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Equities - Defining Risk August 3rd, 2010

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FACT: Most investors are understandably disenchanted with the equity markets right now, but the truth is that to reach their retirement and financial goals, they NEED to have some exposure to equities. How do we sweeten the sour taste in our mouths? I suggest putting the past ten years into a longer-term perspective.

One of my tasks is to understand a client's lifetime financial goals and then assist them to make the right trade-off decisions between risk and return for their investment portfolios. It is also critical to understand how the time frame (how long investments are held) impacts the volatility they experience.

Long-term returns

Let's begin by reviewing after-inflation returns for different investments over the 84 years from 1926 (as far back as we have really good data) to the end of 2009.

Table 1 below compares large-cap U.S. stocks to intermediate, 5-year government bonds and Treasury bills. It's important to frame this in terms of real, after-inflation returns-that's the figure that really matters to clients investing for retirement.

Note that after inflation, stocks have returned three times bonds and 10 times T-bills. For someone investing $100,000 in stocks, the after-inflation appreciation of $259,000 is almost five times that of bonds and almost 20 times the gain in T-bills, which just barely beat inflation.

The odds of losing money

Next, let's review the historical experience of losing money in stocks after inflation, based on different holding periods. Historically, holding stocks has meant that after inflation you lost money in about one in three years.

Looking at three-year periods reduces the chance of losing money on stocks to about one in four years. In 10-year time frames, investors lost money 12% of the time. Based on the experience since 1926, you have to go out to 20 years to completely eliminate the chance of losing money in stocks.

Dan Richards worked with Michael Nairne and his team at Tacita Capital to convert data from Morningstar's Encorr database using the Ibbotson SBBI Large Company Stock Index into a series of charts showing returns over one, three, 10, 15, and 20 years. Several of them are shown in the figures below.

Figure 1 shows one-year returns. It has extreme spikes. If this was all that investing in stocks entailed, most investors would bail out right there.

(Note: Some individuals are actually inclined to check the values of their portfolio weekly or even daily. You can imagine the (unnecessary) emotions that can be stirred by this activity.)

Figure 2 shows rolling three-year returns-still a bit of a roller coaster, but less so.

Figure 3 shows rolling average returns for 10-year periods. By the time you get to 10 years, you see a level of volatility that is still more than many clients would like, but that most can handle.

U.S. stocks have earned, on average, over 6% annually after inflation over the past 84 years, even after the disastrous stock market events of 2008 and early 2009. There is a dramatic difference in the long-term for portfolios that hold stocks, bonds, and cash.

The downside is that if you invest in stocks, history indicates that you'll lose money about three in 10 years, and periodically you will lose more than 20% in a calendar year. And twice-these 20% declines occurred two years in a row. We know this because in the 84 years since 1926, stocks have lost 20% or more eight times after inflation-so about one in 10 years. Three of those were in the 1930s, then in 1946, in 1973 and 1974, and most recently in 2002 and 2008."

The good news is that the longer the holding period, the less you have to worry about this-the extreme ups and downs disappear, and the tops and the bottoms on returns get cut off.

Therefore it is important for me to have ongoing conversations with clients (within the context of their lifetime goals) about their time frame, risk tolerance, return requirement and ability to sleep at night.