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Monday Morning: Stock risk less in long run? Don’t bet on it

Two pieces of investment dogma are being branded as fallacies. They are: “The longer an investor’s investment horizon,…

Two pieces of investment dogma are being branded as fallacies. They are: “The longer an investor’s investment horizon, the less risky stocks are,” and “Stocks are a hedge against inflation.”

Who says they are fallacies? Zvi Bodie, professor of finance at the Boston University School of Management.

Mr. Bodie, a top financial researcher, is not alone in saying that stocks are not less risky in the long run. Paul A. Samuelson, the Nobel Prize-winning economist, was perhaps the first person to make the case, and did so in the late 1960s.

Mr. Bodie used a different approach to reach the same conclusion in 1995, just as the recent bull market gathered steam.

The warnings issued by Mr. Samuelson and Mr. Bodie have been largely ignored. Perhaps now that many investors have seen that bear markets can occur suddenly and without much warning, more will be inclined to listen to it.

At the very least, financial advisers should think about it and draw it to the attention of their clients, though it flies in the face of the “investment education” that many are receiving almost daily on television, in newspapers and magazines, and even in the workplace.

The belief that stocks are less risky in the long run arises from the fact that there has been no 20-year period since 1926 when U.S. stock returns have been negative. The lowest return was 3.1% compounded annually between January 1929 and December 1948.

But Mr. Bodie has a simple test for those who believe that stocks are less risky in the long run: Call any major investment banking house and ask what it would cost to buy a guarantee that at the end of a 30-year investment horizon, a diversified stock portfolio will have earned at least the risk-free rate.

If stocks are indeed less risky over time, the cost of the insurance for a 30-year horizon should be close to zero. In fact, such insurance would cost about 50% of the investment capital. Those who have to risk real money to provide the guarantee don’t believe stocks get less risky over time.

The problem, says Mr. Bodie, is that the historical market return data look only at the U.S. market. If you looked at all stock markets, you would get different results, with the most recent 20-year period in Japan being an example.

As for stocks as an inflation hedge, Mr. Bodie points to the performance of stock markets during the only inflationary period in modern U.S. history – the 1970s.

For example, a variable annuity tied to a value-weighted portfolio invested in all stocks listed on the New York Stock Exchange, which had a value of 100 in 1968, would have fallen to a real value of only 37 in 1974 and would not have fully recovered until 1991.

A person retiring on such an annuity in 1968 would have suffered a crippling cut in living standards in just the first six years.

What would Mr. Bodie do? For young workers, he says a heavy commitment to equities may make sense because they can accept the higher risk of equities to earn the higher returns. That’s because their investments are only a small part of their total wealth, which includes their future earning capacity.

For older workers, their investments are a much larger part of total wealth, and future earning power is a far smaller part. But older workers still have a shock absorber – the decision about when to retire. If they have poor investment results, they can continue to work.

For retirees, he suggests using a mix of inflation-protected bonds (such as I bonds) and stock index options to guarantee a minimum acceptable level of retirement income, while offering the opportunity to share in any stock market gains.

For example, someone with $1 million to invest could put $900,000 into indexed bonds (currently paying 5.92%) for a risk-free inflation-protected income of $53,280 per year, and invest the remainder in call options in an index fund at an exercise price equal to the current value of the index.

The investor will never have less than $53,280 per year to live on, and, if stocks do outperform again, the investor could have significantly more.

At the very least, let’s stop telling investors that stocks get less risky over time.

Mike Clowes is the editorial director of InvestmentNews.