Crisis challenges long-held investing truths

Two important lessons of the current bear market are that stocks don’t always outperform bonds over significant time periods and that investors can’t assume a 10% annual return over the long run.

The implications are that investors and their financial advisers will have to be more flexible and quicker on their feet.

Investment professionals have been taught that common stocks should yield a “risk premium” over bonds.

This seems to make sense, since investing in stocks is riskier than investing in bonds, because stock prices are more volatile than bond prices.

The belief was strengthened by the Ibbotson-Sinquefield research of 1976, updated every year since by Ibbotson Associates Inc. of Chicago, which showed that since 1926, common-stock returns have exceeded the returns on bonds by substantial margins.

That conviction was reinforced by such best-selling books such as “Stocks for the Long Run: The Definitive Guide to Financial Market Returns & Long-Term Investment Strategy” (McGraw-Hill Cos., 2007) by Jeremy Siegel, a finance professor at The Wharton School of the University of Pennsylvania in Philadelphia.

But the current bear market has led some experts to question the superiority of stocks, even the concept of investing for the long run.

Peter L. Bernstein, who runs an eponymous economic consulting firm in New York, suggested in his February “Economics and Portfolio Strategy” commentary that “relying on the long run for investment decisions is essentially relying on trend lines. But how certain can we be that trends are destiny — and today, especially, how much do we know about trends? … How do we know how to define ‘the long run’?”

Mr. Bernstein pointed out that the equity risk premium appeared — and grew — only from about 1949 onward. ”

The nominal return on stocks from 1871 to 1951 was only 2% a year. From 1951 to 2008, the total return was 6.8% a year. From 1983 to 2008, the annual total return was 9.8% a year — but long Treasuries produced 11%. What is the long run?”

Even less knowable, as Mr. Bernstein said, is what kind of long run the current economic crisis will produce. What kind of capitalism will emerge given the unprecedented level of government intervention in the economy and the markets, as exemplified by President Obama’s essentially firing Rick Wagoner, chairman and chief executive General Motors Corp. in Detroit?

Will long-term risk-taking be rewarded as well as it has been in the past? If not, does that imply less risk-taking and therefore slower economic growth and lower investment returns?

The new uncertainty about the old verities suggests that investment professionals and their clients will have to be more flexible in their investment planning. No longer will a long-term asset mix be established and tweaked only around the edges because no one can be sure of the relative risk-adjusted return profiles of the various asset classes — nor, as Mr. Bernstein suggested, can anyone be sure how to define the relevant long run.

Investors will have to approach long-term investing as a series of short-run strategies.

The economic and investment outlook will have to be monitored and analyzed more carefully, and portfolio asset mixes will likely have to be changed more frequently than in the past.

The economic crisis and bear market also have shown that there are new sources of investment risk, of which advisers and clients will have to be aware in their investment planning.

Those who best learn these lessons will be best-positioned to survive and prosper in the new investment world that emerges from this crisis.