Risk-Free Stock Investing?

Beyond Buy-and-Hold #60

I was talking over the wonders of Valuation-Informed Indexing with a fellow money blogger at the recent Financial Bloggers Conference in Chicago and, effusive fellow that I am, I uttered a phrase that shocked even me. I was explaining how the academic research of the past 30 years (the research that must not be mentioned when Buy-and-Holders are in the room) allows us all to achieve far higher returns while taking on greatly diminished risk. ?That?s investor heaven!? I often cry.

This time a different catch phrase popped out of my mouth — ?Risk-Free Stock Investing!?

?I don?t know if I would go that far,? she laughed. And in a technical sense, she?s right. There is no such thing as entirely risk-free stock investing.

Risk-free stock investing may be closer than we think

Still, the reality is that we can get a lot closer to it today than just about anyone realizes is possible. Certificates of Deposit (CDs) are not risk-free, but the risk of investing in CDs is so slight compared to the risks of investing in stocks following a Buy-and-Hold strategy that there are many who think of them as providing something close to a risk-free investing experience. The happy reality today is that there are circumstances in which stocks are a less risky asset class than CDs for those open to the idea of taking valuations into consideration when setting their stock allocations.

Say that you are debating between investing your retirement money in CDs or in a broad stock index at a time when stocks are selling at fair-value prices. Most experts would tell you that stocks are the better choice because you need to take on the added risk of stocks to have any realistic hope of financing a middle-class retirement by the normal retirement age of 65.

That?s the conventional wisdom. But is it so? There is now 30 years of academic research and 140 years of historical stock-return data showing that it is very much not the case. When stocks are selling at fair-value prices — a scenario that is obviously much more the norm than the 16 years of sky-high prices we have seen during the time-period from 1996 forward –there is less risk attached to stock investing than there is to investing in CDs.

Can stocks actually be less risky than CDs?

Let?s take a look at the numbers.

A regression analysis of the historical data shows that the best annualized 10-year return you can hope for when you buy stocks at fair value is 12.3 percent. The most likely annualized 10-year return is 6.3 percent. The worst possible annualized 10-year return is 0.34.

The 12.3 return and the 6.3 return both handily beat the 2 percent real return that might available from CDs. So there?s no risk in investing in stocks at that price level so long as you feel confident that you can avoid any panic sales for 10 years. It?s only the worst-case scenario that presents any problem.

There is only a 5 percent chance that your return will be less than 0.34 percent. There is only a 10 percent chance that it will be much less than 2 percent real. So long as you earn 2 percent real or better, you beat the return that was available from CDs. So is it not fair to say that the risk you take when investing in stocks at those prices is the one-in-ten chance that you will see a worst-case returns sequence pop up? It sure seems so to me.

Still, there is no chance of seeing a 10-year return of less than 2 percent real if you invest in CDs. So there is certainly is a sense in which it can be said that stocks are the more risky asset class.

But wait.

The retirement planning ?X? Factor

Is there not a risk factor that we are not considering here?

None of us know precisely how much money we will need in retirement. We don?t know what goods and services are going to cost in future days and to what extent we will want to buy goods and services that today are not even available to us (many of today?s retirees did not budget for cell phones or wide-screen, high definition televisions). We don?t know whether we will have particularly costly health problems or not. We don?t know the extent to which we might need to help out our children financially in our retirement years.

So one of the risks you must weigh when making investment choices is the risk that you will run out of money in retirement not because your investment choices performed poorly but because you miscalculated your spending needs. There?s a 10 percent chance that the CDs will provide better 10-year returns than stocks in the circumstances outlined above. But there is a 90 percent chance that the stocks will provide higher returns. There?s a 50 percent chance that stocks will provide a 10-year annualized return of three times the return that will be provided by the CDs.

The fact that stocks perform so much better in the vast majority of circumstances does not negate that 10 percent chance that investing in them may leave you with less money than what you would have had if you had invested in CDs. But I think it would be fair to say that it counters it.

You are taking on more than one form of risk when you choose investment classes. One is the chance that the investment class will perform poorly. Another is that you might miscalculate how much you need to retire and thus end up in trouble even if all of your investment choices perform precisely how you hoped they would.

Stocks counter this risk because they perform so much better than CDs in the vast majority of return sequences likely to pop up. Investing in stocks exposes you to slightly more of one type of investing risk but investing in CDs exposes you to much more of another type of investing risk. Stocks are in an overall sense the less risky asset class, in my assessment.

Rob Bennett argues that personal finance planning is not about self-denial anymore. Rob?s bio is here.

( Photo from Flickr by Helico )

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