money indefinitely: the stock market is the primary mechanism through which investors bear market risk, which requires compensation. If you think of all the owners of firms (stockholders and bondholders, generally) the risk premium that stocks earn stocks is the way bondholders pay equityholders to bear the risk that they do not wish to.

Will stock prices always go up in the long run?

As long as companies pay out less in dividends than their profit, prices will go up. That could change if we were to change our corporate culture and/or tax practices so that firms paid out more in dividends. However, for the purposes of your question, I think it doesn't matter much whether the investor makes money as dividends or capital gains.

Does the 5-7% guess apply only to the US market?

I didn't write (nor read) the books in question, but most likely that is a global number. The US dominates the global equity market, so it's often a good proxy. However, international returns taken together have no less risk and earn no less over long horizons in general. The particular examples you have pointed out are special cases that only apply to a part of the global economy and a particular time period. There are plenty of examples of stock markets and time periods that did much better than the US market to offset your examples.

Is 5-7% a reasonable long-term estimate of equity returns?

Equity will always earn more in expectation than risk-free securities will. How much more depends on major economic factors. 5-7% has been a good estimate for the market risk premium for many, many decades (stocks should earn this plus whatever the risk-free rate is). However, that is just an empirical observation, not a rule. It can change. Some day technological progress could slow down or stop, we could run out of important resources in a way that we can't compensate for, our population permanently could stop growing, aliens could invade, etc.

Down the road it is certainly possible for expected equity returns to go down and never go back up again. This would result from a permanent, global, economic shift that I think would be pretty obvious. That is, you wouldn't have to look at stock prices to know it was happening.

farnsy
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    Note that this doesn't apply to individual stocks, only the market in aggregate. – Hot Licks Jun 25 '17 at 20:46
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    "the stock market is the primary mechanism through which investors bear market risk, which requires compensation" and? That just means that if the market goes down for too long it will crash right? That doesn't imply at all that the market will go up indefinitely... – Shautieh Jun 26 '17 at 02:50
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    @Shautieh It implies that we expect it to go up indefinitely for the same reason that we expect that insurance companies will always charge a positive amount for the service they provide. They are bearing our risk, so they will be compensated (on average). – farnsy Jun 26 '17 at 03:35
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    @farnsy I understand that, but isn't that wishful thinking? If energy become rarer and more expensive (and unless we master fusion this time will come within a few decades), then there is no way the economy can continue to grow. Will investors continue to invest in stocks if they have no confidence in the future? – Shautieh Jun 26 '17 at 03:44
  • @Shautieh No, it's not. As I pointed out in my answer, major changes to our long-term growth trajectory may some day change the size of the equity premium, but my point is that equity earnings are not based solely on expectations of economic growth. Even in a stagnant or shrinking economy, stock returns have positive expected value because they are compensation for risk. – farnsy Jun 26 '17 at 03:54
  • This is all correct but you should always bear in mind stocks can and do loose value. 5-7% is a mean average. It does not mean all your stocks will always increase in value by this figure. Some go up some go down. This is why you need to spread your risk. –  Jun 26 '17 at 12:44
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    (-1) I think the explanation is completely backward. The stock market does not go up just because investors bear risk, it goes up because the economy grows and stocks represent ownership/ability to capture part of that growth. The rest is not wrong per se but it's secondary. – Relaxed Jun 27 '17 at 11:39
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    @Relaxed While economic growth can enhance short-term stock returns, in an economy with no (or negative) expected growth, stocks will continue to make money in expectation because of their risk-bearing function. That is the answer to the OP's question. Short run stock trends are dominated by changes in economic prospects, which is what causes many people to think this is the basis of long-term expected returns. However, it is not. Finance theory is unambiguous in showing that the basis of long-term expected returns is risk and risk-aversion. – farnsy Jun 27 '17 at 15:28
  • @farnsy No they won't. I am not talking about short-term prospects, no half-way functioning economy has long-term negative expected growth… Finance theory only comes into play because the economy is generally growing in the first place. – Relaxed Jun 27 '17 at 16:03
  • Finance theory is not at all restricted as you suggest and it is certainly possible to have zero expected growth--certainly as a teaching tool. If you would like to understand this issue better let's talk in the discussion area, rather than in comments. – farnsy Jun 27 '17 at 16:08
  • Do you have data for your assertion that "the stock market is the primary mechanism through which investors bear market risk, which requires compensation?" 1. I'm curious if public equities are actually larger than bonds (gov and corporate) and 2. If it is in fact the largest investment vehicle, it hasn't always been and does not need to always be. Our public stock market is just currently built to absorb pension and retirement dollars, but it doesn't need to stay that way. Separately, it seems counter-intuitive for the riskiest asset class to also hold the most investment dollars. – quid Jun 28 '17 at 02:03
  • By primary mechanism, I do not mean to suggest that the stock market is larger in terms of value than the bond market. The bond market simply doesn't have very much market risk in it (probabilities of default are very small and payments are fixed). The way our system is currently structured, the market risk of a firm gets concentrated in its common stock. To see which is the primary mechanism, ask which market overall loses more value during a downturn: the stock market or the bond market? – farnsy Jun 29 '17 at 14:41
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I have read in many personal finance books that stocks are a great investment for the long term, because on average they go up 5-7% every year. This has been true for the last 100 years for the S&P500 index, but is there reason to believe this trend will continue indefinitely into the future?

