Conventional wisdom often portrays the stock market as a retirement savings vehicle, a means to accumulate a nest egg by diligently contributing to a portfolio. However, this perception belies the market's true raison d'être – to serve as an efficient mechanism for businesses to raise capital and fuel growth.
While investors seek returns on their investments, the enterprises they invest in are selling stocks and bonds to access funds that allow them to invest and grow at a level that may be beyond their current operational funding capacity. This capital influx from outside investors enables companies to pursue expansion opportunities, drive innovation, and potentially boost profits – a mutually beneficial arrangement for both the investor and the company when the investor's required rate of return equals the cost of capital the company is willing to generate.
Remember, capital, like many other things, operates in a competitive market. Just as investors will gravitate toward what they perceive as attractive risk-reward investments, on the flip side companies have a choice about how they raise capital and what return it's willing to generate and pay out to investors.
Senior investment executives at Dimensional Funds¹ illustrate this concept with a thought-provoking example: the (so-called) Magnificent 7 stocks grew by a staggering 76% in 20232. But is such an extraordinary return a reasonable long-term cost of equity capital for these companies? Unlikely, as they would seek alternative, more cost-effective funding sources if available.
As stated in the piece: "If the Mag 7 companies can secure funding at a lower rate through other means, 76% is not their cost of capital, which means it’s not an investor’s expected return."
This implies that a 76% return is improbable to sustain in the future.
The crux of the matter lies in recognizing that stocks are traded within a market for capital, subject to market forces and rates. When short-term investors drive up stock prices in pursuit of the "next big thing," they inadvertently sow the seeds for an eventual decline, as the stock will tend to revert to market rates for that capital. Historically, the broad U.S. market has posted annualized returns averaging around 10% across a century.
The sage advice from Dimensional resonates: "Rather than trying to guess which stocks might provide next year's outsized returns, or getting caught up in a cycle of fear and greed, we believe it is better to set reasonable long-term expectations to track progress toward your financial goals."
Pinning your hopes on extraordinary outcomes that are unlikely to recur can lead to disappointment, frustration, or worse. Instead, set reasonable expectations aligned with your investing timeline, risk tolerance, and unique financial situation. This grounded approach can offer a more sustainable a path to long-term success and financial contentment.
¹ Cost of Capital: A Gut Check on High-Flying Stock Returns | Dimensional
2 Ibid (Dimensional) In USD. Magnificent 7 stocks include Alphabet, Amazon, Apple, Meta, Microsoft, Nvidia, Tesla. Named securities may be held in accounts managed by Dimensional. Magnificent 7 return based on monthly market-cap-weighted average returns. Data provided by Bloomberg and calculated by Dimensional.
All investing involves risk including possible loss of amount invested. Past performance is no guarantee of future results.
2024-180012 Exp 08/26