Rethinking Stocks for the Long Haul

[MasterBlaster]

Rethinking Stocks for the Long Haul - BusinessWeek

the combination of recent experience and a substantial body of finance research makes a convincing case that there's no safety in owning stocks for 10, 15, 20, 30 years—quite the opposite. Far too many investors may be taking on more risk than they know with their retirement nest egg in target-date funds or comparable portfolios put together by a DIY generation of savers. The risk in stocks is that they may stay down for a long time, wiping out a generation of savers who could be long dead before the market starts climbing again.

 

[kumquat]

Now let's do the same with bonds.

 

[MasterBlaster]

did you even read what the article had to say ?

In a nutshell many retirees are betting the farm on an equity premium which might just not be there over the time frame that they need it. Absent an equity premium many people will be in trouble.

 

[Bestwifeever]

Are they saying it's the death of equities?

 

[kumquat]

did you even read what the article had to say ?

In a nutshell many retirees are betting the farm on an equity premium which might just not be there over the time frame that they need it. Absent an equity premium many people will be in trouble.

I think I read it. Want to bet the farm on bonds from Egypt, Zimbabwe, the US or California?

 

[MasterBlaster]

OK - I posted it for some (modestly) intelligent discourse.

Evidently that isn't going to happen.

 

[kumquat]

Well, who started it?

Actually, you posted a link. Where is the rest?

 

[HatePayingTaxes]

I wish they keep publishing these articles. Then, when the market tanks, I can buy into some more cheap stocks, nice nice.

 

[Bestwifeever]

Who you calling modest?

Lots of history on this board about the timing of articles on the death of equities, by the way--I meant it as a legitimate comment:

Early Retirement & Financial Independence Community - Search Results

 

[ziggy29]

The point is, we don't know. The best we can do, unless we think we know something the "experts" don't, is to fashion a portfolio that historically works for our risk tolerances and time horizons.

 

[Gumby]

I did read the article and found it somewhat lacking. The fact that the market (or my particular slice of it) can go down sharply is hardly new. So what's the alternative? All fixed income? I am certain that strategy won't have a prayer of maintaining a 4% inflation adjusted payout. With a slug of equities, at least I have a chance to hedge against inflation.

 

[dex]

OK - I posted it for some (modestly) intelligent discourse.

Evidently that isn't going to happen.

If you wanted that to happen; you could have directed it in that direction by posting your thoughts.

Since you didn't do that; you left it to others to influence the direction of the discussion.

 

[harley]

There's nothing new in the article, he gives no alternatives for better investing, and doesn't mention that diversified investing with rebalancing can help solve potential low returns in the equity market. Just another paycheck article, IMO.

 

[traineeinvestor]

I have mixed views about the article but on the whole found it unconvincing.

I am much more comfortable buying equities for the longer term than I am buying bonds - given (i) that the earnings yield (inverse of PE) is higher than the yield on longer term bonds (YMMV - depending on which equities and which bonds you are talking about) and (ii) I belive that corporate earnings as a whole should grow over time (in both nominal and real terms), in my rather simplistic view of the investing universe, equities are actually safer preservers of wealth in the longer term than bonds. Given that I expect we will continue to see at least modest inflation in the forseeable future, this would hold true even if corporate earnings only grew in nominal (not real) terms.

I appreciate that in the shorter term (or longer) there will be occasions in which equities do very badly - but that does not destroy the longer term case for owning equities. Instead, it leads to the important conclusion that one shouldn't hold all equities. At the very least a few years worth of expenses in the form of cash/near cash should be kept to avoid being put in the position of having to sell assets at depressed prices to fund living expenses. In addition, market volatility creates situations in which equities are both over valued and undervalued (relative to historical norms) - holding a mix of asset classes and being prepared to sell when things look materially over priced and buy when they look materially underpriced (or rebalance to a fixed asset allocation if you prefer) provides opportunities to benefit from that volatility.

Then again, I'm something of an equity cultist.....

 

[haha]

I have zero interest in arguing investment policies with members here. But things like Zvi Bodie's reasoning are pretty powerful.

A book with a title that is misleading to some-Triumph of the Optimists, by Elroy Dimson, makes a similar point. The US has had blessed path, which of course may or may not persist. I see no indication that we are better governed (meaning more intelligently governed) than many other countries, so I really don't know why we should be able to keep skating across thin ice
forever.

No sense making challenges like ?But are bonds better?- what really counts is that one has his eyes open. Early retirement is a leap of faith. Best approach is to become a soldier or cop, and if people try to stop funding your pension, just shoot them.

Ha

 

[REWahoo]

Best approach is to become a soldier or cop, and if people try to[-] stop funding your pension[/-] [trample your grass], just shoot them.

Ha

Fixed it for ya...

YouTube - Get off my lawn

 

[haha]

Fixed it for ya...

YouTube - Get off my lawn

Boy, you really like this one! I am beginning to feel like your set-up guy.

Ha

 

[Gumby]

It's a tough job, but you're up to the challenge.

 

[FIRE'd@51]

OK - I posted it for some (modestly) intelligent discourse.

Evidently that isn't going to happen.

Maybe not. I believe the answer may lie here

 

[Purron]

In a nutshell many retirees are betting the farm on an equity premium which might just not be there over the time frame that they need it. Absent an equity premium many people will be in trouble.

The old rule of thumb used to be that you should subtract your age from 100 - and that's the percentage of your portfolio that you should keep in stocks. I've not heard much of this old rule around here. Most seem to be much more willing to take on risk and some much less.

