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Stocks (Not) for the Long Run

Financial Follies pervade the personal finance arena and a lot of those fallacies stem from misaligned incentives. Financial professionals’ primary incentive is usually to make the largest commission possible for the least amount of work.  Many financial advisors receive hefty fees for pushing certain mutual funds on clients and many of those advisors who sell insurance products are more than happy to push equity indexed annuities on the unknowing elderly so long as they receive their fat 10% plus commissions versus a much lower commission on a fixed annuities.  Incentives are powerful devices that often do not work in the best interest of the investor.

The misconception about equity returns and the statement “stocks always outperform over the long run” is as misleading as it gets.  The problem is that we can all simply calculate the average return from stocks for the last two hundred years and make a generalization that on average stocks have returned 8 or 9% per year.  What this does not tell you is what happened during that period.  Were there periods where you would have been much better off owning government securities or corporate bonds had higher returns?  The simple answer is yes.  As Robert Arnott pointed out in his rather enlightening piece entitled “Bonds: Why Bother?“, treasuries have outperformed stocks the last 41 years between 1968 and February 2009.  There goes the rather pervasive assumption that stocks are a better long-term investment.

Stocks were trampled by bonds for over 41 years!

Stocks were trampled by bonds for over 41 years!

The aspect that is missing in nearly every analysis regarding the long-term performance of equities is the intraperiod volatility.  If we assume that in any given year stocks should earn 8-9% with an annual volatility assumption of 20%, then in any given year let us suggest that we could earn a high of 30% or a low of -10% but on average the middle of the distribution will be 8-9%.  If we lose 10% one year we could lose 10% the next year and so on…  As we go further out in time the probability that we will lose money will go down, but that does not mean that it cannot happen – just what we saw in the 10 year period between 1999 and 2009.  The problem comes in the random draw.  If that 10 year period where you lose 70% of your assets in stocks occurs right before you are ready to retire, then is it truly correct that over a 30 year period you are smart to invest in stocks because on average they have high positive returns?

A few more financial fallacies that have generally been debunked are as follows:

  1. Most mutual fund managers outperform their benchmarks
  2. Housing prices never decline over multi-year periods
  3. The expected risk premium for holding stocks is always 3-5%
  4. Investing in international and domestic equities provides good diversification
  5. We would never see volatility in equities like that experienced during the great depression

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