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Ten Years of Losses Will Leave You With a Bigger Portfolio Than Ten Years of Gains

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.

 

Related Posts:

The Question That Should Terrify Investors
Your Favorite Investing Expert is NOT Your Friend
Am I Crazy For Being Out of the Stock Market for 14 Years?
Most Stock Investors Are Gambling With Their Retirement Money
Risk-Free Stock Investing?
How a Valuation Informed Indexer Chooses His Stock Allocation

( Photo from Flickr by Helico )

4 Responses to Ten Years of Losses Will Leave You With a Bigger Portfolio Than Ten Years of Gains

  1. This may be totally off subject, have been waiting to see if this subject comes up – maybe could be a future blog. I would like to start investing but just do not see myself pouring in my “freelancing” income into this right now. God has been GOOD, but I also have to be realistic and take care of bills when I do get “blessed” with income. I run my “freelancing” business “Whatever Needs To Be Done, Inc.” as a ministry – free to those that cannot afford to pay me and those that can, I let them decide what to “bless” me with. It has been an AWESOME journey since being laid off in 2008 in my 50’s. Okay, enough of the background. Now to my question – can I start somewhere with what I just told you?

    Thank you,
    Angela J. Shirley
    “How To Survive Unemployment”

  2. Hi Angela–The first financial order of business is to survive, so don’t worry about investing until you have that under control. Investing is what you do with money that’s left over after survival expenses are paid. And if you never do more than survive, God still has a purpose for your life! So maybe financial order of business #2 is to live the best life you can with what you have. From what I’m reading you’re already doing that.

    None of us will get out of this life alive, so money certainly isn’t everything. “What good is it for someone to gain the whole world, yet forfeit their soul?”–Mark 8:36. I’m not saying money is evil or that we shouldn’t pursue it to some degree, but rather that life isn’t meaningless if we don’t have it.

  3. I really don’t understand your aticle. What does the efficient market theory have to do with the simple mathematical fact that it is better to take losses early in a compound-interest system set so that the final percentage loss is constant?

    Can you explain the workins of your calculator?

  4. You are asking a super question, John. Thanks for taking the time to put it forward.

    You are 100 percent correct that this is a simple mathematical exercise. That should be everybody’s starting point. Anyone who understands that understands that the numbers generated by the calculator are obviously correct. There is no other way this exercise could turn out.

    Your question zeroes in on the startling thing here. The results of the calculator are in complete conflict with what the efficient market hypothesis (on which the entire Buy-and-Hold Model was built) says must be the case. If the numbers generated by the calculator are accurate (and, again, this is a painfully simple calculation), the efficient market hypothesis and 90 percent of the investing advice we have heard from the experts in this field for the past 30 years is total nonsense.

    The root problem is that the Efficient Market Hypothesis ASSUMES something that has never been shown to be so. It ASSUMES investor rationality. The entire historical record shows that investors do NOT make rational choices when setting their stock allocations. But the EMH and the Buy-and-Hold Model support advice rooted in a premise that investors are ALWAYS rational. Models rooted in false assumptions support bad advice.

    The historical data shows that the most likely annualized 10-year return for stocks purchased at the price that applied in 2000 is a negative 1 percent real. IBonds at the time were offering 4 percent real. So each investor who went with stocks made a decision likely to cause a loss of 5 percent real on average for ten years running. That’s a total loss of 50 percent of the initial portfolio value. Many of those investors delayed their retirements by 10 years by making that choice.

    But what were the experts saying at the time? They were telling us to stick with our high stock allocations, they were saying that timing doesn’t work or isn’t required, they were saying that Buy-and-Hold is the way to go.

    Buy-and-Hold cannot be the way to go unless the laws of mathematics have been repealed. The calculator performs a simple mathematical calculation to show people with numbers how dangerous Buy-and-Hold is, how important it is that we look beyond what the experts in this field (who are almost without exception in the business of selling stocks) tell us when setting our stock allocations.

    Your question made me happy because I feel that you “get it” to an extent that many others do not. Please come back with further questions if there are still aspects of this that remain unclear to you.

    Please take care.

    Rob

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