It has also been wrong for 20+ year time periods during those last 100 years. It's an average, and you can live your whole career at a loss.

There are many things to support the retention of the average, over the next 100 years. I think the quip is out of scope of your actual investment philosophy.

But basically there are many ways to lower your cost basis, by reinvesting dividends, selling options, or contributing to your position at any price from a portion of your income, and by inflation, and by the growth of the world economy. With a low enough cost basis then a smaller percentage gain in the index gives you a magnified profit.

JTP - Apologise to Monica
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CQM
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I feel something needs to be addressed

The last 100 years have been a period of economic prosperity for the US, so it's no surprise that stocks have done so well, but is economic prosperity required for such stock growth?

Two world wars. The Great Depression. The dotcom bust. The telecom bust. The cold war. Vietnam, Korea. OPEC's oil cartel. The Savings and Loans crisis. Stagflation. The Great Recession. I could go on.

While I don't fully endorse this view, I find it convincing: If the USA has managed 7% growth through all those disasters, is it really preposterous to think it may continue?

Lan
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    You list the cold war, Vietnam War, and Korean War, but those were all political and military crises, not economic crises. From the point of view of much of corporate America, e.g., aerospace contractors, these were very profitable historical events. –  Jun 23 '17 at 19:19
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    @BenCrowell Broken window fallacy? – Lan Jun 24 '17 at 03:17
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    Disasters??? the best thing that can happen to a government-banking complex is a war, indeed, why do you think wars happen?? We just lived through a century of war-manufactured "boom". ie other than those who got killed by it. – Fattie Jun 24 '17 at 20:42
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    @Lan: Broken window fallacy? It seems to me that the broken window fallacy would consist of claiming that everyone was better off because of those wars. I'm only claiming that much of corporate America was better off. The biggest losers in those wars were the millions of combatants and noncombatants killed in Korea, Vietnam, and Cambodia, along with the tens of thousands of foreign soldiers who were also killed. But the S&P 500 doesn't measure survival of Vietnamese children, it measures the profits of big US corporations. –  Jun 25 '17 at 23:42
  • WW1 and WW2 allowed the USA to pillage the resources of Europe and become the most powerful country besides Russia during the cold war. That means a LOT of gold, cash and resources, the best engineers moved to the USA which created wealth there, allowed NASA to even exist and opened the world to USA products. Without those WW, and later skirmishes, the USA would still be under developed. – Shautieh Jun 26 '17 at 04:29
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    @Shautieh: To say that the USA plundered the resources of Europe after WW1 and WW2 is quite counterfactual. After WW1, Germany indeed had to pay restitutions, but those went primarily to France and the UK, not the US. After WW2, under the Marshall plan the money transfer was from the USA to Europe, not the other way around. – MSalters Jun 26 '17 at 13:18
  • @BenCrowell So the USA benefited from a half million of her able-bodied, young men dying and her allies losing millions of productive citizens? Do you not see how that is outlandish to claim? Today, only 4% of the USA GDP is the military industrial complex. Wars (trade or military) deplete the resources (humans) that the other 96% hire or trade with. – Lan Jun 26 '17 at 16:06
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    @MSalters pillage was maybe too strong a word, but I meant the USA benefited GREATLY from the wars. The Marshall plan helped Western Europe a lot, but helped the USA more by boosting its exports and industry (the money sent to Europe was spent on USA goods...), plus preparing (forcing) Europe to consume American goods and services massively. Without WW2, there would have been no Bretton Woods, and the USD would never have been so powerful. European countries, completely broke, gave almost all their gold to the USA, which ended up owning 70% of all the gold by 1947. I could go on and on... – Shautieh Jun 27 '17 at 01:24
  • @Lan maturation of war bonds, massive industrialisation resulting from the war, massive progress to industrial processes and overall productivity, opening of new markets after the collapse of all European industries and empires, etc. Economically, the millions of dead Europeans and the overall devastation were of great profit to the USA, which could take over those markets. The cost of maimed American veterans is nothing compared to all this. Also, sweat nazi gold: http://www.nytimes.com/1997/11/02/world/nazi-gold-was-recast-and-issued-in-the-us.html – Shautieh Jun 27 '17 at 02:04
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The total value of the stock market more or less tracks the total value of the companies listed in the stock market, which is more or less the total value of the US economy (since very few industries are nationalized or dominated by privately held companies).

