How did they do?

bestEvery year Gallup asks the following question: “What do you think is the best long-term investment?” The results of the most recent query show that Americans favor real estate (25%), gold (24%), stocks (22%), savings accounts and CDs (16%) and bonds (9%).  Bankrate undertakes a monthly survey to measure how secure Americans feel about their personal finances compared to 12 months prior. The latest such survey shows that for money not needed for more than 10 years, people making six figures annually prefer to invest in stocks (34%) and real estate (32%). People making less than that prefer cash investments (29%), real estate (23%) and precious metals (18%). Women prefer cash investments slightly more than men do (30% v. 21%), while men prefer stocks more than women do (18% v. 11%).

Even though Gallup asks about “long-term investment” and Bankrate specified a hold period of more than 10 years, we can assume that the answers reflect some recency bias.  Indeed, gold was favored by 34 percent of Gallup respondents in 2011 and 28 percent last year. That said, these survey results offer some helpful insight into what the public thinks.  Putting aside the extent to which these choices are good ones, it is important to consider how each of these asset classes have performed historically as a starting point for further discussion.  Continue reading

If Investing = Faith, I’m Agnostic

If investing = faith (as the always engaging Bucks blog from The New York Times contends), this Christian is decidedly agnostic.

In Bucks yesterday, Carl Richards makes a plea for investors to “stay the course” based upon faith.

This act of faith is most evident when it comes to the stock market. …[T]he core question becomes this: do you still believe that stocks will continue to do better than bonds, and bonds will continue to do better than cash, just like they always have?

I do not necessarily accept the premise of the question in that bonds *have* outperformed stocks over significant periods of time. Moreover, we do not have anything like enough data to be terribly confident about any alleged trend going forward.  However, to the extent that this question is a valid one, my answer is “no” with respect to the short and intermediate terms and “I have no idea” with respect to the longer term. It is usually wrong to think so, but things may really be different this time.

Financial services advertising typically includes a disclaimer something like “Past performance is not indicative of future results” for very good reason.  If the 2008-2009 financial crisis taught us nothing else, it taught us that just because something has not happened or is highly unlikely to happen does not mean it cannot happen.  Therefore, assuming that something will not happen is extremely dangerous, especially when the consequences of being wrong are dire.   

United States domestic equities have returned nearly 10% per year on average over the past 100 years. These historical returns compare to slightly above 5% for bonds and a “risk-free” (Treasury bill) rate of slightly more than 3.5 percent. In the long run, then, stocks have been a great investment, at least to this point. Unfortunately, the long run may be much longer than an investor has. Owners of equities have been well rewarded over most substantial time periods, but not all.  As John Maynard Keynes famously put it, the market can stay irrational far longer than one can stay solvent.

Advocates to staying the course typically argue that downturns are opportunities to buy stocks on sale and I generally agree.  But even with this year’s struggles, U.S. markets still appear overvalued.

Source: Pension Consulting Alliance – Investment Market Risk Metrics

Moreover, projecting returns over the next ten years based upon present values suggests that equity investors will see nothing like average historical returns over the near to intermediate term (even though strong cyclical rallies – as in 3/09-3/11 – are to be expected).

Data courtesy of Robert Shiller, Yale University Department of Economics and his Irrational Exuberance

As emphasized above past performance is not indicative of future results – almost anything *could* happen – with the exception of the 1990s period dominated by the tech bubble, the stock market has never had a positive 10-year return that began from valuation levels like those seen at present.  Secular bear markets (like the one we have been in since 2000) can see dramatic swings but no real advance – what Time magazine, in 1977, called a “roller-coaster to nowhere.” John Hussman sagely calls the faith of the buy-and-hold-hope-all-the-time investor “hanging around, hoping to get lucky.”[1] 

Accordingly, even investors who perceive themselves as “in it for the long haul” need to be clear about how long that is.  Wade Pfau, a professor at the National Graduate Institute for Policy Studies in Japan, has shown that Americans who retired around the turn of the century are often in real danger if they are using their portfoilios to provide income using an alleged “safe withdrawal rate” (usually around 4 percent).  Indeed, for 2008 retirees, Pfau estimates a maximum sustainable withdrawal rate of only 1.5 percent.[2]  Blind faith in historical return levels for these investors is likely misguided.

That said, Bucks is right that “[o]ne of the biggest risks to investing in the stock market is getting scared out of it at the wrong time.”  As behavioral economics teaches, we all tend to buy when markets are high and sell when markets are low.[3]  Moreover, we all have a perfectly human – but erroneous – tendency to chase the most recent “hot” thing or to get out of the current “cold” thing in the market. If recent returns are good, we expect that trend to continue (and vice versa).  Even professional managers suffer this flaw. We also know that investors simply trade too much and hurt their investment performance accordingly. Attempts at market timing are not the answer.

Bucks purports to see an appropriate object for the faith it commends:

“Approaching investing based on the data from the past doesn’t require you to ignore the tough economic challenges we face. It just requires that we believe we will find a way through them.”

I agree that “a way through” can be found.  However, the key to discovering it is not by blindly clinging to the past as indicative of the future, especially if one’s “long-term” is ten years or less.  Richards claims that “investing based on the weighty evidence of history is the most prudent thing we can do.”  I agree that it’s foolish to ignore history.  But the history must be accurately recorded and wisely interpreted.  As Christianity teaches, faith without works is dead.


[1] See also, Lessons from a Lost Decade, The Likely Range of Market Returns in the Coming Decade, Valuing the S&P 500 Using Forward Operating Earnings, and No Margin of Safety, No Room for Error. Robert Shiller doesn’t like the investment universe much at all over the near and intermediate-term either – except for farmland.  Jeremy Grantham is extremely risk-averse right now too.

[2] Wade suggests that retirees would be well advised to consider the market value (and not just price) of a retirement portfolio when determining a withdrawal rate. He has shown that the amount of wealth remaining 10-years into retirement accounts for up to 80 percent of the variation in final outcome measures after 30-years (“sequence risk”). Therefore, retirees who are unlucky and retire into a down market and who have not provided adequate guaranteed income will need to try to readjust their spending downward and consider returning to work. In his view, since current dividend yields are low, earnings valuations are near historical highs, and nominal bond yields are low, current retirees should assume lower portfolio returns than normal for the near-to-intermediate term and should lower their withdrawal expectations accordingly to try to avoid plan failure. His recent paper entitled Can We Predict the Sustainable Withdrawal Rate for New Retirees? gives a solid framework for how to do that. A helpful summary of some of Wade’s work is available here.

[3]The Dalbar study annually finds, based upon mutual fund flows, that the average equity investor’s return on stocks is dramatically less than the return of the S&P 500 index.