Why Stocks Generally Outperform Cash

The financial world operates on a fundamental principle: higher risk should, ideally, lead to higher returns. This principle underpins why stocks, over the long term, tend to outperform cash. To understand this phenomenon, we must delve into the concept of the “risk of time” and other factors that contribute to the superior performance of stocks compared to cash.

The Risk of Time
The “risk of time” refers to the uncertainty associated with the extended duration of an investment. Stocks, as shares in companies, represent a stake in the future earnings and growth of those companies. This future is inherently uncertain. The longer the time horizon of an investment, the more unknown variables come into play, such as market fluctuations, economic cycles, and changes in business fortunes.

When you invest in stocks, you are accepting this uncertainty and the accompanying risk. In exchange for taking on this risk, investors expect to be compensated with higher returns. This is in stark contrast to holding cash, which has minimal risk over short periods and correspondingly low returns.

Compensation for Time Risk
Why should investors be compensated for the risk of time? The answer lies in the opportunity cost and the time value of money. Money today is worth more than the same amount in the future due to its potential earning capacity. When investors tie up their capital in stocks for a long period, they forego other investment opportunities. Therefore, the expected return on stocks includes compensation for this opportunity cost.

Factors Contributing to Stock Outperformance Over Cash

1. Economic Growth and Corporate Earnings: Over time, the economy tends to grow, and with it, corporate earnings increase. Stocks represent a claim on these future earnings. As companies grow and become more profitable, the value of stocks tends to rise.

2. Inflation Impact: Inflation erodes the purchasing power of cash. Stocks, on the other hand, often act as a hedge against inflation. As the cost of goods and services increases, companies can increase prices, potentially leading to higher profits and stock prices.

3. Liquidity Premium: Stocks are generally less liquid than cash. This lack of liquidity means that stocks carry a premium to compensate investors for the difficulty in quickly converting them into cash without a loss in value.

4. Risk Premium: The stock market is more volatile than the cash market. This volatility is a measure of risk, and investors demand a premium, in the form of higher expected returns, to compensate for this additional risk.

In summary, stocks should outperform cash most of the time due to the compensation required for the risk of time and other factors such as economic growth, dividend reinvestment, inflation impacts, liquidity, and the inherent risk premium associated with market volatility. Understanding these principles is key to comprehending why stocks are a crucial component of a long-term investment strategy, despite their higher risk compared to holding cash.