The US economy has consistently grown over time, thanks to the wonders of industrialization, the discovery of new markets, new natural resources, etc. Thus, the stock market has continued to grow as well.

Will it forever? No. The United States will not exist for ever. But there's no obvious reason it won't continue to grow, at least for a while, though of course if I could accurately predict that I would be far richer than I am.

Why do other countries not have the same result? China is its own ball of wax since it's a sort-of-market-sort-of-command economy. Japan has major issues economically right now and doesn't really have the natural or people resources; it also had a huge market bubble a while back that it's never recovered from.

And many European countries are doing fine. German's DAX30 index was at around 2500 in 2004 and is now at nearly 13000. That's pretty fast growth. If you go back further (there was a crash ending in around 2004), you can see around the fall of the Berlin wall it was still around 2000; even going that far back, that's about an 8% annual bump. The FTSE was also around 2000 back then, around 8000 now, which is around 5% annual growth.

Many of these indexes were more seriously hurt than the US markets in the two major crashes of this millenium; while the US markets fell a lot in 2008, they didn't fall nearly as much as many smaller markets in 2002, so had less to recover from. Both DAX and FTSE suffered similar falls in 2002 to 2008, and so even though during good periods they've grown quite quickly, they haven't overall done as well as they could have given the crashes.

Joe
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The last 300 years of civilization have been amazingly atypical.

We have experienced industrial revolution after industrial revolution. Economic revolutions that would have changed the world in 1000 AD show up as noise. Coal, Canal, Rail, Trade, Electricity, Refrigeration, Oil, Gas, Nuclear, Assembly Line, Vacuum Tube, Mass Education, Transistor, Integrated Circuit, Nano-tech, Antibiotics, Slaying of absolute Poverty, Democratic, Feminism, Superhighway, Automobile, Airplane, and on and on and on.

A cascade of miracles and world-shaking events that have intertwined and together generated a many century long economic singularity that has upended the entire world and generated today's world.

The question you should ask, is tomorrow going to be like today? And the answer is yes; in weather, and in economics, the most likely bet bet is always "things keep on going like they have in the short term". But next week? Next month? That is often not much like today.

There is reason to believe that the yield on the above revolutions will continue to propel the economy forward, and that there are multiple promising new revolutions on the horizon.

But barring that kind of world-shaking revolution, you are not going to maintain a 5% real return on investment over another centuries for the stock market. The value of investments has to go up by a factor of over 100 in order for that to happen, and the US stock market is already close to 20 trillion dollars.

For it to have a market cap of 2 quadrillion dollars the world economy will have to be much larger than it is today. And to be that much larger, the world would have to be a much stranger place that values very different things.

We are currently roughly a K-type 0.72 civilization. A simple linear expansion of our power of 100x brings us up to K-type 0.92, which is going to cook the planet from waste heat (not from CO2, but just from the waste heat of the energy it uses!)

Efficiency can mitigate this, but only to a degree. 100x more efficient technology is going to less believable than a beanstalk and space colonies.

If you believe that the stock market is going to continue to grow at 5%/year for the next century, start investing in really out-there technologies. Gene editing, virtual and augmented reality, space beanstalks and private lift, miraculously cheap energy storage, etc. Because simply refining the technology of today won't get us there.

Modern industrial civilization has been a miracle factory. That is what pulled off that growth rate. If the miracles stop coming, so does the growth.

There is a road to it. It would involve clean energy, mass personal automation and friendly (not smarter than human) AI, and the entire world lifted up to the standard of living of the top 3% of the USA on average. But it is far from guaranteed.

