Stocks and time
Jeremy Siegel has a recent piece in the Financial Times that restates his view that stocks are the most appropriate investment for investors with a long horizon. I wonder how most of you look at this issue, especially after the recent market gyrations.
Are you still listening to Professor Siegel, or did you shred his book along with your fund statements from last year? I’d love to know how many of you agree with that view, and if your investment strategy reflects it.
Anyway, the assessment of “long run” risk in the stock market, and financial markets generally, is an issue that people in economics and finance have been examining and arguing about for decades. In the late 1960s, Nobel Prize-winner Paul Samuelson presented rigorous mathematical analysis showing that investors should not alter their portfolio allocations to emphasize riskier assets on the basis of time frame alone, given some basic and plausible assumptions about how people trade off risks and returns, and about the nature of asset returns.
Needless to say, not everyone was convinced by his argument. Many continued to advocate that the best portfolio for distant-horizon investors is the one with the highest geometric return, and finance journals are full of articles on the subject even to this day. (This argument reached an amusing crescendo in 1979, when Samuelson published an article on the subject in the Journal of Banking & Finance using only one-syllable words: “Why We Should Not Make Mean Log of Wealth Big Though Years to Act Are Long.”)
This debate has a personal angle for me as well as an intellectual one. My wife is from Japan, and we have extended family living there whom we visit from time to time. And while it is true that stock ownership is not as common among Japanese households as in American households, I am continually taken aback by the fact that broad measures of stock valuations on the Tokyo exchange are still roughly 75% below where they stood in the early 1990s. It’s not “a lost decade” they are reading about and living through in Japan. It’s two.
My own view on the subject is, quite frankly, that equity risk does not meaningfully diminish over time. I base that view on the logic of Samuelson’s analysis, history of the Japanese market, and the practical observation that basically no one is willing to write cheap long-term (20- or 30-year) insurance on the stock market into a straightforward financial contract. Such long-term arrangements are very rare in general outside of certain types of insurance products—which do not have the reputation for being inexpensive.
I’d also refer the more technically minded readers (i.e., those of you who actually enjoy calculus) to a recent, more technical analysis that tries to take into account the issue of statistical uncertainty around parameter estimates in thinking about long-run equity returns. The analysis argues that equities are significantly riskier at longer horizons than shorter.
So, am I saying that everything you’ve heard about “investing for the long term” is bunk? Of course not.
Stocks can play a very important role in a diversified portfolio of investments, especially for younger people. But in my mind, the reason young people should consider higher equity allocations than older people is not because of the old cliché that “they have time to ride out the ups and downs.” It’s because they have a lifetime of work in front of them. This gives them far greater flexibility than older investors around altering goals, lifestyles, and their commitments to work or particular careers in circumstances in which equity returns are poor.
In other words, human capital is a very important part of the problem. So, in my view, if you don’t have other resources that can help you to offset the consequences of poor markets, heavy equity exposure involves significant risk even over decades-long periods.
That’s not to say that risk is not worth bearing. If investors are risk-averse, theory and basic logic suggest equity risk should, on average, be rewarded with a significant and positive return in excess of what one would obtain from less-risky investments. Otherwise, investors would shun stocks. It’s critical to keep in mind that the “equity risk premium” exists on average precisely—and only—because it doesn’t exist in all circumstances. In other words, no matter what the time frame, there is risk of underperformance (and, potentially, dramatic underperformance). It’s a “risk premium,” not a “return premium.”
If anything good can come out of the current financial crisis, my hope is that it’s investors having a better understanding of risk, and making decisions to hold stocks because they believe the potential rewards are worth the risk—not because they don’t think the risk is there.
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Well-said, John!
This article is very insightful and thoughtful. I read a recent Vanguard study that demonstrated that moving average long term equity performance measures are largely determined by short term results. I only wish the realities of risks and opportunity of equity investing were as clearly communicated by mainstream media.
Thank you.
Secular Bear markets, by definition, last one generation. During that time, there are business cycles that provide good equity returns, especially if one uses dollar cost averaging. It is critical that one’s portfolio has enough cash to ride out 5 years of down markets in order to reap the benefits of the dollar cost averaging.
The Japanese are about to have one of the greatest secular bull markets in their history!
I’m a firm believer in “stocks for the long run.” I’ve been investing for nearly 40 years and have always held a diversified portfolio of equities and fixed income, rebalancing about every year. I’ve made more money investing than in my entire working career. All this bunk about fixed income being better is just data mining. Ten years ago bond yields were much higher than now, and stocks had just come off a long period of higher-than-normal returns. With bond yields so low now, it is very hard to believe the next ten years will favor bonds over stocks.
