You can get rich buying stocks. You can stay rich buying bonds.

It's as simple as that.

If you want to grow your money over time, stocks are the only game in town. Don't waste your time on rare coins or stamps or Picassos or baseball cards or ostrich farms or collectibles.

Buy stocks.

Long-Term Performance of Stocks

Stocks, given enough time to grow, provide huge returns for investors. Jeremy Siegel, in his fine book, Stocks for the Long Run (McGraw-Hill), provides the following example of the long-term potential of stock investing:

$1 invested in stocks in 1802 would have been worth nearly $7.5 million at the end of 1997. Granted, none of us has a 195-year holding period. You don't have to hold stocks for that long to get a nice bang for your buck. For example, for the 10-year period ended December 1998, $1000 invested in large-company stocks became $5,780, a 478 percent gain. Obviously, a buy-and-hold strategy does not guarantee profits - no investment strategy does- and past performance is no guarantee of future results.

Since 1926, stocks have returned, on average, 11.2 percent per year. During that same time, government bonds have returned an average of 5.3 percent per year.

That performance gap of nearly six percentage points per year (11.2 percent per year for stocks versus 5.3 percent for bonds) may not seem like much.

In fact, however, it's huge.

For example, $1 invested in the S&P 500 index at the end of 1925 grew to $2,350 by the end of 1998. That's what 11 percent per year does to your money over 73 years — $1000 into $2.35 million.

If you had your money in bonds for that 73-year period, $1 would have become $44. In other words, 5 percent per year for 73 years turns $1000 into $44,000 in 1998.

Hmmm. $2.35 million (stocks) versus $44,000 (long-term government bonds). Keep in mind that government bonds are guaranteed by the government if held to maturity and they have a fixed rate of return and fixes principal value.

Which would you rather have?

11 Percent will do Nicely

Keep in mind that 11 percent is the market's long-run average annual return since 1926. Stocks periodically do better than 11 percent. A lot better. From 1996 through 1998, for example, stocks (as measured by the S&P 500) rose roughly 30 percent per year. To show you how powerful 30 percent per year returns are, consider this: If you entered 1996 with $200,000 in the stocks, you finished 1998 with $439,000. In three years, you would have more than doubled your money, without putting another penny into the market. The securities markets are subject to the risks of fluctuating prices, the uncertainty of rates of return, and the yields inherent in investing. And, of course, past performance is no guarantee of future results.

Obviously, you cannot rely on such brief market periods to extrapolate the future. Clearly the last three years have been an aberration. Do I hope they continue? You bet. But I'm not banking on it. You shouldn't either. Run from any broker or financial adviser who promises 20 percent annual returns going forward. You will be assuming a huge level of risk to try to capture such high expected returns.

Fortunately, you don't need 20 percent or 30 percent annual returns in stocks to build a seven-figure portfolio. Even if stocks return to more traditional annual returns of 11 percent, that 11 percent annual return will be adequate for you to achieve seven figures.

Rule of 72

I find the "Rule of 72" useful when comparing expected returns between stocks and other investments. The rule of 72 says that in order to find out how many years it takes your money to double in a particular investment, choose a rate of return and divide it into 72.

For example, if the long-run average annual return of stocks is 11 percent, the rule of 72 means that, on average, stock returns double every 6.5 years (72 divided by 11). If the long-run average return on bonds is 5 percent per year, then bonds double every 14.4 years (72 divided by 5).

Let's see what happens to a $10,000 investment, over 26 years, earning 11 percent per year. That $10,000 will double approximately four times (26 divided by 6.5). Thus, $10,000 becomes $20,000 becomes $40,000 becomes $80,000 becomes approximately $151,000.

Now let's look at bonds. Since bonds return, on average, 5 percent per year, the value of the bond doubles nearly twice in 28 years. That means $10,000 becomes $36,000 at the end of 26 years.

Which would you rather own — stocks or bonds?

Moral of the story: Your money has the best potential to grow by investing in stocks.

What about risk?

But, some of you might ask, aren't stocks riskier than bonds?

I'll answer that question with a question: What do you mean by risk?

Do you mean the risk associated with the volatility of investment returns?

Do you mean the risk that your money won't grow enough to offset the rising cost of living?

Do you mean the risk that the market and your individual investments will tank?

Do you mean the risk that the "safe" investments you buy will kill you because of opportunity costs?

Risk means different things to different people. Risk is not necessarily a four-letter word. In fact, you won't achieve a seven-figure portfolio without taking risks. Why? Because risk and return are joined at the hip. You cannot have higher expected returns without assuming a higher level of risk.

I'm going to repeat that statement since it is a concept lost on most investors.

You cannot have higher expected returns without assuming a higher level of risk.

What that means is that if you invest strictly in risk-free investments, such as passbook savings accounts or CDs at your local bank, you'll never achieve the expected returns of stocks. It cannot be done. Period.

Likewise, if your broker promises an annual return of, say, 20 percent on your investment, rest assured that you are going to be assuming an extremely high level of risk to try to capture that 20 percent.

Volatility of Returns

In investment circles, risk means volatility of returns. In other words, riskier investments experience larger swings in annual returns.

If you define risk in terms of volatility, then yes — stocks are riskier than bonds.

So what?

Volatility is a measure of short-term risk. Who knows how investments will behave today, tomorrow, a week from now, a month from now, a year from now. The shorter the time frame, the more random the likely returns. Buying and holding stocks for one year is risky. Who knows how the market will behave in a one-year time frame?

According to Siegel, stocks have risen as much as 66.6 percent and fallen nearly 39 percent over any given year. That's a huge spread in potential returns. That's risk.

