Stocks are risky.
Everybody knows that.
Except me.
I don’t believe it is so. Not anymore. My aim with this post is to explain why and see if I can persuade you that maybe I am on to something.
When you buy an index fund, you are buying a share of the productivity of the U.S. economy. Is there some reason why that should be a risky proposition?
I’ll be darned if I can see why. The U.S. economy has been generating nice profits for a long, long time now. Owning a share of those profits has been a rewarding thing for a long, long time now. Where’s the risk?
But there must be risk. Everyone knows that stocks are risky. Everyone wouldn’t think that without a good reason.
That’s so.
But my belief is that the reason no longer applies. Please note that when I made my case for why stocks are not risky, I made reference to buying an index fund. Index funds didn’t exist until John Bogle founded Vanguard in the mid-1970s.
Until then, owning stocks meant owning shares of individual companies. It’s not possible to know in advance which individual companies will be generating nice profits and which ones will not. So those buying stocks had to form assessments of which companies would do well and take the chance that they would lose their money if they made bad choices. That’s a risky business. Buying individual stocks really is risky.
But index funds are available to us today. And the chance that the entire U.S. economy is going to go belly up is obviously very small, much smaller than the chance that any one company is going to go belly up. So for those of us who invest in index funds stocks are not risky anymore.
I know what you are thinking.
How about 2008?
Indexers didn’t see that one coming. They lost lots of money. They got scared. The prices of the stock indexes change dramatically from time to time and that means that the portfolios of indexers can be diminished overnight. So even indexers view stocks as risky.
Most indexers don’t change their stock allocations when stocks become overvalued. They follow Buy-and-Hold strategies. That is, they stick with the same stock allocation regardless of the price at which stocks are being offered for sale.
Could that be the source of the risk? Could it be that overvaluation is always a temporary thing, that stocks always return to fair-value prices after the passage of 10 years or so? So those who elect to go with high stock allocations at times of high valuations are fated to suffer bone-crushing losses in days to come.
If that’s the case, you cannot properly say that stocks are risky. The proper way to describe the reality would be to say that stocks offer a good long-term value proposition when properly priced and a poor long-term value proposition when overpriced. But we cannot really say that stocks are risky if we are able to know in advance when they are going to provide poor returns.
Risk is uncertainty. If we have available to us the means of protecting ourselves from the effects of price drops, it is not fair to characterize such price drops as a risk of stock investing. Those who experience those price drops choose to do so (presumably not as a matter of conscious intent but because they permit emotion rather than reason to govern their investing decisions).
The academic research of recent years shows that we can know in advance when stocks are going to provide poor long-term returns. Consider this study by Wade Pfau, Associate Professor of Economics at the National Graduate Institute of for Policy Studies in Tokyo, Japan. Pfau concludes that: “Valuation-based market timing with P/E10 has the potential to improve risk-adjusted returns for conservative long-term investors.”
Please take a look at the table near the top of Page 8. Pfau compares a portfolio of 100 percent stocks held by a Buy-and-Hold investor with a stock portfolio held by a Valuation-Informed Indexer who goes with a 100 percent stock allocation at times when valuations are reasonable and with a zero percent stock allocation at times when valuations signal danger up ahead.
The portfolio held by the Valuation-Informed Indexer earns roughly the same return as the portfolio held by the Buy-and-Holder over the 140 years for which we have records of stock returns. But look at the line on the table for “Maximum Drawdown.” That line shows the greatest loss in portfolio value experienced over the 140 years. The Buy-and-Holder at one time experienced a portfolio value drop of 61 percent. That’s risk!
In contrast, the Valuation-Informed Indexer never experienced a drop in portfolio value of more than 21 percent. Valuation-Informed Indexers take on little risk when investing in stocks. The value of certificates of deposit (CDs) can drop by more than 21 percent in times of high inflation and few think of CDs as a risky asset class.
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In all likelihood, you will not own stocks at the worst time in history to own them and thus will never see a portfolio value drop of as large as 21 percent. Even if you did, given the high returns generated by stocks, taking on the chance that you may see a loss of 21 percent once in your investing lifetime is no biggie. It’s a tiny bit of risk for a worst-case scenario, almost insignificant in the grand scheme of things.
Stocks are not risky anymore. Not for indexers willing to take valuations into account when setting their stock allocations. Stock risk today is something we choose to take on by electing either to pick individual stocks or to invest in indexes pursuant to Buy-and-Hold strategies.
I agree with you in concept, but a 21% maximum draw down would still be a devastating portfolio loss for a retiree.
The Normalized (i.e. Shiller 10) P/E ratio is a useful tool for determining long-term valuation, but I believe such analysis should be complemented with an understanding of what is driving those P/Es.
P/E’s are snapshots in time. We need to look under the hood and understand how developments in the economy are driving the earnings component and how investor sentiment is influencing the price.
Hence, not just one tool but three to determine the appropriate asset allocation at any given time.
Thanks much, J.D.
Rob
Thanks much for taking time out of your day to share your thoughts with us, Don.
Rob
Short term investing in the stock market can be risky, but if you’re in it for the long term, chances are you’re going to do alright.
Interesting thoughts Rob. I flip flop on my own investing strategy which is probably why I’ve done so poorly.
I agree with a lot of what you said and should probably just focus on a simple asset allocation that I am comfortable with that adjusts itself when things go out of whack on the higher or lower end of the scale. I’m in the process of opening up some TFSAs and trying to get my investing plan together. I think by the end of this year I’ll be in much better shape!
SavingMentor:
Thanks for your kind words.
I became an effective saver in the days before the internet. You would find it hard to believe what things were like then. There was NOTHING available to people who wanted to learn how to save effectively. No communities. Very few good books. I was able to find two, which I read over and over for support because there was nothing else around.
People learn by talking things over with other people. We need that. We have it today in the saving area. People who want to become effective savers have many places to go to get help and support. We do not have this today in the investing area and we need it badly. 90 percent of the “advice” we hear re investing comes from people trying to sell us stocks. It’s like aspiring savers getting their advice on how to manage their money from The Credit-Card Industry!
I have hopes that the Personal Finance Blogosphere is going to be providing help in this area in coming days. We need to reexamine fundamental questions. Where the industry lets financial considerations bias their advice, we need to help people to see that. Most importantly, we need to help people with the emotional aspects of the investing project. The emotional stuff is the hard stuff and this aspect of the project is too often ignored or downplayed by the experts.
I hope we get to talk some more. I will be attending the Financial Bloggers Conference in Denver in September. If by any chance you are attending, please let me know and we need to be sure to connect for a meal together.
Please take care.
Rob
What indexes do you recommend? I think most people are generally looking to get rich quick and stay away from the buy and hold strategy. I think you’ve got some good points and betting on America’s economic growth has been a generally good strategy in the past. Better than most!