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Not Owning Stocks Today Is Risking Dollars To Make Pennies

A recent article posited that owning stocks today is “risking dollars to make pennies.” A review of historical data suggests this is alarmist and statistically unlikely; it also implies an overly narrow definition of risk. Stocks in general are expensive, but they still offer better return potential than bonds over the next decade, and there are plenty of individual stocks that offer low-risk returns. A recent article proclaimed owning stocks today is risking dollars to make pennies . For investors with a sufficiently long time horizon, I believe the truth is the opposite: NOT owning stocks today is risking dollars to make pennies. I’m not advocating being all-in on the S&P 500 or anything like that – I have plenty of cash reserves – but in line with Seeking Alpha’s “read, decide, invest” motto, I think it’s important for investors to understand both sides of the issue. I would recommend you read the linked article (written by Jesse Felder) prior to going any further. Let’s start from a high level: What does “risking dollars to make pennies” mean? Well, according to Jesse, it means stocks are so wildly overvalued that your potential return over the next ten years is miniscule, and your potential downside is massive. I posit this is: A) alarmist and statistically inaccurate; B) overly narrow in its definition of risk; and C) treats “stocks” as some monolithic entity (which devalues the excellent investment ideas posted every month here on Seeking Alpha). Starting with point A: What is the actual likelihood of stocks resulting in a significantly negative 10-year return? Here’s a link to a nice document providing this data from 1926 through 2013 in both tabular and graphical format. Summarily, there were only a very few rolling 10-year periods when investing in the S&P 500 would have resulted in losses in nominal terms. Specifically, you would have had to invest right before the Great Depression or in the late 1990s – two of the larger bubbles of all time. Even on an inflation-adjusted basis, there were not many periods when stocks had negative returns. Most of the time, stocks have had substantially positive 10-year returns, averaging 201.15% across all rolling ten-year periods during those 87 years. The two supporting arguments for the author’s assertion that the 10-year return on stocks will be less than the risk-free rate are: a graph of GDP versus market cap over time, and a graph of household equity ownership. The former is merely one data point that ignores substantial changes in the makeup of the economy. Relative to the past, today it is much more service- and knowledge-oriented – thus, there are higher returns on capital. This statistic also ignores changes in effective tax rates over time, which have benefited reported profitability (and consequently, valuation). As for the latter point of equity ownership, let’s discuss that. Point B: Paraphrasing the original article title, I believe NOT owning stocks today is risking dollars to make pennies. Paltry yields on fixed income mean traditional “your age in bonds” portfolios may no longer achieve the returns they used to, and this is likely one factor driving more investors into equities. The 10-year yield barely exceeds the Fed’s targeted inflation; while there are reasons to believe inflation may be on hold for now, the point remains that you will make no more than pennies by investing in bonds. Moreover, there is more than one definition of “risking dollars” – assuming you have a ten-year or greater time horizon and need to invest to fund long-term liabilities (kids’ college funds, retirement, etc.), then earning near-zero returns by investing exclusively in bonds is just as much of a risk as potential volatility from investing in stocks. Risk, in this context, means you won’t meet your financial goals – and if you don’t invest in any stocks, it’s very hard to see how you will generate sufficient returns with yields on fixed income where they are. Please note that I am not arguing stocks are cheap – in fact, I think most indexes are on the expensive side – I’m just saying that if I had to put all of my money in either stocks or bonds for the next ten years, it would be stocks without a question. Finally, point C: I think it’s unfair to treat “stocks” as a monolithic entity – as if you either own the S&P 500 (NYSEARCA: SPY ) or you do not, and there’s no other alternative. Even if you believe the market as a whole is overvalued, like I do, that doesn’t mean every single component of the market is overvalued. To the contrary, there are plenty of low-risk, high-quality companies with good management teams, conservative balance sheets, and solid future prospects that trade at reasonable multiples of cash flow or earnings. One such company which meets these criteria is Prosperity Bancshares (NYSE: PB ), which I’ve written about here . That is far from your only option, of course – but as long as you stick to those basic criteria, you will certainly be able to identify companies that will outperform 10-year Treasuries or corporate bonds. If you can’t find a single stock which meets these criteria, then you’re not spending enough time on Seeking Alpha! To conclude, there is a charming (if crude) saying about what part of your body opinions are like – the punchline is “they all stink” – and this aphorism applies especially to macro predictions, which almost always end up being wrong. Economists have predicted 12 of the last 2 recessions, etc. The future is obviously unpredictable, so we have to make logical decisions based on the information we have available. Despite the high valuation of most indices, stocks (whether individually or via ETFs or mutual funds) still seem to offer much better prospective returns over the next ten years than fixed income. As such, while it’s obviously the responsibility of every investor to determine their own risk tolerance and investment goals, it seems not owning any stocks is risking (future) dollars to make pennies.

