Stocks for the Long Run...Or Not
The ascendance of equities as the most important investment in one's portfolio ahead of all else (particularly as many were lobbying to find ways to invest Social Security payments in the stock market) coincided with the underperformance of that very asset class against more conservative investments. An investor who elected, in 1969, to invest in the bond market rather than stocks would have likely outperformed the stock market. According to Chicago-based research firm Ibbotson & Associates, long-term government bonds returned, on average, a compound annualized total return of 8.79 percent since 1969, beating the Standard & Poor's 500-stock index, which gained 8.70 percent in that time. That difference in performance is not dramatic, but it is notable considering the safety of government bonds with the riskier stock market.
What stands out amid the performance of stocks and bonds is that the former remains much more volatile than the latter. Both the bond and stock markets have had great years—the best year for stocks since 1969 was in 1975, when the market rose by 37 percent, and bonds nearly equaled that feat in 1982, gaining 36 percent. On the other hand, a bad year for bonds is 1999, when they fell 6 percent. But stocks are like the proverbial little girl with the little curl in her forehead: When they're good, they're very very good, but when they're bad, they're horrid. In 2008, the S&P fell 37 percent, and many individual names did worse.
Slicing and dicing those figures further brings better results for bonds in some cases, and more favorable outcomes for stocks in others. Government bonds easily beat stocks for the 20-year period beginning in April 1989, returning 9.61 percent, compared with a 7.42 percent gain for the S&P 500. Intermediate-term bond funds (which concentrated on buying bonds that mature in two to seven years) pull in a return of 7.39 percent, just behind the stock index. Stocks do better if the starting point is placed in 1979—a 10.3 percent return compared with a 9.93 percent return for bonds—and of course when the last ten years are considered bonds wipe the floor with the stock market.
The choice between bonds and stocks does tilt in favor of stocks over much longer periods of time. Ibbotson notes that the S&P 500 produced a compound annual average return of 9.44 percent between January 1926 and March 2009, whereas bonds, in that period of time, returned 5.6 percent annually. And Wharton professor Jeremy Siegel used historic data beginning in 1802 to argue for the superiority of equity market returns.
However, those early figures have been challenged by a number of analysts as spotty, relying on just a few stocks to serve as the benchmark for 19th-century figures and overstating the dividend component; others believe the long-run return of stocks is perhaps closer to 7 percent or even 5 percent, as the classic tome Triumph of the Optimists points out.
Market mavens hold this kind of history up as a sign that it's folly to consider the bond market as a potentially superior investment. Then again, there are very few people who started investing in 1926 and 83 years later, were still saving for retirement, other than perhaps 900-year-old Jedi master Yoda and Jeanne Calment, the French woman who died in 1997 at the age of 122.
Some would argue that the stock market has not really had a long enough period for one to analyze whether it indeed is truly an outperformer. The S&P 500 has only been around since the 1920s. Historical looks at stocks show that over 200 years, stocks have beaten bonds by about two percentage points, but Rob Arnott, chairman of money manager Research Affiliates, noted to the Wall Street Journal5 that half of that two-point outperformance in stocks comes from the 1949 to 1965 period, when stocks enjoyed a historic run, brought on by the post-war growth period in the U.S.
Notably, this sharp run-up came after nearly two decades of poor performance amid the Great Depression, the original event that turned investors off of equities for decades. Without that post-war period, stocks beat bonds over 200 years by one measly percentage point, and with that one point you get a heck of a lot more volatility and substantial additional risk.
This long-term performance makes investor willingness to place greater hope in the stock market puzzling. Perhaps the desire to invest in stocks comes from the dangling possibilities of riches that an investment in a staid government bond cannot promise. A person buys a bond in the knowledge that he will get his money back, with a steady interest payment. A person buys a stock hoping she's stumbled upon the next Google—which tripled between 2005 and 2007.
Perhaps the psychological preference to stocks comes from the desire for getting the most for as little as possible, or the hope for something bigger and better, which is what equity markets promise. The stock market gets at the very heart of the optimism that is part of human nature. Bonds? Bonds are like eating vegetables.
Investors in stocks are essentially telling the company in question, "Here. Here's my money. Good luck. Hopefully, this will all work out for all of us."
