Busting Market Myths

Eric Schurenburg: The disaster in the financial markets has led people to question some of their me basic assumptions about how markets work. Joining me today is Rob Arnott, chairman and CEO of research affiliates, and a man that's done a lot of thinking over the years about what works when it comes to investing. Rob, thanks for being here. Rob Arnott: Delighted to be here. Eric Schurenburg: The crisis has led people to question some of the most basic truths about the market. I'm going to run three of those precepts past you, and I'd like you to tell me whether they're still true, or were they oversold, and if so, how did they go wrong. Here's the first bit of received wisdom. Stocks out perform in the long run. Rob Arnott: You know, the notion of stocks for the long run is one of the most dangerous myths propagated in the last quarter century. It -- stocks worked for the long run during a period of rising evaluation multiples , but a simple fact -- and this is really shocking -- is that ordinary long government bonds for the last 40 years have out performed stocks. You go back to the early 1969, and take it right on up to today. That span covering the careers of most of the people in the investing community and the business community. And it's a span of time in which ordinary government long bonds have out performed stocks. Stocks for the long run is a myth. And the very, very, very long run, spanning many, many decades, stocks generally beat bonds. But your starting point matters hugely. If you're buying in, in the year 2000 at a 1% yield, stocks for the long run will lose. Eric Schurenburg: Let's go on to precept number two. Diversification will keep you safe. What has gone wrong with the way people have taken this belief. Rob Arnott: There's an old cliche on Wall Street that the only thing that goes up in a market crash is correlation. What that means is that when assets are tumbling they start to move similarly. They start to behave, drop and rally, at the same times. So that diversification temporarily fails you. I think the notion that diversification doesn't matter any more is a very dangerous myth because in the long run diversification matters hugely. You do get times, October, we tracked 16 different asset classes in our global asset allocation work, and in October all 16 were down. So exceptions. Many of them that were not stocks were down worse than stocks. In February it happened again. And so you do get these times when markets move in lock-step, markets that normally behave differently, markets that normally diversify our risk. But what you get coming out of those periods is delayed diversification. After the carnage, the market sorts through the damage and tries to identify the walking-wounded, the markets that were hit too hard and yet can spring back. And so you get a delayed benefit of diversification, even in the aftermath of a crash. So I do think diversification is extremely important, but one of the lessons of 2008 was that you can have a year in which you're down 10, 20, 25%, in which that's a win. And that's alarming, but true. Eric Schurenburg: Precept number three. The returns you get are commensurate with the risks you take. Rob Arnott: The notion of a linkage between risk and reward is widely misunderstood. The notion that if you take more risk you will get more return is not true. The notion that if you invest in order to get more return you may have to take more risk is true. So it goes the other way from the way most people think. Taking on incremental risk does not mean higher returns. It just means higher risk. And the best evidence of that is the last 40 years when ordinary treasury bonds out performed stocks. Well, ordinary treasury bonds aren't without risk. They go up and down in price quite a bit, but less than stocks. And they had a higher return for 40 years. So the notion that take on more risk and you're entitled to higher return, that's a myth. What counts is the starting price. If you overpay for a risky asset, you're setting yourself up to experience the down side of risk. Risk just means a wide range of returns, including big up and big down. And if your starting point is too richly priced you're going to experience the latter. Eric Schurenburg: Rob, thank you very much for joining us today. Rob Arnott: Thanks for the opportunity. I really enjoyed it. Eric Schurenburg: I'm Eric Schurenburg for Moneywatch.com. Thanks for watching.

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