Stocks Are A Lot Less Risky Than You Think

Beyond Buy-and-Hold #3

By Rob Bennett

I explained in last week?s column that Valuation-Informed Indexing offers long-term investors both higher returns and less risk than what they can expect following a Buy-and-Hold strategy. It sounds good, of course. The trouble is — It sounds too good.

Higher returns and lower risk both? If there really were a way to pull that off, everyone would be doing it. No?

I think that?s right. Eventually, everyone will be doing it.

The reason why everyone is not already doing it today is that the Valuation-Informed Indexing option has only been available to us for a few decades. John Bogle founded Vanguard in the mid-1970s and it was Vanguard that put index funds on the map. You cannot practice Valuation-Informed Indexing without index funds. So we have only had this possibility available to us for about 35 years.

And something has been holding us back during that time-period. Buy-and-Hold! For as long as index funds have been available, The Stock-Selling Industry has been pushing Buy-and-Hold hard. It is all we ever heard about in the papers and on the web sites for most of those 35 years.

It is only since the price crash that large numbers of investors have opened up to the possibility of trying something new. Now that people are losing confidence in Buy-and-Hold, an exciting opportunity has opened up to us.

We didn?t know that long-term returns were predictable at the time when Vanguard was founded; that came in 1981, several years later. Now that we know so much more about how stock investing really works than we did when Buy-and-Hold Model was developed, why not develop an approach to index investing that truly makes sense?

Indexing to the rescue

Indexing changes everything. The sad thing is that most indexers (including Bogle) have little idea today just how important an innovation indexing is. The availability of indexes revolutionizes our understanding of stock risk.

And in an entirely positive way. The truth is, stocks are far less risky than even the most enthusiastic stock advocates today realize. For investors willing to invest in indexes and open to taking valuations into consideration when setting their stock allocations, stocks are a significantly less risky asset class than bonds.

Why is it that we think of stocks as risky? It is because the returns they provide are so unpredictable. Those who invested heavily in Apple a few years ago are rich men and women today. Those who invested heavily in BP before the oil spill are hurting. Uncertainty is risk. And stocks returns are highly uncertain.

Or are they?

Long-term index fund returns are not even a little bit uncertain. The 30-year return for the entire market has been something near 6.5 percent real for as far back as we have records. The only real uncertainty is at the 10-year and 15-year and 20-year marks (the short term is of course entirely uncertain but long-term investors don?t care about that).

And that uncertainty is caused by valuation swings. Stocks obviously cannot provide an intermediate-term 6.5 percent return starting from all possible valuation levels. Buy stocks at fair prices and you will obtain an intermediate return in that neighborhood. Buy stocks at super low prices and you will do a lot better. Buy stocks at super high prices and you will do a lot worse.

The true risk in the stock market

So what?s the risk? There?s some uncertainty even for those following a Valuation-Informed Indexing strategy. We cannot predict returns with precision. But you remove most of the uncertainty from the stock investing project when you invest in indexes rather than individual companies. You don?t have to worry about whether particular products will do well or whether particular managers will hang around or whether a particular industry will become more or less important. Buy index funds and none of that matters — you get a mix of the winners and losers and a mix pays a 30-year return of about 6.5 percent real.

The only remaining major risk is the risk that follows from ignoring valuations. Buy stocks at the wrong time and your 10-year, 15-year and 20-year returns may be a whole big bunch less than 6.5 percent real. Buy at the sorts of prices that have applied since 1996 and your intermediate return may well be a negative number.

So don?t do that! Buy stocks when they are available at reasonable prices and not otherwise and stock investing for you becomes a not-too-risky business.

Stock investing is not risky. It is setting your stock allocation without taking valuations into consideration (Buy-and-Hold) that is risky. Nobody forces you to do that. That?s a choice. The academic research of the past 30 years tells us that it is a bad choice.

Rob Bennett is the creator of The Stock-Return Predictor and ?The First Retirement Calculator that Gets the Numbers Right.?. Rob is also the owner and creator of A Rich Life, a blog that aims to put the “personal” back into “personal finance”. Rob developed the Passion Saving approach to money management as well as the Valuation-Informed Indexing investing strategy, both of which are described on his blog.

( Photo courtesy of epicharmus )

2 Responses to Stocks Are A Lot Less Risky Than You Think

  1. Hey Rob,

    There is a minor discussion over on my blog about this post. You may want to stop by and defend yourself. Just kidding.

    Bret

  2. There is a minor discussion over on my blog about this post. You may want to stop by and defend yourself. Just kidding.

    Thanks for letting me know, Bret. I just saw this today and took a look over there and found that your comments were actually quite kind (and also properly skeptical). Thanks for the mention!

    I wish I hadn’t been so late to the party. But I did go ahead and put up a brief comment over at your blog.

    I hope we run into each other more often in coming days!

    Rob

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