Feb 25, 2009

The true risk of stocks for the long run (part 3)

If investors have been systematically underestimating the risk of holding stocks, where did this bias come from? The financial services industry deserves some of the blame, as do individual investors.

Financial advisers are compensated based on their ability to get clients to invest primarily in equity funds instead of bond funds because higher management fees can be earned on equity funds. It is a lot easier to collect a 2% expense ratio from a stock fund earning 12% than a bond fund earning 5%. There is also a herd mentality - if you put your clients in safe but low return investments, when they hear about their neighbor's awesome returns for 2 or 3 years in a row, you are likely to be out of a job. So advisers try to stay close to the benchmark of what everyone else is doing and speak of performance in relative terms, "we outperformed the S&P 500 by 5% last year." But if the S&P lost 40%, you still lost 35%. As the saying goes, “you can’t eat relative returns,” meaning that if you depend on your portfolio for living expenses, a 35% loss may drastically reduce your standard of living. Another common fallacy: many people think that after a 35% loss, a 35% gain will get them back to break-even. In reality, you need a 54% gain the subsequent year just to break even (and if there was inflation, you still lost ground). We must pay more attention to absolute returns and capital preservation along with growth and inflation protection.

Investors are also guilty of focusing on returns rather than risk. With higher expected returns, they can afford to save less and spend more today. If you assume your investments will earn 12% compounded over the next 30 years (illustrated graphically in almost every investment advisor proposal), you hardly need to save anything at all for retirement. This fallacy was believable not only because we heard it from the "experts" but because we wanted to believe it. It is much easier to increase your 401k’s allocation to equities than to save an additional 10% of your income. I’ve heard from people close to retirement who realize they cannot save enough to afford the lifestyle they expect – so they increase their equity allocation in the hopes of doubling down and winning big. People in that situation should be taking less risk, not more. Stock returns in the 1980s and 1990s made it even easier to believe that stocks would always bounce back. Unfortunately, the power of leverage and cheap credit to inflate those returns is only now fully understood.

The bottom line: asset allocation is the single most important factor in investment returns. But investment returns are only a means to achieve an even more important objective: a comfortable retirement (or college savings, or whatever your goal may be). The most certain way to achieve your long-term financial goals comes not from investing a high percentage of your net worth in stocks, but in saving a higher percentage of your after-tax income and reducing household debt. Stocks are unquestionably an important part of any portfolio. I do not deny the benefits of diversification and its ability to improve the risk-return tradeoff. But stocks are not a low risk investment, no matter how long you hold them. They are also not a silver bullet that will allow you to save 3% of your income and guarantee a comfortable retirement just because you put 90% of your IRA in equities. “Saving” should be risk free, and “investing” should be risky. Somewhere along the way we confused the two terms.

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