By Jason Zweig | Oct. 14, 2009 12:01 a.m. ET
Image Credit: Heath Hinegardner
Can you make the risk of stocks go away just by owning them long enough? Many investors still think so.
“Over any 20-year period in history, in any market, an equity portfolio has outperformed a fixed-income portfolio,” one reader recently emailed me. “Warren Buffett believes in this rule as well,” he added, referring to Mr. Buffett’s bullish selling of long-term put options on the Standard & Poor’s 500-stock index in recent years. (Selling those puts will be profitable if U.S. stocks go up over the next decade or so.)
As the philosopher Bertrand Russell warned, you shouldn’t mistake wishes for facts.
Bonds have beaten stocks for as long as two decades — in the 20 years that ended this June 30, for example, as well as 1989 through 2008.
Nor does Mr. Buffett believe stocks are sure to beat all other investments over the next 20 years.
“I certainly don’t mean to say that,” Mr. Buffett told me this week. “I would say that if you hold the S&P 500 long enough, you will show some gain. I think the probability of owning equities for 25 years, and having them end up at a lower price than where you started, is probably 1 in 100.”
But what about the probability that stocks will beat everything else, including bonds and inflation? “Who knows?” Mr. Buffett said. “People say that stocks have to be better than bonds, but I’ve pointed out just the opposite: That all depends on the starting price.”
Why, then, do so many investors think stocks become safe if you simply hang on for at least 20 years?
In the past, the longer the measurement period, the less the rate of return on stocks has varied. Any given year was a crapshoot. But over decades, stocks have tended to go up at a fairly steady average annual rate of 9% to 10%. If “risk” is the chance of deviating from that average, then that kind of risk has indeed declined over very long periods.
But the risk of investing in stocks isn’t the chance that your rate of return might vary from an average; it is the possibility that stocks might wipe you out. That risk never goes away, no matter how long you hang on.
The belief that extending your holding period can eliminate the risk of stocks is simply bogus. Time might be your ally. But it also might turn out to be your enemy. While a longer horizon gives you more opportunities to recover from crashes, it also gives you more opportunities to experience them.
Look at the long-term average annual rate of return on stocks since 1926, when good data begin. From the market peak in 2007 to its trough this March, that long-term annual return fell only a smidgen, from 10.4% to 9.3%. But if you had $1 million in U.S. stocks on Sept. 30, 2007, you had only $498,300 left by March 1, 2009. If losing more than 50% of your money in a year-and-a-half isn’t risk, what is?
What if you retired into the teeth of that bear market? If, as many financial advisers recommend, you withdrew 4% of your wealth in equal monthly installments for living expenses, your $1 million would have shrunk to less than $465,000. You now needed roughly a 115% gain just to get back to where you started, and you were left in the meantime with less than half as much money to live on.
But time can turn out to be an enemy for anyone, not just retirees. A 50-year-old might have shrugged off the 38% fall in the U.S. stock market in 2000 to 2002 and told himself, “I have plenty of time to recover.” He’s now pushing 60 and, even after the market’s recent bounce, still has a 27% loss from two years ago — and is even down 14% from the beginning of 2000, according to Ibbotson Associates. He needs roughly a 38% gain just to get back to where he was in 2007. So does a 40-year-old. So does a 30-year-old.
In short, you can’t count on time alone to bail you out on your U.S. stocks. That is what bonds and foreign stocks and cash and real estate are for.
In his classic book The Intelligent Investor, Benjamin Graham — Mr. Buffett’s mentor — advised splitting your money equally between stocks and bonds. Graham added that your stock proportion should never go below 25% (when you think stocks are expensive and bonds are cheap) or above 75% (when stocks seem cheap).
Graham’s rule remains a good starting point even today. If time turns out to be your enemy instead of your friend, you will be very glad to have some of your money elsewhere.
Source: The Wall Street Journal