04/22/2011

by John Wasik, Prism Money on Reuters Blogs

With all of the negative economic news still haunting the market, do stocks still make sense for long-term investors?

An all-in, head-in-the-sand commitment to stocks makes little sense. No matter how long you hold onto them, the volatility will never go away. In fact, with mega-banks getting even bigger after 2008 and hyper-fast computer trading, the risk is probably higher than ever.

Still, there’s the allure of a decent year and the need to beat the awful returns on savings vehicles and bonds. How should you view this age-old question?

Let’s start with a familiar shibboleth that the risk in stocks drops over time, that is, the longer you hold a stock portfolio, the lesser the chances of losing money.

If a verifiable risk reduction in long-term stock holding was true, then there would be a simple way of measuring it. You would need to price “portfolio insurance” on a stock portfolio. One simple way would be to value put options. These are derivatives that would pay you if the value of your stocks dropped by a certain date.

According to Zvi Bodie, a professor of economics at Boston University School of Management, “if holding equities for the long run leads to higher average returns, with negligible risk, why don’t investment banks provide guaranteed equity outperformance for a modest fee reflecting the (supposedly) modest risk?”

Bodie said you’d pay a 25 percent premium for put options to protect your portfolio from stock-market risk over 10 years and 30 percent over 20 years. This is the derivatives market telling you that stock portfolio insurance carries significant future risk.

What about “Stocks for the Long Run” Wharton School Professor Jeremy Siegel’s research that shows that diversified basket of stocks has averaged 6.2 percent going back to 1802? Siegel, who was conspicuously silent in 2008, says we’re now in a “stealth bull market” based on his long-term trend line of average stock returns.

If you had been investing for two centuries, no doubt you would have done well. But most people haven’t and can’t be all that choosy on the ideal time to retire. We all hit the rocking chair during a bull market.

Michael Alexander, author of Stock Cycles, has charted bull and bear markets since 1800. The profile of returns is mixed and depends upon when you were investing.

Here’s the record for bull markets: In the past century, you would have done well in stocks from 1982-2000; 1949-1966; 1921-1929; and 1900-1906. Yet stocks were lagging during long periods as well: 2000-2008; 1966-1982; 1929-1949; 1906-1921.

The 19th Century was even worse with boom-bust cycles every decade or so. The historical record is not a straight line in either case.

You can never consistently time the market with any precision. Don’t look at long-term averages going backwards and assume that you will always get that average. Take a close look at your portfolio and ask these questions:

• Have you paid attention to different kinds of asset classes? There’s life beyond the S&P 500 and U.S. Treasury Bonds. For example, last year among the top performers were small-company growth and value stocks (29 percent and 24 percent returns); and emerging markets (19 percent).
• Have you paid attention to inflation?  It’s coming back after years of deflation and dormancy. Just look at what’s happening in China. You’ll need Treasury-Inflation Protected Securities (TIPS) and commodities (DBC) to protect against loss of purchasing power.
• Do you have a mixture of bonds?  In 2008, when just about everything lost money, the broad-basket Lehman Aggregate Bond Index (now the Barclays Capital index), gained a modest 5.24 percent. The index holds government, corporate and mortgage bonds. A good vehicle for this index is the iShares Barclays Aggregate Bond ETF.

Am I saying you should avoid stocks because of ever-present risk? Not at all. You need to calibrate your portfolio to how much risk you can afford to take.

If you’re dependent on every dollar in your portfolio for income, then stay away from stocks. Pay heed to inflation, bond-market risk and spread your bets among many asset classes. This isn’t like horse racing where you can only bet on three horses.

Exchange Tickers: (NYSE:AGG), (NYSE:DBC), (NYSE:TIPS), (NYSE:SPY), (NYSE:EEM)

Symbols: AGG, DBC, TIPS, SPY, EEM

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