I’m 67 years old and still keep 55 to 60 percent of my investment portfolio in stocks.
I am a conservative investor in Vanguard mutual funds. I am retired and have stayed the course during the current recession (40-50% stocks). Stocks are the most appropriate investment for me partly because I do not consider my home to be a good investment. I live in Allegheny county, PA where property taxes are very high and homes evaluate over the long term about 4% per year, if that during this recession. I can safely currently get about 4%/yr from bonds and historically 11% per yr from stocks. Thus stocks are a better long-term bet in my view.
The stock markets returns for 2008 brought home to me that stocks are risky investments. I did not think a 50% deline was possible. Risk tolerance tools that I had used asked questions about what I would do if there was a 20% or 30% decline in the stock markets: would I buy more stock or sell stocks. I always answered that I would buy more stocks. The reality of a 50% decline in value though confronted me with my inability to rebalance into stocks. I just could not do it. I did not sell but neither did I buy. I am nearing retirement and the recently departed recession has made me assess my need to assume risk. One’s need to invest in stocks for the long term seems to be a frequently ignored factor when risk assessment is discussed. If one does not need to invest in stocks, why do it?
I don’t believe Jeremy Siegel, or anyone else even remotely associated with Investing, or Stocks in general. I’m 63 and have lost more money over the years by ‘prudent investing’ and following common investing practices and advise. These losses have amounted to a tremendous amount of Inflation that one is supposedly investing to counteract. What a farce. I have returned to the basics of just saving my money, as I always have. This is how I acquired the wealth that I had that was ’squandered’ by poor performance and market whims, not to mention the corruption that we all have known and suffered from. In reassessing my Investment Position, I had to come to the hard reality that the ’small’ investor is not destined to ‘Win’ in this game. I have always been happy with the simple life, so why try to aspire to what I’m not by risking my ‘wealth’ with scurrilous investments and practices that are rife today. I am extremely happy with my meager, but steady, Vanguard returns, and my safe CD and Bond investments. Much like our Politicians, Investment folks are speaking from a position of unusual wealth and privilege, and care not one iota for ‘our’ Future, other than the fees they can generate by leading us on. I have LONG ago given up on being advised into poverty. I sincerely doubt that Vanguard will post this comment, but they should, on many counts. It’s Honest and non-controversial, and no doubt could be many of their other investors feelings.
Yes, I agree with Jeremy Seigel. I was 98% in equities (mostly strocks, some commercial real estate) for over 50 years. Good stock selection (no dot.com stocks) got me through the 2000-2002 downdraft, then i became an avid Vanguard mutiual fund investor with asset allocation and rebalancing (eventually a 67% stock/33% bond asset allcation) of my invested assets. This worked well despite the losses since Oct. 2007. This allocation, combined with asset allocations to several stock and bond asset classes and frequent stock/bond rebalancing, kept my losses to less than 1/2 of what an all srock portfolio would have achieved. I have read Jeremy’s book, and I don’t think he emphasizes careful stock/bond asset allocation and rebalancing enough to limit losses in stock bear markets, inhis zeal to emphasize the superiority of stocks for the best long term investment performance.
Moreover, if I “annuitize” my fixed pension funds with a lump sum (giving me a fixed 4% income equal to my pensions, and add this lumpo sum to my bonds), I have a 42.5% stock/ 58.5% bond asset allocation. I am age 73. Using the usual 100-age stock allocaiton, I should have only 100-73 = 27% stocks. Thus, “annuitizing” the pension income is essential to come anywhere close to an otpimal allocation to stocks. For me, I am using a formula of 115 - age (equals 42%) for my “annuitized pension adjusted” stock/bond asset allocation.
I feel that any type of investing comes with the responsibility of monitoring your investments to ensure that the fundamentals of the investment have not changed significantly. This is an ongoing process and must be done on a continuing basis. Anyone who makes an investment and decides to only read their quarterly statements is doomed to failure. I dedicate at least an hour per week for every stock I own and I’m always comparing the stocks to others in their peer group. I tend to never invest in what’s hot now, generally you’re trying to get in when everyone else is getting out. Have an investing discipline and stick with it, but that doesn’t mean stay with a bad investment.
I have tended to agree with Professor Siegel’s recommendation of “Stocks for the Long Run”.His data show stocks outperforming government bonds,say,over a lifetime.However,in a lifetime one may experience a 1929 or 2007/2008 crippling decline in equities values.Disconcerting.Is it worth it? People who invested in the S&P 500 Index 10 years ago are still hurting.
