(MoneyWatch) We recently discussed the issues with Bill Gross's article . I wasn't alone in rebutting Gross's thoughts. Wharton finance professor Jeremy Siegel, whom Gross named specifically in his piece, also offered a rebuttal to Gross. The problem is that Siegel's ideas on the lack of risk in stocks over the long term are also flawed.
Partly due to Siegel's best-selling book, "Stocks for the Long Run," many investors act as if stocks are only risky if your horizon is short. Unfortunately, this bit of wisdom is as right as the earth is flat. Let's see why this is the case.
Simply put, we might have just been lucky that stocks performed as they did over the very long period Siegel studied. However, we can also look outside our borders to see if other nations experienced what we did for stock returns. Unfortunately, investors in other markets didn't receive the kind of returns U.S. investors earned.
In the 1880s, there were two promising countries in the Western Hemisphere that were receiving capital inflows from Europe for development purposes. One was the U.S.; the other was Argentina. One group of long-term investors was rewarded. The other wasn't. If an alternative universe (to use a Star Trek term) had shown up, the results might have been reversed, and professor Siegel's book might have been published in Spanish.
And consider the case of Japanese investors. In 1989, the Nikkei index hit a peak of almost 40,000. Twenty-three years later, it's below 9,000, down about 80 percent. Do you think that long-term Japanese investors believe that stocks are not risky when your horizon is long?
We even have long-term examples in the U.S. For the 41-year period 1968-2008, U.S. large-cap growth stocks returned 7.7 percent and underperformed long-term U.S. Treasury bonds (20-year), which returned 8.3 percent. Similarly, for the 44-year period 1966-2011, U.S. small-cap growth stocks returned 7.7 percent and underperformed long-term U.S. Treasury bonds, which returned 8 percent. This shows that it's possible, even in domestic stocks, to be invested for a very long time and still not be rewarded for the extra risk.
Another long-term example should help illustrate the impact from a dollar perspective. The longer your time horizon, the broader the range of your portfolio in dollar terms. Consider the following.
From 1926 through 2011, the S&P 500 returned 9.8 percent per year. The worst year was 1931, when the index lost 43.3 percent. The best year was 1933, when it gained 54 percent. The gap between the best and worst years was 97.3 percent. Contrast that figure with the largest gap in returns for a 25-year horizon being just 10.1 percent.
Now let's consider the experiences of investors A and B, each with a 25-year horizon. Investor A's starting point is 1928, the beginning of the worst 25-year period. For the 25-year period ending in 1953, he earns 7.2 percent per year and each dollar invested grew to $6.02, a total return of 502 percent. Investor B's starting point is 1975, the start of the best 25-year period. He earns 17.3 percent per year and each dollar invested grew to $53.40, a total return of 5,242 percent.
While the difference in compound returns was "just" 10.1 percent, the power of compounding over the long period produced a gap of 4,740 percent in total return!
Now consider the investor who built his financial plan on the assumption that his stock portfolio would compound at 10 percent a year for his 25-year horizon. Had this investor started in 1928, he would have only achieved 56 percent of his goal.
Because the ending wealth of your portfolio is what matters, these examples demonstrate that the conventional wisdom that stocks become less risky if your horizon is long just isn't true. You must consider what happens if your investments fall short of projections by having what I refer to as a Plan B -- options that can be exercised if returns turn out to be below expectations. Options might include:
- Working longer
- Saving more
- Moving to a lower cost of living area
- Downsizing your home
- Spending less
For good reasons, the expression "those who fail to plan, plan to fail" is a cliche.
Investing isn't a science, like physics. No one knows in advance precisely what the return of risky asset classes will be over any given number of years. For this reason, projections of the possible results of an investment plan should also be expressed in terms of probabilities, which can be done through a method of statistical modelling called a Monte Carlo simulation. For example, such simulations may show you that your portfolio has:
- A 95 percent chance that you won't run out of money in retirement
- A 50 percent probability that you'll accumulate at least $1 million
- A 25 percent chance that you'll have $2 million or more
- A 10 percent chance that you'll have $100,000 or less
Considering such potential outcomes will help you determine not only the appropriate asset allocation, savings rates and withdrawal rates, but also underscore the need for a Plan B.