Saturday, October 13, 2007

The Stock Market is Not That Safe

A few days ago I had a lively discussion with Matthew of Crazy Money about whether it is a wise thing to hold a long term portfolio consisting entirely of stock investments. I argued for a well diversified portfolio comprised of weakly correlated asset classes. Matthew argued that since the stock market provides the highest long term expected returns, the best way to go is a 100% stock based portfolio. I wanted to revisit this issue and add a little more data.

Essentially, the core of Matthew's argument is that over the long term the stock market is safe. If you have 40 years to wait, the stock market will invariably go up. In last week's The Economist, I found an article called To Infinity and Beyond, which addresses this very issue. Let me offer a few choice quotes from the article:

"Among American financial commentators, it is almost universally accepted that shares always rise over the long run. And this perception does seem to be backed up by evidence; if you take any 20-year period, Wall Street has always delivered positive real returns. In addition, one ought to expect shares (which are risky) to deliver a higher return than risk-free assets such as government bonds.

Nevertheless, investors ought also to remember the world's second largest economy, Japan. Its most popular stockmarket average, the Nikkei 225, peaked at 38,915 on the last trading day of the 1980s; this week, nearly 18 years later, it was still only around 17,000, less than half its peak. Buying on the dips did not work either. By 1994, the Nikkei had fallen to 21,000—at which point a technical analyst, after poring over his charts, told this columnist that it had to be one of the great long-term buying opportunities."

And another quote:

Elroy Dimson, Paul Marsh and Mike Staunton of the London Business School examined the record of 16 stockmarkets which were in continuous operation over the course of the 20th century. In itself, this selection showed survivorship bias by excluding the likes of Russia and China. The academics found that only three other countries could match the American record of having no 20-year periods with negative real returns.

Other investors were far less lucky. Japanese, French, German and Spanish investors all suffered instances where they had to wait 50-60 years to earn a positive real return; in Italy and Belgium, the waiting period stretched to 70 years. It was no good following the famous advice to “put the shares in a drawer and forget about them”; the furniture would not have lasted that long"

I still have some QQQQ shares I bought in 2002 which are still about 20% below their nominal purchase value, they are much lower than that if you take inflation into account.

Now, don't get me wrong, most of our portfolio is invested in the stock market. However, I think that this article underscores the need to diversify beyond that asset class, and into assets that would not be impacted - and hopefully would even benefit from a decline in the stock market. Many would argue that the American stock market is unique and that it will not experience the kind of decades long bear market that other markets have seen internationally. They may be right, but is it wise to bet your financial well being on this assumption?


plonkee said...

I'm not surprised that the countries mentioned had long periods with little growth. If I recall correctly, they didn't have success throughout every minute of the 20th century. I imagine that their slow periods coincided with a less democratic/capitalist period.

Shadox said...

Yup. You are right. Some of those countries really had a "tough century". Still, nothing guarantees that your specific country, whatever that country may be, is one of those that will suffer a serious set-back over the next couple of decades.

Contrary to popular belief, history does not repeat itself. It just follows the same themes again and again... :-)

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