Assessing The Utility Of Wall Street’s Annual Forecasts

It’s that time of year when everyone starts preparing for the New Year and Wall Street makes its 2016 predictions. I’ll get right to the point here – these annual predictions are largely useless. But it’s still helpful to put these predictions in perspective, because it highlights a good deal of behavioral bias and some of the mistakes investors make when analyzing their portfolios. The 2016 annual stock market predictions are reliably bullish. Of the analysts that Barrons surveyed, they found no bears and an expected average return of 10%. This is pretty much what we should expect. After all, predicting a negative return is a fool’s errand given that the S&P 500 is positive about 80% of the time on an annual basis. And the S&P 500 has averaged about a 12.74% return in the post-war era. So, that 10% expected return isn’t far off from what a smart analyst might guess, if they’re at all familiar with probabilities. There is a chorus of boos (and some cheers) every year when this is done. No analyst will get the exact figure right, and there will tend to be many pundits who ridicule these predictions despite the fact that expecting a positive return of about 10% is the smart probabilistic prediction. In fact, if most investors actually listened to these analysts and their permabullish views, they’d have been far better off buying and holding stocks based on these predictions than most investors who constantly flip their portfolios in and out of stocks and bonds. But that’s the reason why these predictions exist in the first place. Because every year, investors perform their annual check-ups and evaluate the last 12 months’ performance before deciding to make changes. And of course, Wall Street encourages you to do exactly that, because turning over your portfolio means increasing the fees paid to the people who promote these annual predictions. But when we put this analysis in the right perspective, it becomes clear that this mentality is misleading at best and highly destructive at worst. Stocks and bonds are relatively long-term instruments. The average lifespan of a public company in the USA is about 15 years.¹ And the average effective maturity of the aggregate bond index is about 8 years.² This means an investor who holds a portfolio of balanced stocks and bonds holds instruments with a lifespan of about 11.5 years. When viewed through this lens, it becomes clear that evaluating a portfolio of long-term instruments on a 12-month basis makes very little sense. What we do on an annual basis with these portfolios is a lot like owning a 12-month CD that pays a one-time 1% coupon at maturity and getting mad that the CD hasn’t generated a return every month. But this annual perspective makes even less sense from a probabilistic perspective. As I’ve described previously , great investors think in terms of probabilities. When we look at the returns of the S&P 500, we know that returns tend to become more predictable as we extend time frames. And the probability of being able to predict the market’s returns increases as you increase the duration of the holding period. While the probability of positive returns becomes increasingly skewed as you extend the time frame, there is still far too much randomness inside of a 1-year return for us to place any faith in these predictions. The number of negative data points is only a bit lower than the number of positive data points, even though the average return is positively skewed: (click to enlarge) So, at what point do returns become reliably positive? If we look at the historical data, we don’t have reliably positive returns from the stock market until we look about 5 years into the future, when the average 5-year returns become positively skewed. A 50/50 stock/bond portfolio has a purely positive skew, with an average rolling return of 3 years. Interestingly, this stock market data is just as random even though it’s positively skewed. So, trying to pinpoint what the 5-year average returns will be is probably a fool’s errand (even though stocks will be reliably positive, on average, over a 5-year period). (click to enlarge) All of this provides us with some good insights into the relevancy of making forecasts about future returns. When it comes to stocks and bonds, we really shouldn’t bother listening to or analyzing predictions made inside of a 12-month period. The data is simply too random. As we extend our time horizons, the data becomes increasingly reliable with a positive skew. But it still remains a very imprecise science. The bottom line – If you’re going to hold stocks and bonds, it’s almost certainly best to plan on having at least a 3-5 year+ time horizon. Any analysis and prediction inside of this time horizon is likely to resemble gambling. As Blaise Pascal once said, “All of human unhappiness comes from a single thing: not knowing how to remain at rest in a room”. The urge to be excessively “active” in the financial markets is strong; however, the investor who can take a reasonable temporal perspective will very likely increase their odds of making smarter decisions, leading to higher odds of a happy ending. Sources: ¹ – Can a company live forever? ² – Vanguard Total Bond Market ETF, Morningstar