Now, they can point to historical figures, such as steady earnings, past performance of the stock and related companies, or economic growth, for justification of their investment in the unknown. But really, there are only two ways to make money in stocks: Payment of dividends, or later sales of the stock in question at a higher price. These two methods hearken to the two major theories of stock investment—the firm foundation theory and the castle-in-the-sky theory. The former is based on the premise that stocks have an intrinsic value that is a discount on their future earnings and dividends and are valued based on that—investing in a stock that is undervalued will produce steady returns over long periods of time. The latter describes the market's psyche of the last two decades, namely that it does not matter what you think of a company's intrinsic value, it only matters that someone else thinks it is worth more. It calls to mind the old saw about two people being chased in the woods by a bear. One of the men expresses doubt that they can outrun the bear, and his friend replies: "I don't have to outrun the bear. I only have to outrun you." Investing since the run-up in the mid-to-late 1990s has been a repeated application of the "greater fool" theory, where one only needs to find another willing investor to buy stuff, another person who cannot outrun the bear.
In the realm of the stock market, many investors employ dividend-seeking strategies, and base their decisions on the companies paying the heftiest dividends back to investors as a percentage of the stock price, which is referred to as the "dividend yield."
For example, say a company priced at $10 a share is paying a $1 dividend per year. When one buys that stock, the investor is guaranteeing themselves at least a 10 percent return—$1 for every $10 spent. If, for instance, the S&P 500's overall dividend yield is about 5 percent, and government bond yields are hovering around 3.5 percent, the decision to buy stocks becomes easier.
But many companies do not pay dividends, and in 2008 and 2009, many have eliminated or curtailed such payments due to the market's problems. (This will reverse in time, though.)
That leaves the second way to make money in stocks—through sales of the shares to someone else. But this relies on expectations that someone else will—based on a company's earnings, cash, assets and other indications—value the company at a higher price than you did. If dividends aren't part of the picture, this is basically a mathematically inclined form of gambling, where an investor hopes someone else will appraise their stock at a higher price than the last person. Yes, many will argue that stocks will appreciate over time based on those expectations for greater growth and steady earnings, and in many cases, this is how it works out. But intrinsically there's still a bet that the other guy is going to look at a particular stock and agree to buy it at a higher price than you did. It depends on an ongoing supply of new investors who believe the investment in question is worth more than the last guy. Don't believe me? Look to James Cramer, the hard-to-miss TV personality who ran (at its peak) the $450 million Cramer Berkowitz hedge fund. In his 2005 book, Real Money, Cramer also argued that the stock market had more in common with gambling than almost anything else, even advocating horse-racing guides as a valuable bit of reading for investors.
The argument in favor of buying because of expectations for greater growth is that the economy continues to grow, and companies continue to make more money, which justifies a stock being worth more over the years. And one would think that the traditional measures of valuation—price-to-earnings ratios, earnings growth expectations—would help investors guard against buying stocks when they reach levels that would be considered overvalued. If the market was truly efficient and was able to constantly adjust prices to reflect the true value of an enterprise, this kind of discussion wouldn't need to take place at all.
But in the last several years, the market has become more of a feeding frenzy. On average, investors hold stocks for much shorter periods of time than in the past, as more try to take advantage of buying interest based on unrealistic expectations—which adds to the Ponzi-scheme element of the market. It seems there's no shortage of reasoning (or rationalization, if you prefer) for buying stocks when they reach levels that should nominally be considered too expensive based on history, as long as someone else is buying them.
To say that stocks are a de facto Ponzi scheme is overstating matters—after all, companies that return dividends are giving investors back something for their money, and that dividend comes from earnings. It's not fake. But contrary to the popular disclaimer that "past performance is not a guarantee of future success," most investors rely simply on that. Or as current Credit Suisse strategist Doug Cliggott put it in 1999, "the 'greater fool' theory has been around a long time."6
Legions of investors built fortunes (and later lost them) asserting that the Internet would increase productivity, thus obviating all of the old reasons for traditional ways of valuing investments. As a result, the Nasdaq Composite Index, an index heavily concentrated in technology stocks, exploded in the late 1990s. It reached 3000 on November 3, 1999, for the first time, and hit 4000—a 33 percent gain—just two months later. But it wasn't done! The 5000 level was hit in early March.
Convoluted rationalizations led a pair of authors, James K. Glassman and Kevin Hassett, to declare that the popular Dow Jones Industrial Average should reach 36,000 within a few years. This book was published in 1999. This prediction has not turned out so well. Stocks peaked in 2000, and then entered a corrective phase that continues to this day, despite hitting a new high in October 2007. The prediction seemed ridiculous from the outset and has since become the object of scorn, similar to Irving Fisher's assertion in 1929 that stocks had reached a "permanently high plateau."
Those who argue that stocks maintain a superior advantage over equities also can be guilty of looking too closely at U.S. stocks. The world's third largest economy is Japan. That country underwent a boom fueled by excessive speculation in real estate that at one point famously valued the Imperial Palace in Tokyo at more than all of the real estate in California. The country's primary stock market index, the Nikkei, peaked at the end of 1989 at nearly 39,000. Two decades later, the Nikkei trades at about 10,000, or about one-fourth of that market's peak, as the country spent more than a decade trying to pull its banks out of the rubble of the post-boom crisis. Such a situation persists in the United States, where major financial institutions have elected to keep credit tight for fear of more losses.
