28 August 2020


By Raul Elizalde

This article also appeared on forbes.com

The S&P 500 reached another record high. Normally this would be celebrated as good news, but many investors are nervous about getting to that level when some economic indicators are at their worst in a generation (or since records started, in some cases).

The concern is that stocks may be running on euphoria alone and therefore are at risk of crashing again. The missing element is that stocks are not going up despite weak economic numbers but because there are solid reasons driving the strong demand for stocks. We described in a recent post that a large amount of money is sloshing around the system and finding its way to the equity market. Interest rates just above all-time lows and surprisingly strong earnings numbers help steer the money in that direction.

Still, these reasons do not resonate with everyone. The market crash of last March was the fastest on record and stirred the fears of investors who still remember the pain of the financial crisis of 2008. Many don’t see volatility as a stock market feature that can be understood and controlled, but as a destructive force that must be avoided at all costs.

This fear can lead to bad decisions, derail investment plans and damage the financial future of many savers. One potential mistake is to slash equity exposure.

Longer holding times makes stock more predictable

U.S. equities have shown a strong potential to deliver returns, especially for investors who hold on for long periods. While market returns are unpredictable in any given year, they are much more consistent over longer time spans.

We used the database created by Prof. Robert Shiller from Yale University to look at the total return of stocks after WWII. We found that one-year total returns, including dividends, were as high as +60% (7/82-7/83) and as low as -40% (3/08-3/09). The chance of having a profit in any 12-month period was 78% – which means that there was also a 22% chance of recording a loss.

Both the range of outcomes and the probability of losing money declined for longer holding periods. Annual returns for 5-year spans, for example were between +30% and -6%, and the chance of losing money fell to just 7%. This means that a portfolio of stocks had a 93% chance of making a profit after 5 years.

For any period longer than 12 years, the stock market showed no negative total returns. Annual results ranged between just under +1% (12/1999-12/2011) and +19% (6/1949-6/1961, almost tied with 12/1987-12/1999).

source: Path Financial LLC, Prof. Robert Shiller - Yale U.
This, of course, only describes the past and in no way guarantees the future. Still it gives an idea of what may be possible to achieve by holding on to stocks for longer periods. Balancing returns and risk tolerance for optimal results

All of the above is not groundbreaking research. Prof. Jeremy Siegel of UPenn published the first edition of his famous “Stocks for the Long Run” book in 1994, where he reaches similar conclusions. Why, then, if this has been so widely established, do investors tend to flee the stock market during times of trouble, when they should instead be flocking to it seeking for good entry points?

One answer is, of course, that people are not rational.

This is not meant in any disparaging way. People are not robots, and the maximization of wealth that finance textbooks hail as the objective of every rational human being is not a guiding principle for everyone. The ability to sleep well at night is important for many, and those who have a hard time tolerating uncertainty will always try to avoid it regardless of what anyone says about the importance of wealth accumulation. For them, a strategy that tries to limit downside risk and capture a reasonable portion of the upside will always be preferable to another that aims at maximizing returns regardless of the roller-coaster.

Another reason why people don’t max out on stocks is that not everyone has a long investment horizon. Many people start late, often because it takes time to build enough savings requiring an investment strategy. For someone with a maximum horizon of 10 years, the probability that a stock-only portfolio will lose money is quite small – less than 4%. But it still ended up with a significant loss if they bought on March 1999, close to the dot-com boom peak, and sold on March 2009, at the trough of the financial crisis.

Interestingly, no 10-year period in the 75 year history we examined resulted in a loss except for those ending between the end of 2008 and the beginning of 2010 – another reason why selling in a panic is almost guaranteed to end up badly.

Retirees living off their savings belong to another class of investors who should concentrate on reducing risk rather than maximizing returns. Taking money from a portfolio that is subject to withdrawals can amplify losses during weak market periods.

These examples are meant to explain why people wouldn’t want a 100% stock exposure in their portfolio even if, in the long run, stocks have proved to be excellent investments. But avoiding stocks because they could be too volatile can also create bad investment outcomes and leave people way short of their goals.

The siren song of “guaranteed” investments

Another mistake that risk-averse investors make is to fall for “guaranteed” investments that promise to erase uncertainty. Annuities, in particular, are sold like investments – often during free-dinner “seminars” – but are actually insurance products that can result in considerable heartache.

The annuity sales pitch often include irresistible words such as “guaranteed income for life.” In a nutshell, an annuity promises to give back the buyer what they paid (minus the sales commission, which could be as high as 7%). The “guaranteed income” is the stream of periodic payments going back to the annuity buyer for the rest of their lives.

Thus, annuity buyers are essentially betting that they will get more than they paid by virtue of living longer than what the actuarial experts think. It is very unlikely that annuity buyers can beat the experts at their game.

These instruments can also be mind-bogglingly complex, with contracts typically running for dozens of jargon-filled pages that most investors do not understand. FINRA, the regulatory agency that oversees most investments, regularly issues fines to companies that fail to disclose these complexities. Still, the distaste for volatility can lead savers to instruments that may not be adequate for their needs. Focusing on long-term goals can help alleviate short-term uncertainty

Many market participants have become increasingly intolerant of volatility, and this makes it more likely that they will fall short of achieving their financial goals. Often, their fears exceed the actual dangers posed by stocks, and sometimes drive them to investments that offer doubtful value.

One thing investors can do is focus on establishing clear long-term goals and strategies that are appropriate for their investment horizons, preferably with the help of a professional who can help plan a sensible course of action. Doing this can go a long way towards preventing costly mistakes.

Questions? Talk to us.