 

[samclem]

From the article:

especially with the market up 90 percent since reaching its low on Mar. 9, 2010.

I don't know what "market" he's referring to, but if it is US equities I think he meant 2009. Maybe Business Week gave their editors the week off.

Wilshire 5000 Total Market Index (full-cap)

Anyway, yes stocks might be risky (i.e. volatile, which, IMO does a poor job of capturing the "risk" most people need to be concerned about). What alternatives does the author propose--lock in those appetizing 2.5% CD yields for 5 years and wait for the coming 7% inflation? Maybe some rock solid California bonds? It's very possible that the equity premium in US staocks will be lower for the next 50 years than the last 50--that's a good reason to diversify globally and to own US multinationals. Is it likely that over a multi-decade period stocks (with higher risk) will yield less than corporate bonds? Most importantly: will a portfolio with equities, bonds, and cash that is rebalanced periodically perform better or worse than a portfolio without equities? Which approach is truly riskier (not just less volatile, but also less likely to lose to inflation?)

Just another paycheck article, IMO.

+1. But, hey, what is he supposed to do? The deadline is approaching, the boss wants 1000 words to fill the page . . .

 

[GregLee]

I have mixed views about the article but on the whole found it unconvincing.

I found it completely unconvincing. Consider this passage:

Like their scholarly peers who are more positive on equities, these two believe bull markets and bear markets largely cancel each other out. In other words, stocks are "mean reverting" over the long haul. It helps explain why U.S. stock returns have been so consistent over time, about 7 percent after inflation since the early 1800s.

A real 7 percent gain over more than 200 years demonstrates stocks are "mean reverting", or bull markets are largely canceled out by bear markets? That's not even close to making sense.

 

[FIRE'd@51]

Maybe not. I believe the answer may lie here

OK, I didn't really expect people to run off and read the Margrabe article thoroughly (I linked it as a kind of swipe at MB who seemed to suggest we couldn't be serious ). I think it is relevant, however, and here is my interpretation of how it applies. I think the most fascinating point in the article linked by MB is that raised by Zvi Bodie near the end when he talks about "shortfall insurance".


— If stock market risk fell the longer the investment was held, the cost of owning options to protect the portfolio from a "shortfall loss" should also decline. (A shortfall loss is a loss relative to what an investor could have earned by putting money into a safe asset over the same time period, such as U.S. Treasuries.)

In an elegant exercise in 1995, Professor Zvi Bodie of Boston University tapped into the insights of option-pricing theory to challenge the notion that stocks became less risky for the buy-and-hold investor. Yet the cost of insuring a portfolio with options goes up, not down, with time. For instance, he estimated at the time that a one-year shortfall "put" option would cost 7.98 percent of the portfolio, and at 30 years the cost of the shortfall insurance jumped to 41.63 percent. (At 200 years the comparable number was 84.27 percent.)


Bodie's numbers can be computed using Black-Scholes (which is really a special case of the Margrabe option, i.e. an option to exchange a zero coupon Treasury security (i.e. the strike price) for the S&P 500). A one-year call option on the total return of the S&P 500 with a strike price 5% (the risk-free rate at the end of 1995) above the then value of the S&P 500 would cost 7.98%. So if the S&P were 100 at the end of 1995, one could exchange the strike price 105 for the index itself plus the dividends paid in one year. Bodie talks in terms of a put, which is the cost of the shortfall insurance, but since the strike price is the forward price of the total return of the S&P 500, the call and put prices are the same. Bodie then says that if you price the cost of the shortfall option for 30 years, it is 41.63% of the initial value of the S&P 500. That's because the strike price in the 30-year example would be 432.19 (the future value of a risk free asset that grows at 5% per year for 30 years.

Bodie then argues that, because the insurance cost (i.e. the put price) against a shortfall increases with one's time horizon, the risk of underperforming the risk-free asset must be increasing as well. I think this is a very clever and interesting insight, since common "wisdom" is that the risk of holding equities decreases if one increases one's investment horizon. Bodie seems to be saying this isn't really the case, since the risk of a shortfall increases with horizon, and it's shortfall risk one should focus on.

 

[HFWR]

A real 7 percent gain over more than 200 years demonstrates stocks are "mean reverting", or bull markets are largely canceled out by bear markets? That's not even close to making sense.

I assume the author considers seven percent to be the mean to which bull and bear markets revert, thus canceling each other out...

That stocks are risky should be crystal clear at this point. I was diversified across countries, and asset classes, and when the big dump came, all correlations mean-reverted to one...

 

[samclem]

Bodie then argues that, because the insurance cost (i.e. the put price) against a shortfall increases with one's time horizon, the risk of underperforming the risk-free asset must be increasing as well. I think this is a very clever and interesting insight, since common "wisdom" is that the risk of holding equities decreases if one increases one's investment horizon. Bodie seems to be saying this isn't really the case, since the risk of a shortfall increases with horizon, and it's shortfall risk one should focus on.

Can you help my simple mind with this:
1)The article's premise is that the market is fundamentally overvaluing equities (relative to bonds).
2) Brodie's research indicates that the market "believes" (as expressed by long-term put prices) that the risk of equity underperfomance (vs risk-free investments) increases with time.

If "the market" can be wrong about the correct price for equities today (#1 above) is it proper to base another leg of the argument (#2) on what the market believes about the future price of equities vs. a risk-free investment? Seems to me we'd need more data to determine in which case the market is making a more accurate pricing determination.