Instead of government bonds,how would long term equity performance vs. investment grade corporate bonds look? I believe corporates generally have a plus 200 basis point yield over governments.Einstein said that the eight wonder of the world is compund interest.On a risk adjusted basis would corporates come out the winner? About one-quarter of my portfolio is in old-fashioned E Bonds.Like the Energizer Bunny,their value just keeps growing and growing through thick and thin.If this money had been in corporates,I think the results would have been outstanding.
Bottom line,unless you are Warren Buffett smart or lucky,I suspect using compounding bond interest is the way to go.Even Siegels results require reinvestment of dividends to achieve the advantage he shows for equities.Nobel prize winners and Graham of Graham and Dodd recommend a 50/50 bond/equity ratio.Sounds good…maybe even a higher percentage of bonds.
Interesting analysis that needs expansion. It seems that, in its simplest form, you are saying that if given a die with various positive and negative returns printed on its six faces, even in a fair game you could roll a bad sequence that could last 20 or 30 rolls. But this is not a fair game. Our economy is constantly subjected to government policies, social tragedies, miscalculations, graft (think Madoff) that lower the returns on the die during the sequence based on the sequence itself — i.e. the rolls are not independent of one another. This is problem #1.
Problem #2 is illustrated by the constant “evolution” of technology (of all sorts). Companies come and go. If an invester holds individual stocks, they had better know technology. I am struggling to come up with an example of a tech stock that I could have bought in the 70’s that would have made me a reasonable return (9% per year) over 40 years (i.e. an increase of 31 times the purchase price, i.e. bought at $10 now worth $315). Kodak? Smith Corona? Joy Manufacturing? Digital Equipment Corporation? Xerox? Solid State Scientific? Morotola? Polaroid? Caterpillar? GM? Ford? Wang? RCA? Chrysler? Half are defunct, the others are zombies. This example lends support to the notion that, because of “creative destruction”, the longer you hold, the more likely you’ll fail. Long-term, blind holding of a basket of stocks is a bad, bad strategy.
This is an excellent article that shows how important comparative perspective is in investing. For me the most important information of this article is in the reference to the fact that ordinary Japanese do not invest in their stock market. It is the same situation in most of the developed countries: they keep their pensions and savings away from the market, the same for education and healthcare. Countries where ordinary citizens do not play on the market with their life savings, are doing much better than the only developed countries where citizens were encouraged to follow the US frenzy with the stock market, as well as their institutions - Ireland, Iceland, Baltic Countries, etc. These poor countries are broke now, beginning from the EU and IMF (and yes, China), to help them. As you visit Japan, it is clear your family members their do not invest.
US government should follow your article, and bravely urge a decoupling of huge pension funds from the stock market. The same for healthcare, the same for education: just as in the rest of the developed world. There is nothing wrong with the stock market, but as you suggest, it should be ideally left to professionals and financial institutions, to play with their own money. And they should be honest and openly, like you, warn citizen-investors and municipal investors that this is not the place for their savings, it is the place for ‘extra’ cash that they would not mind to part with.
When I started investing thirty years ago, I understood that risk and performance of equities would fluctuate in relation to the performance of the company. I did not fully understand the vulgarities of the marketplace as they exist today . . . day traders, investors shorting the market, use of derivatives and leverage hightening the risk. I have started to question the due diligence that I assumed that was being performed by those who had such responsibility. I cannot reconcile the consequences to my retirement portfolio with the diligence I expended in being a buy and hold investor. I feel duped.
Excellent article, John, and interesting comments. My father was my teacher. He did poorly in 1929, lost again in 1973-1974 (during retirement), and died in 1978, never seeing the bull market return in the early eighties. As a result of his example I never bought a stock! By 1984 my children finished college and we lived beneath our means saving the difference in E-Bonds, CD’s, and when available I-Bonds and TIPs. We feel like winners. This blog in an eye-opener. Keep it up!
Dollar cost averaging will stand the test of time with stocks. I see the bear markets as an opportunity to be buying mutual fund shares (though I’m not changing the amount I am purchasing) at a cheaper price, and thus, when they go up in value, be worth more. In 2009, I made a little less than 2% on my principal in dividends. Has anyone factored in this extra accumulation into their buying decisions? Regular dollar cost averaging will result in a hyperbolic graph over time (hence the Einstein theory that exponential growth is the 8th wonder of the world).