Making money in the stock market: Where do equity returns come from?

There are many ways investors make money on their stock investments, but one in particular accounts for the highest equity returns since 1970.

  • By Paulina Likos,
  • U.S. News & World Report
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When you invest your money in the stock market, your expected returns are coming from somewhere, but where?

Stock returns come from earnings, which are company profits trickled down to investors as dividends. From 1970 until today, dividends make up close to 70% of equity returns in the S&P 500 Index (.SPX).

Tim McGrath, managing partner at Riverpoint Wealth Management in Chicago explains, clients should be cautious, today more than ever, about dividend yields compared to future changes, especially in our current volatile environment.

When companies increase their dividends, they want to make them seem more attractive to the investor, "Given the fact that bonds are producing so little right now, everyone is searching for income and yield, which could be exposing the investor in taking higher risk," McGrath says.

But there are other ways stock earnings are achieved. Experts say, in the history of the S&P 500, U.S. equities have produced about an average of 10.1% in gains from 1926 until today; however, the average investor generates profits below this figure.

Understanding the anatomy of equity returns and where they come from could help investors see where they're falling short and how they can avoid making bad money moves.

Here's what investors should know about stock market returns and what they can do about it:

  • Short-term versus long-term gain.
  • What accounts for overall stock market returns?
  • How should investors respond?

Short-term vs. Long-term Gain

The average market returns historically are between 10% and 11%, but that's not always how the market performs. In 2019, the S&P 500 was up 31%, which was higher than normal. In 2018, the market was down 3%, so investors shouldn't get caught up on what happens on a year-over-year basis.

In the short run, equities are dominated by changes in multiples or what people are willing to pay for their earnings stream. Over the long term, equity returns are influenced by growth and earnings, which is why the "buy and hold" investing strategy will reward investors in the long run.

"Equity investment over the long term allows investors to reap the benefits of economies of scale as equities are the asset class that most closely tracks the overall value of goods and services in a market," says Christopher McMahon, president and CEO of MFA Wealth in Pittsburgh.

"Year-to-year volatility is much higher and if an investor can withstand short-term volatility, they almost always have a greater return than trying to time market tops and bottoms," adds McMahon.

The "buy and hold" strategy produces long-term growth. When you are in and out of the market, investors are susceptible to lose more money. The stock market produces a great amount of wealth for investors over time. For those that try to use the stock market as a "get rich quick" scheme, it's usually short-lived because stocks can be unforgiving with short-term volatility.

"Over short periods of time, equities can provide extremely high or low returns as markets respond to surprises in earnings, the economy and other factors," says David Schneider, president of Schneider Wealth Strategies in New York City.

"Over longer stretches of time, investors are generally compensated for the risks of equity ownership with higher long-term returns than could be obtained in fixed income securities or cash," Schneider adds.

Evaluating stock market returns in the short term is not a predictable gauge of stock market performance. Over the long term, however, investors can better see their realized stock returns versus their starting value.

What accounts for overall stock market returns?

As an investor, you hold equity in a company – meaning you are part owner of all the assets of that company and receive shares of their dividends. But there are multiple ways stock market returns are achieved.

Stock price appreciations, dividends and dividend reinvestments are driving components of how investors increase their rate of return on their investments in the long term.

Equity returns come in a variety of forms, "The first is the dividend yield averaged at about 2% at the history of the S&P 500, which hasn't changed much year to year," says Christopher Mizer, president and CEO of Vivaris Capital in San Diego.

What the company earns and distributes is a fundamental way investors realize stock market returns. Investors who hold dividend-paying stocks receive a dividend yield as distributions, which act as a form of income.

Furthermore, increases in dividend income bring about stock price increases in the long-term, making it more valuable. The compounding of earnings and dividends over time earn the investor a higher rate of return. This is why going in and out, or trying to time the market, can be detrimental to an investor's growth of wealth.

Market valuations are dependent on multiples or the market indicators that value different companies.

An example of a market multiple is the price-earnings ratio, or P/E ratio, which helps value a company by measuring the stock's share price relative to the income earned by the company.

P/E ratio is often referred to as the "multiple," since it shows how much an investor is willing to pay for $1 of earnings. There are a variety of reasons P/Es fluctuate, and just because the value is low or high doesn't indicate it's good or bad. The P/E ratio is an important function that sheds light on investor interest for a particular stock, and it helps determine equity returns.

"The additional return comes from the change in earnings per share and the P/E multiple," Mizer adds

An investor who is willing to pay up for a business' earnings determines their rate of return on their investment. This is the market multiple, which determines the value of the business.

As earnings grow at a higher rate, year after year, and if the market multiple remains exponentially higher than the income the company generates, then the market value of the business will continue to increase.

"The average P/E is 15.5x for the S&P 500 year-over-year return. Right now, the P/E ratio is about 21.2x earnings, which is high by historical standards," Mizer says. This is to say the stock market is trading at a very high valuation.

The P/E ratio has a huge influence on the increase in stock price. "Historically, when the markets are trading for lower P/E multiples, the subsequent period tends to have higher increases in stock price," Mizer adds.

If you're searching for stocks that are a potential buy, Mizer recommends looking to stocks with a lower P/E because "they have a higher likelihood of the stock price going up over time, as long as earnings are maintained."

Even though the future of stock market performance is unpredictable, by evaluating equities through market multiples, investors can have reasonable expectations on their equity returns.

Investors will realize a capital gain if they sell the asset for more than its original purchase price. Investors experience a capital loss if an asset is sold for less than its original price. You can choose to hold these dividend returns as income or reinvest the dividends to generate more returns.

For compound investing, or the reinvestment of dividends, investors can consider a dividend reinvestment plan option, otherwise known as a DRIP. When an investor reinvests dividends in additional shares, their money is really working for them, and over the long term, their portfolio's wealth will naturally grow.

Capital gains come from assets that are sold, which, in the long term, are acquired from holding on to assets for more than a year, whereas short-term capital gains come from selling assets at a profit that are held for a year or less.

How should investors respond?

Have a financial plan. When it comes to investing, make sure you have a list of standards you abide by so your portfolio endures the minimum amount of risk possible.

Understand that the valuation of a company is vital and using market multiples is necessary when buying stock in a company. When you're building your portfolio, look for companies that are dominant in their industry and dividend payers for compounding your income.

Know your personal appetite for risk. High risk can come with high rewards, but that may not be the best for an investor in the long run, especially for those in or nearing retirement.

In a portfolio, there are a lot of asset classes that might not even provide dividends, but they may still have attractive returns and provide diversification.

"Most people get caught up in large-cap equity stocks and tend to be overexposed themselves. We try to diversify them into small- and mid-cap to give them a more safe, diversified portfolio that will help them manage their risk exposure," McGrath says.

This is why, when managing risk, the trade-off between risk and reward is an important aspect to keep tabs on.

Keep in mind that it's difficult to beat the market averages over time. For the long-term investor, being consistent and disciplined tends to dominate returns rather than buying the stock at the "right" time.

Takeaway

Multiple factors drive equity returns, including what the company earns and distributes, their growth and their market multiples.

For investors focusing on buying opportunities, it's important to keep these drivers in mind to build optimal strategies that strengthen their positions and ultimately growing their wealth.

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