Where ‘Stocks for the Long Run’ Went Wrong

by Patrick McDevitt | Mar 19, 2009 | Comments

Key Stats

• Theory: Stocks become less risky over the long run, and the longer you hold them, the more likely you are to outperform bonds.
• Believers: Author Jeremy Siegel, thousands of investment managers, millions of investors
• Critics: Zvi Bodie, Paul Samuelson, Jeremy Grantham
• Reality: Stock returns have lagged bond returns by 2 percent per year for the 20 years ended March 2009.
• What you can do: Don’t swing for the fences. Set a strategic asset allocation you can live with through good times and bad. Don’t rely on a long holding period to bail you out. Consider tweaks to your stock allocation if valuations get extreme.

In 1994 Jeremy Siegel wrote the best-selling book Stocks for the Long Run. In it, he demonstrated that stocks had been the best-performing asset class over the prior 120 years. It wasn’t even close. Of course, stock returns were highly volatile in the short term, but Siegel showed that over longer holding periods, the range of the stock market’s annual returns narrowed considerably.

Then came the recent stock market meltdown, which resulted in stunning losses for stocks. The losses have been so large, in fact, that in the 20 years that ended March 2009, the S&P 500’s 7.4 percent annual return has lagged the 9.4 percent return that long-term Treasury bonds provided. No wonder many erstwhile believers in Siegel’s “stocks for the long term” gospel are asking: Were we snookered?

The Theory: Stocks for the Long Term

Siegel was just one of the best-known members of a chorus of experts — including academics, advisors, and asset managers — who reached a seemingly unanimous conclusion:

1. Stocks had provided the highest long-term return of any asset class;
2. Over holding periods of 10 years or more, the volatility of their annualized returns greatly declined;
3. Therefore, stocks are less risky if you plan to hold them for a long period of time — a theory known in academic circles as time diversification. According to this theory, stocks were an anomaly. They provided higher long-term returns with lower long-term risk.

These experts were preaching to an ever-expanding flock. Led by the growing adoption of IRAs and 401(k)s, and the tremendous bull market of the 1990s, Americans embraced equity ownership. From 1983 to 1989, the share of American households owning stocks more than doubled, from 19 percent to 39 percent. By 2001, that figure reached 57 percent. Millions of investors ramped up their stock allocations, convinced that a long time horizon and stocks’ inevitable outperformance would richly reward them.

What If the Theory Was Wrong?

There’s long been a cadre of professionals who took issue with this conventional wisdom. Their criticism of the “stocks for the long run” philosophy boils down to three parts.

First, they believe that annualized returns provide a false sense of security, because only total returns matter. For instance, in their best 40-year stretch, stocks provided an annual return of 12.5 percent; in the worst period, the annual return was 5 percent. But compounding those returns presents an entirely different picture of that relatively narrow spread: earning 5 percent annually, $1 grows to $7.50 over 40 years; at 12.5 percent, it grows to $112, a total return gap that much better illustrates stock market volatility.

The second criticism involves the use of probabilities. Since 1872, stocks have outperformed bonds in over 90 percent of all 20-year periods. But in constructing a portfolio, investors must consider not just the likelihood of outperformance, but also the amount of the shortfall they might face. If stock returns lag by just 0.05 percent annually, as happened in one period, the penalty is rather small. But falling short by 2 percent annually, as in the most recent period, produces a total return that is less than half that provided by bonds.

To illustrate the importance of shortfall risk, Boston University professor Zvi Bodie famously calculated the cost of insuring a stock portfolio against a shortfall over various time periods. If the risk of equities truly declined as time horizons grew, you would expect the insurance cost to decline as well. But it doesn’t. Because the insurer has to consider not just the probability of a shortfall but also the magnitude of it, the cost of insurance rises as the holding period grows.

Which leads to the critics’ third complaint: A long holding period actually increases the odds of encountering a severe bear market. And while you might have believed you were equipped to endure a 50 percent market decline, watching five years worth of earnings and contributions vanish can make you reevaluate just how brave you really are. Investors who find, too late, that they assumed more risk than they bargained for are often the ones who flee the market entirely, further endangering their long-term wealth.

And of course, it’s folly to believe that past returns represent the limits of future performance, because anything can happen in the stock market. A 35-year-old investor is likely in the accumulation stage for only one full 20-year period. If you reach age 55 with your portfolio in tatters, it’s cold comfort to know you’ve experienced a historical anomaly.

What You Can Do

So what do you do with this information? Begin by taking these three steps:

Step 1. Ditch the notion of “retiring rich.”

Focus on accumulating enough to maintain your current lifestyle.

Honestly, if you’re not wealthy today, it’s unlikely that saving and investing will make you so 30 years from now. You might invest your way to a higher standard of living than your spendthrift neighbors, but that means purchasing an Acura instead of a Honda, not summering in Paris instead of Cleveland. Focus foremost on accumulating enough to maintain your current standard of living in retirement. Once you have your final destination in mind, figure out how to get there with minimal risk.

Step 2. Err on the side of caution.

Set a strategic asset allocation plan for good times and bad.

Rather than seeking to maximize your portfolio’s long-term growth at all costs, establish an asset allocation that you’ll be comfortable with, in thick or thin, for years to come. In advocating the prudence of a conservative approach, Peter Bernstein once noted that “few decisions in life motivated by greed ever have happy outcomes.” Indeed.

Step 3. Prepare to be a little flexible.

Adjust your asset allocation at market extremes.

Buy-and-hold remains the sine qua non investment approach, but a case can be made for a bit of flexibility. Vanguard founder Jack Bogle wrote that you might encounter one or two occasions in your lifetime when markets reach such an extreme (like when stocks were selling at 32 times earnings in 1999, or today, when they’re approaching single digits) that you might consider slowly adjusting your stock allocation up or down 10 percent to 15 percent. It’s not a casual undertaking; you might be wrong for a long period of time. (Recall that Alan Greenspan’s “irrational exuberance” speech was delivered in 1996.) But as Nobel Laureate Paul Samuelson wrote, prudence might dictate that we “sin, but only a little.”

There’s nothing inherently wrong with a stock-heavy portfolio. But you should go that route because it suits your needs and stomach for risk, not because you expect the risk of equities to melt away as the years pass. The Roman orator Horace said that the golden mean avoids the poverty of a hovel and the envy of a palace. That’s not a bad investment policy, either.