Stocks for the Long Haul
Chad is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.
I recently read that a Boston University finance professor said, “So often you will hear the wildly-believed fallacy that if you have a long time horizon, the risk of investing in stocks goes away, that is not true.” This is a quote from Zvi Bodie from his book “Risk Less and Prosper." Now admittedly, Bodie is not saying to avoid the stock market. He is saying that your investment choices, and savings patterns, should align with your goals. In plain english, if you plan on reaching a particular goal, you have to either save more and take less risk, or save less and take on more risk. While I agree in principal with this idea, I have a problem with the idea that the average investor can avoid risk and still “prosper.”
Let me give you some facts to think about. In a paper produced by the Federal Reserve Bank of St. Louis dated Nov/Dec 2007, we find that the national savings rate has been dropping. In the 1980s the savings rate was “around 9%”, in the 1990s the rate dropped to about 5%. Since the year 2000, and up until the Great Recession, the savings rate was near 2%. Even looking since the recession, the savings rate has averaged between 3-5%. The reason I point this out is, this percentage is not enough for the average American to take on significantly less risk and still “prosper."
Bodie's assumptions for avoiding the stock market, focus a lot on the last 10 or 11 year period. He mentions several stories, about how the 2000 and 2009 corrections played into investors thoughts and expectations. His idea of goal based investing, means you decide when you need the funds, then make your investments based on that time frame. The problem is in many cases investors use the last 5 or 10 year time frame to determine what they can expect going forward. That is a dangerous idea. In addition, for many of us, our bigger goals like retirement, have longer time horizons than 5 or 10 years. For a 30 year old, retirement is at least 25 years away. Just expanding the time frame from 10 years to say 18 years, makes a world of difference in return estimates. If you look back 18 years to 1994 and compare, the S&P 500 has outperformed long term bonds 10.12% to 8.23%. (I picked 18 years because that is when Vanguard began its Long Term Bond Index fund.) While it is true that you took on more risk, over the longer term stocks do outperform bonds.
In the last 10 years, long term bonds have outperformed the S&P 500 Index. This is unlikely to occur again. The reason is simple, interest rates determine bond returns. The reason bonds have outperformed stocks in the last 10 years is two-fold. First, in year 1999 many stocks were wildly overvalued. This caused a market correction that generated negative returns in the S&P 500 for the next 3 years. Second, the interest rate on a 30-year bond in year 2000 was about 5%. The interest rate on that same 30 year bond today is 3.2%. Anytime you see the long term bond rate fall by more than 30%, bonds are going to have a good run. The problem is bond rates can't fall forever, and the stock market is no longer richly valued as it was back in year 2000.
If we go back to 1994, you get a clearer picture of what stocks can do for your portfolio. Let me give you a few names that have outperformed bonds in that time frame. Given the strength of these companies, and their compelling dividend history they should continue this outperformance. You'll notice these are not fly-by-night companies.
3M Company (NYSE: MMM) – Jan. '94 – current = 14.01% avg. annual return not including dividends
Intel (NASDAQ: INTC) – Jan. '94 – current = 31.36% avg. annual return not including dividends
Coca-Cola (NYSE: KO) – Jan. '94 – current = 13.47% avg. annual return not including dividends
The point is, bonds are getting a reputation for being instruments that outperform stocks. That has happened, but trying to forecast the future while looking the the rearview mirror is not a good idea. For investors, one of the biggest threats to future wealth is inflation, which has averaged 2.50% in the same 18 year time frame we've been discussing. If the average savings rate is between 3-5% then some American's are saving just barely more than inflation each year. With short term interest rates near zero, the average American simply cannot afford to be too risk averse. Long term interest rates are at some of their lowest points in years, and there is only one logical way rates can move. When interest rates move up, investors who thought they were safe buying bond funds, are going to lose more than they thought they could.
The bottom line is, with the average American saving 3-5% they must take on risk to accomplish their financial goals. Whether this means 10% or 100% stocks depends on what your goals are and your risk tolerance. The point is, don't assume that you can predict asset returns for the next 10 years, based on the last 10. If you have a short term goal, you should invest accordingly. If you have a long term goal, stocks still represent one of the most attractive ways to reach that goal.
Motley Fool newsletter services recommend Intel, The Coca-Cola Company and 3M Company. The Motley Fool owns shares of Intel and The Coca-Cola Company. MHenage has no positions in the stocks mentioned above. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.