Monday, January 23, 2012

Stocks for the long run?

A recent post on the Fama French Forum asks "over what time period can you be reasonably assured of earning a positive premium for investing in small stocks?"  In other words, how long do you have to wait for the extra risk of small stocks to pay off?  F&F state that like the equity premium overall, you probably have to wait 35 years to be reasonably confident of seeing a positive premium.  But they add that of course, there is still a possibility that after 35 years equities could still trail bonds.

What does this mean for a typical investor?  First of all, most investors look to stocks to provide a higher return  to enable them to reach their retirement goals.  But such a return isn't guaranteed and indeed, may never materialize, particularly over shorter time horizons.  The second issue is that while we know what the historical risk premium is, i.e. the amount by which stocks beat bonds, we really don't have much idea what the future premium will be.   Therefore, investing for the long run in stocks is doubly risky.  First there is uncertainty about whether you will actually earn a positive risk premium, and second, we don't know what that premium should actually be.

Zvi Bodie (Finance Prof at Boston U) makes this point.  He argues that what investors should do is buy TIPs and treat saving for retirement as just that - saving, and not investing.  I think Prof Bodie is perhaps taking an extreme view, because the return on TIPs is likely to be pretty low in real terms for most investors, meaning that they will have to save a lot more to reach their goals.

The other extreme is the case of the investor who assumes a 12% return on stocks and invests the minimum amount, hoping that massive gains in the market will build most of his wealth.  Even worse is the investor who keeps rearranging his allocation in his 401K plan because he thinks he can time the market.  And don't get me started on the person who borrows against their 401K to buy a new car...

My strategy is to take a middle of the road approach.  We should invest in a diversified portfolio of index funds and work under the assumption that the risk premium is very low - say 2%.  This premium would translate into, maybe a 5% portfolio return.  Then based on this low performance, we should invest more today to meet our goals.   If the market does well, you'll be able to sail the world in your retirement.  If it doesn't, you should at least be able to avoid living with your kids.