Whether you’ve been investing for decades or are just getting started, at some point you’ll likely ask yourself some fundamental questions. The 10 listed here highlight key principles, backed by data and common sense, that can help improve your odds of investment success.
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Many investors view government debt as a concern for future market returns. The long-run data suggest country debt-to-GDP has not been correlated with stock market returns. This is likely because debt tends to be a slow-moving variable that investors can observe and account for when setting prices. Markets do not react to circumstances; they react to news. If the government debt is not news, it’s unsurprising it’s not a headwind to stock markets.
Sometimes, however, markets are greeted with news about a government’s fiscal outlook. France’s President Macron recently called for a snap, or unscheduled, parliamentary election. This election opens the door to policy changes that would substantially increase government spending deficits. In the span of just a few days, the cost of sovereign debt relative to peers—represented by the yield spread between French and German bond yields—increased by more than half, from 0.49% to over 0.75% by June 18.
Markets continuously and instantaneously process new information. That’s what makes them so difficult to outguess. But investors can take comfort in the forward-looking nature of markets. Once changes in circumstances are reflected in prices, investors should expect positive returns, regardless of the outcome of elections.
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Investors selecting funds based on dividend yield should be aware that high yield is no assurance of higher expected return. Plotting 10-year annualized returns vs. average dividend yield for US large-cap equity funds shows no meaningful relation between the two. Many of the best-performing funds in the category had below-average yields. And funds specifically targeting high yield can be found on both ends of the return spectrum.
A stock’s total return comprises both capital appreciation and dividends. Emphasizing only one component may reduce diversification and, as the data show, may not increase your expected return.
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It is unlikely any stock has an expected return of 100%. That seems too high to be the cost of equity capital for a company, and it’s doubtful anyone would sell a stock with an expected return ten times higher than the historical stock market return. A realized return that big likely means the company surprised investors in a good way.
The Magnificent 7 stocks returned on average more than 111% in 2023, exceeding the S&P 500 Index by over 85 percentage points. While it’s hard to say what cashflow expectations were built into their stock prices, comparing analyst earnings estimates to actual earnings suggests these companies exceeded expectations for the year. All seven reported earnings exceeding average forecasts. For example, Nvidia posted an earnings per share 37.4% higher than the average analyst expectation. Contrast this with 2022, when five of the seven companies’ earnings fell short of analyst expectations. The average Magnificent 7 stock return that year trailed the S&P 500 Index by 28 percentage points.
Expecting Mag 7 outperformance to continue is to bet on these companies further exceeding the market’s expectations. Simply meeting expectations may result in returns more in line with the market, consistent with the history of top US stocks.
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Research shows that size, value, and profitability are reliable drivers of expected equity returns.1 This paper summarizes the premiums associated with these return drivers across countries and regions. It also shows, using simulated marketwide strategies that integrate multiple premiums, how investors can achieve better outcomes by diversifying across markets.
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