Bonds, by contrast, are a much more conservative investment, germinating from a more cautious rationale. The investment is a loan, not a prayer. Guarantees of yearly payments are given in return, along with the eventual repayment of the original loan. They're not risk-free, of course: Bonds issued by companies in poor financial shape are more likely to go bankrupt, or default on their debt, and as such merit a higher interest rate. (Government bonds generally do not default, unless they're issued by a government like Argentina or Ecuador, both of whom have reneged on debt payments in recent years.) U.S. government bonds are not in such shape, thanks to your tax dollars.
Not everyone is convinced bonds can continue to outperform the market, noting the unimaginably high inflation of the 1970s and the subsequent decline in those rates as crucial to the bond market's stellar returns of the last four decades. This is unlikely to be repeated, and if it is, it would first require massive rises in bond yields—and therefore, sharp losses in the value of those bonds. "Bond returns were not only much higher than their historical averages, but also higher than their current yields," noted Peng Chen and Roger Ibbotson of Ibbotson and Associates, on Morningstar.com's Web site.7 They argue that stocks are more likely to outperform in coming years.
The more reductive thinkers in the crowd would look at the steady growth in the bond market and assume that stocks "have to" perform better, in the same way investors expected that the Internet stocks that once reached $150 a share "had to" return to something close to that level. (It's the kind of thinking that assumes a baseball player is "due" to get a hit after going hitless in his previous 14 at-bats—the chances do not change because of previous outcomes.)
Still, those who believe stocks will rebound may yet be right. As we will see, this still does not necessarily mean investors should default to the decades-old recommendation of 60 percent of one's investments in stocks and 40 percent in bonds. It also does not mean investors should try their hand at beating the market through day-trading or active stock market investment.
Stocks indeed can produce strong returns through certain periods of time, and tend to do well after a period of underperformance such as the one that was experienced between 1999 and 2009. But investors can do plenty of damage if they concentrate their funds in all of the wrong stocks, as many found out through the carnage of the past ten years of investing.
Some of you may be looking at this book and thinking a similar thought as many more than likely felt about those tomes that rode the 1999 boom and confidently predicted the market would soar another 30,000 percent in the next week or what have you—that it's just taking advantage of the current bearish trend in stocks, and it's guaranteed to be proven wrong as the market soars in the next few years. But that's not the idea. What I'm trying to do with this book is let people know that:
- There are options outside of merely accepting that one's money has to be in stocks to gain any kind of real solid return in coming years.
- It is okay to sell from time to time—not willy-nilly, but you needn't ascribe to some vague notion of putting all of your money away and forgetting about it for 40 years until—voila!—you have enough for retirement.
- More importantly, it's to allow people to admit that it's okay if they're not adept in buying individual names, that they can ignore "buying on the dips," or "going bargain hunting." It's not a deficit of character to not want to do this. Feeling this way has ruined many a portfolio as you succumb to envy of what the guy next door is doing, as he confidently regales you with tales of his investing prowess. Never mind all that. When the market does badly, he probably does worse.
You can hang in there by limiting your costs and not buying into the game that Wall Street investment houses, brokerages, advertisers, and the popular media has been selling for the last three decades. You can ignore the hype, the carefully constructed ad campaigns that, contrary to what they say, do not make a person feel empowered but make them feel anxious and inadequate for not following the herd. It's true that stock picking is a talent, which we'll demonstrate in coming pages. But it's a talent that most so-called professionals don't even possess, so you needn't feel bad that you don't have it either. What you can do is know where your money is going and make smart decisions but also as few decisions as possible, instead of going down the rabbit hole of constantly trading stocks.
Again, that's not to say that this book has some kind of magic elixir that will beat the market. If that's why you're holding this, I suggest you put it down and go find something else to read. This book is supposed to wake people up.
This book will show how index funds, over long periods of time, can generally get the job done. But this isn't some kind of ode to the joys of indexing, not when holding an index fund over the last decade has been akin to running on a gerbil wheel. This book also looks at how some prominent investors are finding ways to diversify and beat the market with targeted bets on asset classes rather than on sectors, and how a bit of work—through rebalancing, through holdings of bonds, through discipline and understanding emotions—can make you a lot happier in the coming years.
Again, that's not a secret formula. Being in my profession, I know better than to promise the world, or better returns than the next guy's great formula. There are lots of formulas out there; some of them seem to work, and some of them, as I'll demonstrate, are exposed as unworkable.