Stocks are risky.
Everybody knows that.
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.
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.
Rob Bennett often writes about how to achieve financial independence early in life. His bio is here.