Where 'Stocks for the Long Run' Went Wrong

The Theory: Stocks for the Long Term

Siegel was just one of the best-known members of a chorus of
experts — including academics, advisors, and asset managers —
who reached a seemingly unanimous conclusion:

1. Stocks had provided the highest
   long-term return of any asset class;

2. Over holding periods of 10 years
   or more, the volatility of their annualized returns greatly declined;

3. Therefore, stocks are less risky
   if you plan to hold them for a long period of time — a theory known
   in academic circles as time diversification. According to this theory, stocks
   were an anomaly. They provided higher long-term returns with lower long-term
   risk.

These experts were preaching to an ever-expanding flock. Led
by the growing adoption of IRAs and 401(k)s, and the tremendous bull market of
the 1990s, Americans embraced equity ownership. From 1983 to 1989, the share of
American households owning stocks more than doubled, from 19 percent to 39
percent. By 2001, that figure reached 57 percent. Millions of investors ramped
up their stock allocations, convinced that a long time horizon and stocks’
inevitable outperformance would richly reward them.

What If the Theory Was Wrong?

There’s long been a cadre of professionals who
took issue with this conventional wisdom. Their criticism of the “stocks
for the long run” philosophy boils down to three parts.

First, they believe that annualized returns provide a false
sense of security, because only total returns matter. For instance, in
their best 40-year stretch, stocks provided an annual return of 12.5 percent;
in the worst period, the annual return was 5 percent. But compounding those
returns presents an entirely different picture of that relatively narrow
spread: earning 5 percent annually, $1 grows to $7.50 over 40 years; at 12.5
percent, it grows to $112, a total return gap that much better illustrates
stock market volatility.

The second criticism involves the use of probabilities.
Since 1872, stocks have outperformed bonds in over 90 percent of all 20-year
periods. But in constructing a portfolio, investors must consider not just the
likelihood of outperformance, but also the amount of the shortfall they might face.
If stock returns lag by just 0.05 percent annually, as happened in one period,
the penalty is rather small. But falling short by 2 percent annually, as in the
most recent period, produces a total return that is less than half that
provided by bonds.

To illustrate the importance of shortfall risk, Boston
University professor Zvi Bodie famously calculated the cost of insuring a stock
portfolio against a shortfall over various time periods. If the risk of
equities truly declined as time horizons grew, you would expect the insurance
cost to decline as well. But it doesn’t. Because the insurer has to
consider not just the probability of a shortfall but also the magnitude of it, the cost of insurance rises as the holding period grows.

Which leads to the critics’ third complaint: A
long holding period actually increases the odds of encountering a severe
bear market. And while you might have believed you were equipped to endure a 50
percent market decline, watching five years worth of earnings and contributions
vanish can make you reevaluate just how brave you really are. Investors who
find, too late, that they assumed more risk than they bargained for are often
the ones who flee the market entirely, further endangering their long-term
wealth.

And of course, it’s folly to believe that past
returns represent the limits of future performance, because anything can happen
in the stock market. A 35-year-old investor is likely in the accumulation stage
for only one full 20-year period. If you reach age 55 with your portfolio in tatters,
it’s cold comfort to know you’ve experienced a historical
anomaly.

What You Can Do

So what do you do with this information? Begin by taking
these three steps:

Step 1. Ditch the notion of “retiring rich.”

Focus on accumulating enough to maintain your current
lifestyle.

Honestly, if you’re not wealthy today, it’s
unlikely that saving and investing will make you so 30 years from now. You
might invest your way to a higher standard of living than your spendthrift
neighbors, but that means purchasing an Acura instead of a Honda, not summering
in Paris instead of Cleveland. Focus foremost on accumulating enough to
maintain your current standard of living in retirement. Once you have your
final destination in mind, figure out how to get there with minimal risk.

Step 2. Err on the side of caution.

Set a strategic asset allocation plan for good times and bad.

Rather than seeking to maximize your portfolio’s
long-term growth at all costs, establish an asset allocation that you’ll
be comfortable with, in thick or thin, for years to come. In advocating the
prudence of a conservative approach, Peter Bernstein once
noted that “few decisions in life motivated by greed ever have happy
outcomes.” Indeed.

Step 3. Prepare to be a little flexible.

Adjust your asset allocation at market extremes. name=Editing>

Buy-and-hold remains the sine qua non investment
approach, but a case can be made for a bit of flexibility. Vanguard founder
Jack Bogle wrote that you might encounter one or two occasions in your lifetime
when markets reach such an extreme (like when stocks were selling at 32
times earnings in 1999, or today, when they’re approaching single
digits) that you might consider slowly adjusting your stock allocation
up or down 10 percent to 15 percent. It’s not a casual undertaking;
you might be wrong for a long period of time. (Recall that Alan Greenspan’s
“irrational exuberance” speech was delivered in 1996.) But
as Nobel Laureate Paul Samuelson wrote, prudence might dictate that we “sin,
but only a little.”

There’s nothing inherently wrong with a
stock-heavy portfolio. But you should go that route because it suits your needs
and stomach for risk, not because you expect the risk of equities to melt away
as the years pass. The Roman orator Horace said that the golden mean avoids the
poverty of a hovel and the envy of a palace. That’s not a bad
investment policy, either.