Further Questions On "Stocks For The Long Run" -- Part I

In early October, Wharton School professor Jeremy Siegel contributed an op-ed to the Financial Times, trotting out his old thesis "Stocks For The Long Run," claiming that after the smoke had cleared from the Lehman-AIG crisis, the markets had once again proven that the stocks are the best investment for long-term savers.

At that time I wrote to challenge the idea, and considering the favorable markets we've had through the rest of the year, and the reckoning we are all doing at year and decade-end, I figured the topic deserved some further discussion.

My bottom line is the same: embedded in the theoretically higher returns of stocks is higher volatility. You can't escape it. Therefore stocks may the best choice for some people in some periods, but the answer depends heavily on the span of time during which you save, and the patterns of your cash flows.

But you can't know in advance just when a period of high volatility will come along. So just as before, talking about a generic long run is irrelevant: each of us has just one "run," one try at the metaphorical video game or pinball machine of investing, and the opportunities available in other periods past or future aren't available to us.

I'm no Wharton professor, but I am a Wharton graduate, and have worked in the investment business for over 25 years, and so know my way around the numbers. My following analysis is not exhaustive, and cuts a few corners, but it's still right and makes the point.

Professor Siegel bases his conclusion on the average returns to various assets over very long periods -- for stocks, going back to the early 1800s, or some such. Typically, any statistical exercise is enhanced by more data points, but of course the information needs to be clean. People much smarter than me, specifically Wall Street Journal writer Jason Zweig, have shot plenty of holes in the data on which Prof. Siegel bases his long-term returns.

Setting aside the validity of the data, Professor Siegel bases his judgment on the returns alone -- which asset earns the most -- and not the path of the investment over time.

Let's look at the record of the last three decades. (You've got about 40 years to save for retirement, but in our twenties most of us aren't making enough money, and are having too much fun, to save much, so the more realistic time frame is 30 years or so.)

Graphs of the results are hard to read, so we'll use a table instead. For the first two decades of the most recent 30 years, and starting with an imaginary $100,000 stake, stocks were indeed the place to be (see below, the green boxes).

Staying with stocks the entire time, through the third quarter of 2009, you wound up with $2.3 million (before taxes, and assuming no commissions). "Barcap Agg" refers to the Barclays Capital Aggregate Bond Index, which measures the return of the entire investment grade bond market, including corporate bonds and a large slug of high-quality mortgage bonds.

Second best were Treasury bonds. I haven't done the calculation to adjust for risk, but I'll bet that when the volatility of stocks versus government-guaranteed bonds is taken into account, Treasuries were in fact the better risk-adjusted investment. Second best is highlighted in yellow. Note that for the decade of the 2000s, bonds gave you twice as much as stocks.

So according to the simple, "start with a bundle" method, stocks won over the last 30 years.

But who starts saving with $100,000? I'm taking a different approach, looking at the actual results realized over real-life investment horizons, with two variables - returns as well as cash flows. Instead, we are saving over time, building the asset value with returns on the investment, and periodically adding capital. Because your capital is added gradually, you don't get the full benefit of up markets, or the sustain the full damage when things are falling.

Let's assume we make contributions of $1000 a month over the 30 years. How do equities look under those conditions? See the next table:

Stocks still win for the first 25 years, but don't get the same lengths-ahead lead until the bizarre years of 1995 through 1999.

But look at what happens to stocks from 1999 through 2009 - even though you're contributing your $1000 every month, in 2009 you've got less than you had ten years earlier.

More important, over the full 30 years, Treasury bonds win by pulling ahead after 2000: the tortoise and the hare. Stocks made some very big moves in that last 10 years, and if you had successfully played those, you would really have a bundle. But we're talking about buy-and-hold, stocks-at-all-times strategies here, rather than moving in and out of the market.

Here are a couple of graphs, illustrating two of the 10-year periods. From 1980 to 1989, under the assumption of starting with nothing and saving $1000 a month, look how close the results are, until stocks have unusually good years.

And from 2000 to 2009, when not only long-term Treasuries beat stocks, but ultra-conservative, low-risk low-return Treasury bills did too -- because stocks had unusually bad years:

In this case, if you were scheduled to retire in 2008, your stock assets are all of a sudden down 40 percent -- you'd have to wait for the "long term," and hope for a boom, rather than another drop. And then know when to sell out.

"Stocks for the long run" means you're more exposed to the volatility of stocks, both in a good and bad way, at the end of the run, when you've got the most chips riding on your chosen investment strategy. It's also a point when you have fewer earning years to make up for any mishaps.

Hoping that above-average returns will come along in time is not a long-term investment strategy you can depend on. A better strategy, one more in your control, is to marry well. Or even more reliably, diversify into both stocks and bonds. (My blogging colleague Allan Roth has written an insightful piece on how diversification and balance could have saved investors from a lost decade.)

In Part II, we'll look at one more case, a more realistic one, where the contributions start small and get bigger over time.