Yakk
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    To sum up, are you saying innovations by companies are the key reason we expect stocks to go up in the long term? – user2652379 Apr 23 '18 at 05:11
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    @user2652379 I'm saying past performance does not imply future returns. And for the stock market to continue to expand like it has, we need an exponentially larger economy, which in turn requires world-shaking increases in productivity. That increase in productivity may come from particular companies innovations, or it could come from doug in her basement, or some state funded research lab, or whatever other source. – Yakk Jul 10 '21 at 04:30
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Companies are expected to make a profit, otherwise there is no point to their existence and no motivation for investment. That profit comes back to shareholders as growth and/or dividend. If a company is doing well and has a healthy profit to turn back into investment to facilitate increased future earnings, it increases shareholder equity and share price. If a company is doing well and has a healthy profit to pay out in dividend, it makes the shares more attractive to investors which pushes the price up. Either way, shares go up. Share prices drop when companies lose money, or there are market disturbances affecting all companies (recessions), or when individual companies fail. Averaged over all companies over the long term (decades), stocks can be reasonably expected to go up.

Anthony X
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Stocks "go up 5-7% every year. This has been true for the last 100 years for the S&P500 index...."

This was true in the 20th century in America. It was not true (over the whole century) for other major countries like Germany, Russia, Japan, or China. (It was more or less true for Britain and certain Commonwealth countries like Australia and Canada.) A lot of this had to do with which countries were occupied (or not) during the two world wars.

In one of his company's annual reports, Warren Buffett pointed out that the U.S. standard of living went up 6-7 times in the 20th century, that this was unprecedented (and might not be repeatable in the 21st century). The performance of the U.S. stock market in the past century is representative of those (and other) past facts. If a different set of facts prevails going forward, the U.S. stock market would be reflective of those "different" facts.

Tom Au
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If by "long term" we mean another 40 years or more, then I think the answer is no. The economy is built on top of the planet's ecology and the stability of society. Unless we change our relationship to our planet, the stock market will collapse dramatically. In order to have truly long term returns, our economy must live within the carrying capacity of the planet (number of people and how much each consumes).

We are at an inflection point where the planet can no longer support accelerating consumption. As long as our means of production damages our ecology, then the stock market "growth curve" can roughly be seen as a countdown to human extinction where the clock is ticking exponentially faster each year. It's truly a bad sign that essential things which used to be free (fresh water and air) are now places that corporations look to for profit. There's demand because growing portions of the population lack these essentials. Given the threat of nuclear weapons, degrading the planet's ecology is extremely dangerous because it adds tension to nation states that are already in competition for resources (water wars, oil wars, etc).

Dr. David Suzuki: "If we pollute the air, water and soil that keep us alive and well, and destroy the biodiversity that allows natural systems to function, no amount of money will save us."

https://thebulletin.org/doomsday-clock/

thebiggestlebowski
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  • I see in your "answer" a political polemic, but no actual answer "yes it can continue", or "no, it can't continue". – RonJohn Jun 20 '19 at 22:33
  • No idea what in the original post caused a slide-bar at he bottom of the quote. Fixed it now, still curious. – JTP - Apologise to Monica Jun 20 '19 at 22:37
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    @JoeTaxpayer: It (indentation by 4 or more spaces) was markdown for code, not a quotation. Word wrapping doesn't happen for code blocks. – Ben Voigt Jun 20 '19 at 22:40
  • Unfortunately this is a great rhetoric and something I resonate with but not a direct answer. I can infer answers, esp from It's truly a bad sign that essential things which used to be free (fresh water and air) are now places that corporations look to for profit. that there is always room at the top for the stock market, but it'd help if @thebiggestlebowski could tie it together into an answer of what they think. – perennial_noob Jun 21 '19 at 17:20
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Stock returns cannot be evaluated on its own. You need to take into account inflation and the return of other investment vehicles. Over the long run, you want to earn more than your peers (ie inflation), or lose less than them.

Stock lets you buy into the profits of a company managed by others. So the fundamental question is "do those company managers make better decision than average person?" Of course there are times when they make awful decisions (eg just before dotcom bubble), and sometimes the best decision is to close the business. But overall those people are much better educated, have higher IQ, more resourceful, etc, and so over long time and across all the companies, this is correct and hence the stock market premium.

jf328
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A lot of these answers are strong, but at the end of the day this question really boils down to: Do you want to own things?

Duh, yes. It means you have:

  • A legal claim on what's left over at the end of the day resulting from a value-added activity
  • Superior information and opportunities to invest in other value-added activities
  • Protect yourself from the ever-increasing prices charged by other owners

By this logic, you would expect aggregate stock prices to increase indefinitely.

Whether the price you pay for that ownership claim is worth it at any given point in time is a completely different question entirely.

J7h
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