Returns of Stocks

Investment Snapshot

* On the day Caterpillar announced record second-quarter earnings in 2006, its stock price declined by 1.2 percent.
* Alcoa reported a 62 percent quarterly increase in net income, and the stock price declined by a few dollars on the day of the announcement.
* Citigroup reported an increase of 4 percent in quarterly earnings, and the stock price did not change much on the day of the announcement.

The Investment Snapshot illustrates that stock prices bear a relationship to earnings, but in many cases the short-term relationship can be quite volatile. The price that an investor is willing to pay for a stock depends on the expected return from that stock, which is the present value of both the cash flows from dividends and the expected future selling price of the stock. When a company’s earnings increase, the company can increase the dividends that it pays as well as expand its retained earnings, thereby causing the stock price to rise.

WHAT RETURNS CAN YOU EXPECT FROM STOCKS?

What is the rate of return that you can expect from your stocks? The answer depends on many factors, one of which is the time frame over which question is asked. If you ask the question during a bull market, the rate of return is often quoted to be in the double digits (above 10 percent), whereas during a bear market it is in the 6 to 7 percent range. This discrepancy is not as important as understanding how returns are made up and that stocks generally outperform bonds and money market securities over long holding periods. Professor Jeremy Siegel says that in every 10-year holding period from 1802, stocks outperformed bonds and Treasury bills and that during the same holding period, the worst performance of stocks was better than that of bonds and Treasury bills (2002, p. 26). During short holding periods, stocks are riskier than bonds and Treasury bills, but over long holding periods, the returns from a portfolio of stocks exceed those of bonds and Treasury bills.

Returns from stocks are from two sources: income in the form of dividends (if the company pays dividends) and capital appreciation. When companies are able to increase their earnings, they can then raise the dividends they pay out to shareholders. Companies do not pay out their entire earnings in dividends. The amount of earnings retained (not paid out to shareholders) is invested in the business to increase future earnings. Thus shareholders of companies that do not pay dividends can benefit when these companies grow their earnings. The disappointment when companies fail to grow their earnings at expected rates accounts for the decline in the prices of their stocks. This volatility of stock prices over short periods results in fluctuating returns for stocks, but over long holding periods, investors in stocks are able to earn higher returns than those from bonds and Treasury bills.

KEY CONCEPTS
* What returns can you expect from stocks?
* Calculating a rate of return
* Risk-return tradeoff
* Asset allocation and the selection of investments

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