Beyond Buy-and-Hold #84
U.S. stocks have been providing a 30-year return of something in the neighborhood of 6.5 percent real for as far back as we have records. Let’s say that what has been true for the entire history of U.S. stock investing remains true for the next 30 years.
Would it be better if for the next 10 years we saw a return of 5 percent each year or if for the next 10 years we saw a return of a negative 5 percent each year?
I have a calculator at my web site that answers this sort of question. It is called The Returns Sequence Reality Checker. It tells us that the latter scenario is the far more favorable one.
Why it’s better to take losses early
The assumptions that I entered are that you start with a portfolio of $10,000 and then add $10,000 each year. See a return of 5 percent for each of the first 10 years and you will at the end of 30 years have a portfolio value of $998,579. See a return of a negative 5 percent for each of the first 10 years and at the end of 30 years you will have a portfolio value of $1,739, 987.
That’s a difference of over $700,000. The second portfolio is not quite twice as large as the first portfolio, but it comes not too terribly far short of hitting that mark. Please understand that both scenarios assume the same level of economic growth. In both cases, the annualized annual return is 6.5 percent. The returns are not really better in an overall sense in the second case. They are just a whole big bunch better for you, the investor.
Say that you believe that you can retire as soon as you possess a portfolio of $1 million. The return pattern that plays out in the second scenario permits you to retire in Year 26. The return pattern that plays out in the first scenario does not permit you to retire until Year 31. Being able to retire five years earlier is a pretty darn big deal. But, again, please understand that the returns generated over the 30-year time-periods are precisely the same. We are not here assuming better stock-market performance in the second scenario, only a better return pattern for the investor.
It works even though it doesn’t make sense—on the surface
It’s a puzzle. The returns are the same. But the portfolio sizes are very, very different. Can it be? Does what I am telling you make sense?
From one perspective, it makes no sense at all. From another perspective, it makes all the sense in the world. The issue at play here is the hottest issue being debated by the investing experts of today.
Back in the 1960s, when Buy-and-Hold was being developed, a good number of academics had come to believe in something called “The Efficient Market Hypothesis.” This hypothesis posited that the price of stocks is set each day by investors taking all economic and political factors that influence stock prices properly into account. Almost all of the investing advice you have heard is rooted in this hypothesis.
If the hypothesis were true, the point I make above would be nonsense. In a Buy-and-Hold world, it makes no sense to hold steady the 30-year return and examine how different return patterns affect investors. In a Buy-and-Hold world, stock prices are reestablished on a daily basis. What happened yesterday has no effect on what happens tomorrow and what happened five years ago has no effect on what will happen five years from now.
Research published in 1981 discredited the Efficient Market Hypothesis. We now know that stocks prices are not determined by each day’s economic or political events. Stock prices are determined by investor emotion. And investor emotion is influenced by events from long ago. For example, the fact that stocks were priced so highly in the late 1990s insured that they would be going down hard for the first ten years of the 20th Century. And the fact that stocks have performed poorly for 10 years will be affecting investor psychology in a negative way for years to come, forcing prices lower and lower and lower.
The way forward in stock market investing
The new model is called “Valuation-Informed Indexing.” This model posits that it is no coincidence that the 30-year return is always something in the neighborhood of 6.5 percent real. That’s the return supported by the productivity of the U.S. economy. Knowing that, we can examine what happens under different return patterns and identify those which provide the best and worst results for investors.
The thought process encouraged by the Buy-and-Hold Model causes investors to prefer gains to losses. If each day’s stock price changes are independent events, it makes perfect sense to favor price gains over price losses. So most of us are tempted to conclude that it would be better to see ten years of 5 percent gains than it would be to see ten years of 5 percent losses.
But if the research of the past 30 years is valid, just the opposite it so. If the research of the past 30 years is valid, we all can learn how to retire at least five years sooner by learning the lessons of the new research.
Why is it so much better for us for there to be losses rather than gains over each of the next 10 years?
You will be buying stocks in each of the next 30 years. You will obviously get a better deal if you pay low prices rather than high prices for the stocks you purchase. Price drops lower the amount you are required to pay for the stocks you buy. Price drops provide you an immense advantage.
Rob Bennett believes that the efficient market concept is a big bunch of hooey. His bio is here.
Rob Bennett believes that the efficient market concept is a big bunch of hooey. His bio is here. For background on the Big Fail of Buy-and-Hold and on the need to move to Valuation-Informed Indexing, please check out the “About” page at the “A Rich Life” blog.
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