When you lengthen holding periods, however, that spread reduces. For 10-year holding periods, stocks have risen nearly 17 percent and fallen 4 percent. For 20-year holding periods, stocks have risen nearly 13 percent on the high end and 1 percent on the low end. These numbers mean that for any 20-year holding period since 1802, the worst stocks have performed is a positive 1 percent. If you look at 30-year holding periods, stocks have risen roughly 11 percent at the peak and nearly 3 percent at the bottom. In other words, there has never been a 20- or 30-year period in the market since 1802 when stocks did not provide a positive return.

The longer your holding period, the less volatile your returns. Said another way, the longer your holding period, the less risky it is to own stocks.

Interestingly, while bonds are usually considered "safer" investments because of their lower volatility of returns, a funny thing happens when you extend holding periods. Indeed, while there has never been a 30-year period where stocks produced negative returns, the same cannot be said for bonds or Treasury bills.

Inflation Risk

What is the value of money? Interesting question, isn't it. Actually, the only value of money is what it buys. Money provides purchasing power.

Inflation is an erosion of purchasing power. Inflation means a dollar buys less tomorrow than it does today.

Investors often equate risk with loss of principal. You buy a stock at $45 per share. It drops to $41. You've just lost (at least on paper) $4 per share.

Inflation is much sneakier, but no less lethal to investors. You buy a stock at $45. It rises to $46 over a four-year period. Congratulations, you have a gain of $1 per share. But wait. Inflation has eroded the purchasing power of that dollar. Your "real" gain is more like $0.85 per share. Where did the other 15 cents go? It disappeared in "lost" purchasing power.

The stealth nature of inflation makes it especially dangerous. You don't see the losses. You may be thinking you're doing OK since your portfolio is increasing each year. But unless your investments are outpacing inflation, you are losing.

The following example shows just how mean an animal inflation is. Assuming inflation of just 3 percent per year, what you can buy today for $80,000 will cost you $200,000 30 years from now.

A lot of investors have forgotten about the evils of inflation in recent years because it has been rather benign. That hasn't always been the case. There have been plenty of periods in our nation's economic history when inflation exceeded 3 percent per year. At 5 percent per year, inflation doubles your cost of living every 14.5 years. Said another way, an inflation rate of 5 percent per year means that $41,000 in today's dollars is nearly $180,000 30 years from now.

That's what makes inflation so dangerous. You have a nice chunk of money in your portfolio. You eliminate "risky" investments (i.e. stocks) by moving into "safe" (i.e. bonds) investments. You've decided, in effect, to tread water with your investments. The problem is that you don't tread water. You actually sink little by little each year.

As an investor, inflation has big implications on how you run your portfolio. Just because you have, say, $200,000 today, you can't rest on your laurels. You have to keep growing your money each year.

What's the best way to combat inflation risk?

Once again, the answer is stocks.

"In the long run, stocks are extremely good hedges against inflation, while bonds are not," says Professor Siegel.

One reason stocks are better at outpacing inflation is that common stock dividends are not fixed, unlike bond coupon rates. You buy a 7 percent yielding bond, you receive $70 per year for every $1000 bond. If inflation jumps from 3 percent to 5 percent, you'll still receive only $70 in interest for every bond you own. And if it is a 20- or 30-year bond, you'll receive that same $70 for 20 or 30 years. With stocks, the annual dividend can increase. Since dividend yield is an important component of a stock's annual return, rising dividends provide some hedge against inflation over the long term.

Keep in mind that we're talking about stocks as a long-term inflation hedge — 20 or 30 years. In the short term, say a year or two, stocks are a lousy inflation hedge. So are bonds and Treasury bills.

A Word of Warning

The approach laid out in this article — invest in stocks and only stocks (or stock mutual funds) — works only if you obey the following rules:

		You must stay invested in stocks continuously for a long time, preferably 20 years or more. Long holding periods reduce the risk of owning stocks. If you plan on owning stocks for only a few months or even a few years — perhaps you are saving for a down payment for a house that you'd like to purchase in the next two years — an all-stock approach could be disastrous.
		You must buy during market declines. Over the next 20 or 30 years, stocks will get murdered periodically. Indeed, stocks could track downward for one year. They could stagnate for five years. Although unlikely, they could lose value over a 10-year stretch. To maximize the power of an all-stock strategy, you must buy during down markets as well as good markets. That's how you accumulate enough shares to win big when the market's uptrend returns.
		Remember — you buy stocks for the potential to get rich. Let's take an investor who is 50 and has $3 million in stocks. Should this person's portfolio be exclusively stocks? Probably not. He or she is already rich. This person should be thinking as much about staying rich as becoming richer. Only you know how much money will make you "rich." Once you reach that point, however, you'll want to protect your wealth, regardless of your age. You do this by expanding the types of assets you hold to include bonds and cash. If you're someone who wants to protect his or her wealth (or merely someone who doesn't have the patience or stomach for an all-stock portfolio), a fairly conservative rule of thumb for asset allocation is the following: Subtract your age from 110, and that is the percentage of assets that you should have in stocks. The remainder should be in bonds and cash. According to this rule, if you're 58 years old, you should have 52 percent of your investments in stock and 48 percent in bonds and cash.

Conclusion

You will not build a seven-figure investment portfolio without owning stocks for a long time. Fortunately, you don't need anything else but stocks and time to potentially get rich. So why doesn't everyone buy and hold stocks? Because most people don't have the patience to buy and hold stocks for 20 or 30 years. They panic and sell at every little market blip. Or they sell because they made a little profit. Or they pull money out of stocks to buy a bigger house or a fancier car.

It really is that simple — buy nothing but stocks and hold for 20 or 30 years. Just remember what I said at the beginning of this chapter:

You can get rich buying stocks. You can stay rich buying bonds.

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