Tuesday, 24 November 2009

Stocks and the Long Term - Some Solid Research to Consider

It is a cliché that one should only invest in stocks if one has a long term horizon but often this advice is dispensed with a definition of long term using a number pulled out of the air or even without any number at all! Is long term five years, 10, 15, 20, 25, 30?

Thanks to the fine IndependentInvestor.info website (you will need to register to see content but it's all free and unbiased info) for uncovering some credible answers. As one should expect, there isn't a single number but a sliding scale of declining risk with extension of years invested. How Long is a Long-Term Investment? The 1 in 9 Rule summarizes the paper by economist Pu Shen of the Kansas City Fed, available at How Long is a Long-Term Investment.

Some of Shen's Discoveries
  • showing risk on the basis of a one-time investment at the start (the typical "if you had invested $10,000 in Fund X in 1970, it would be worth $ZZZZZ today") understates the chances of losing money; the more realistic scenario, where an investor puts in money gradually over time, which he calls repeated investments, took at least 24 years before a positive real return on stock investments was always achieved. Stocks = the Center for Research in Security Prices Index, an index for the entire U.S. stock market from 1926 to 2002. The one-time method always showed positive returns after only 19 years, a difference of 5 years. The reason is the net effect of two opposite forces - time diversification (which reduces risk) and shorter effective holding periods (which hurts). Check out Shen's chart 2 below

  • stocks never under-performed bonds (US Government 20 year bonds) after at least 26 years holding period (repeated investment method used), not exactly a mere blink of an eye.
  • though the risk of stocks declined progressively with longer holding periods, the odd time they did have poor results, and even after 20 years the worst stock vs bond under-performance was still quite a hefty difference - check out Shen's chart 5 below. Sobering data, I'd say.

  • quote: "Worse than investing in stocks right before a market crash is liquidating stocks shortly after the crash." (He says this in the context of people needing to retire then but of course a retired person does not typically spend all his/her money, or cash everything out, the day of retirement.) The worst possible 20 year holding period for stocks was ending in 1974 but from then on, there was a bumpy but ever-upward recovery. Moral of the story: hang on, don't panic, don't sell everything, try to sell as little stocks as possible after a crash - viz 2008 crash and 2009 recovery to date.
  • even after 25 years holding period bond investors only beat inflation 34% of the time!! Now that's what I call risky. Stocks always beat inflation over 25 years and beat bonds 99.8% of the time. Stocks for the long-term indeed.
She shows that it is very misleading and harmful to define the long term for stock investment as five or even ten years, such as this article does. One should also keep in mind that Shen's paper did not factor in the annual fund expense fees and tracking error that an actual investor would face. This would lower returns and extend necessary holding periods.

4 comments:

thome.adam said...

How does the long-run performance of stocks compare to GICs. I've read some articles lately that suggest that people who consistently invest in lattered GICs do just aas well as those investing in the market. What are your thoughts?

Traciatim said...

Wow, so my advice that I tell people who don't really want to read all the money stuff in my companies RRSP seems to mimic this research. I've usually told people, the simple way to pick is use the LifePlan Income if you have less than 10 years, the LifePlan Grwth & Inc if you have between 10 and 25 years, and the LifePlan Growth if you have more than 25 years.

We only get to pick from 5 funds, and those three are just mixes of the 5 that seemed to fit in to those descriptions. It seemed like a logical way to pick for the people that just want in the RRSP plan but didn't want to go through the whole picking the funds thing. At the very least they are getting their company match, and that's just fine by me.

Michael James said...

It's hardly surprising that it would take longer to guarantee positive returns for periodic investments. When making periodic investments for 24 years, the average contribution has been invested for only 12 years. The implicit conclusion here is that if you will need your money in less than 24 years, you should start selling out of stocks a bit at a time now. This seems far too conservative. I'd rather take a chance on not making a positive real return than to live with the dismal returns of fixed-income investments.

GirishLaikhra said...

Excellent site, keep up the good work. I read a lot of blogs on a daily basis and for the most part, people lack substance but, I just wanted to make a quick comment to say I’m glad I found your blog. Thanks,
A definite great read…
"Stocks and the Long Term - Some Solid Research to Consider" is a very nice article and news....
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Girish
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