Jack Bogle Was Right – You Could Be Leaving 80% On The Table

The typical investor should accumulate $3.7 million at an 8% annual rate. But the cost of intermediation – 2.5% – reduces that return from 8% to 5.5%. Due to the “tyranny of compounding costs”, the investor surrenders 80% of final wealth. You’ve heard it before – the key to building long-term wealth is to tap into the power of compounding returns. It’s a concept that’s universally accepted by savers, investors, finance professors, and math geeks. But for most of us it still requires a leap of faith because the math can be a little tricky. Anyone willing to devote 5 minutes to this topic will understand just how powerful compounding is. Why is this important? Because the power of compounding is a double-edged sword. Compounding growth (especially in a tax-deferred account like an IRA or 401K) will turbo-charge your wealth, compounding costs are a real drag. It’s important to understand how both of these forces work, and how they impact your portfolio. If you are an experienced investor, or someone who is good at math, you might think you don’t need to go through this exercise. But when it comes to the compounding cost part, you might be surprised to learn just how much of a drag it really is. In his book, The Battle for the Soul of Capitalism, Vanguard founder Jack Bogle made a bold statement. He said that thanks to the “tyranny of compounding costs,” investors leave 80% of their wealth on the table. I was more than a little skeptical – not about the nature of Bogle’s claim, but about the magnitude. Could it be true that investors leave 80% on the table? How does that happen? More importantly, why would any investor allow it to happen? Everyone knows that brokers charge commissions and advisers charge fees, but how much can those costs come to? Maybe 1% or 2% per year? How can that end up taking 80% of an investor’s wealth? Although I have always had great respect for Mr. Bogle, I wondered whether he might have overstated the case. So I set about the task of trying to debunk this astonishing claim. Much to my surprise, the claim holds up to scrutiny. To arrive at the 80% figure, Bogle used a very long investment horizon – 65 years. At first I thought, a-ha! Nobody stays in the market for 65 years! But after thinking about it I realized that it’s not only possible, it’s actually very plausible. Here’s how he arrived at the 65-year time horizon: A 20-year-old investor, just starting out on a long career Works and contributes to savings for the next 45 years, until age 65 Then lives another 20 years in retirement (actuarial tables say this is realistic) And doesn’t liquidate his holdings during retirement, but lives off of the interest on his principal At 85, leaves his nest egg to his children, after a 65-year investing career. Although this timeline is unusual, it’s not unrealistic. When making an argument, it’s completely legit to use best-case and worst-case scenarios in order to illustrate your point. So let’s stipulate that a 65-year horizon is acceptable for illustrative purposes. As you go through the charts and tables below, you can substitute your own likely time horizon for the 65 years that Bogle used. In constructing his argument in the book, Bogle states the following: “$1,000 invested at the outset of the period, earning an assumed annual return of, say, 8 percent would have a final value of $148,780 – the magic of compounding returns.” Here’s what that looks like in chart form. (You’ve undoubtedly seen this graph before, but bear with me – I’m establishing a baseline here.) (click to enlarge) Bogle then warns that this outcome is unlikely to be achieved. Why? Because the graph above excludes what he calls “intermediation costs.” And these costs also compound over time. Bogle’s argument is that the power of compounding returns is eventually overwhelmed by the tyranny of compounding costs – a concept that many investors fail to fully appreciate. Bogle continues… “Assuming an annual intermediation cost of only 2.5 percent, the 8 percent return would be reduced to 5.5 percent. At that rate, the same initial $1,000 would have a final value of only $32,465 – the tyranny of compounding costs. The triumph of tyranny over magic, then, is reflected in a stunning reduction of almost 80 percent in accumulated wealth for the investor… consumed… by our financial system.” Here’s what the tyranny of compounding costs looks like in chart form: (click to enlarge) As Bogle points out, financial intermediaries – the money managers, sellers of investment products and financial advisers – “put up zero percent of the capital and assume zero percent of the risk yet receive almost 80 percent of the return.” And it’s true – I ran the numbers six ways to Sunday and I came up with the same results every time. Now let’s take a look at the numbers from a different angle. Instead of using a static $1,000 deposit at the beginning of the period, I devised a more realistic scenario. The median household income in the U.S. today is $55,000. If we assume that this household sets aside 5% of that income each year, they will end up with a nest egg of roughly $800,000 when they retire after 45 years. And if they leave that money in their account for the next 20 years, only spending the interest on their principal, it will continue to grow, and their final account value will be roughly $3.7 million, using an 8% annual rate of return. That’s the power of compounding returns. Now let’s assume that the total cost of investing – what Bogle describes as financial intermediation – comes to 2.5% per year. This is a reasonable figure, based on many studies from academia and from the financial industry itself. When you combine the visible costs like mutual fund expense ratios, management fees, and account servicing charges, you get to 1.5%. When you add in the hidden costs, like the commissions that mutual funds pay to the brokers who execute their trades, trading impact costs, bid/ask spreads, capital gains taxes, and payment for order flow – you get to 2.5%. Now let’s see how much this typical household gives away to financial intermediaries – after 45 years, and after 65 years. (click to enlarge) After investing for 45 years, this household would – in theory – have accumulated a $798,000 nest egg. And if they kept their principal intact for the next 20 years of retirement, their nest egg would grow to $3.7 million. However, due to the tyranny of compounding costs, the financial intermediaries who “helped” them build this wealth would take 65% of their nest egg after 45 years, leaving them with just $278,000. At the end of the full 65 years, the financial intermediaries will have taken 78% of our household’s wealth, leaving them with $811,615. The true cost of financial intermediation is outrageous and unjustified. But most of these costs are hidden, which explains why so many investors aren’t aware of the destructive impact these costs have on their future wealth. In my next article on this topic, I’ll dig into the details of the costs to show you how they sneak up on us and overwhelm the power of compounding returns. In the meantime, I’ll leave you with a set of low-cost, high-quality mutual funds and ETFs that will help you cut down on the high cost of financial intermediation. I created this list using Morningstar’s fund screening tool. I screened for a combination of low expenses and high analyst ratings. It’s not a perfect list, and it doesn’t cover every asset class – but it’s a good place to start. If you own some funds that have high expenses, it might be worth your time to compare what you own to the funds shown below. Every dime you save on expenses gets moved from the intermediation side of the ledger to the wealth side. Think about it. (click to enlarge)