What's the alternative?
Markus Muhs - Sep 17, 2019
Aversion to investing in stocks can only be rational if there truly is an alternative to invest in. Is there an alternative?
I made this tweet one morning...
History proves that for a 30 year time horizon, faced with the alternative of owning a 30 year t-bond at 2%, ALWAYS was the time to buy stocks (even from market highs onward). https://t.co/gFc4GyYReu— Markus Muhs (@CGWM_Muhs) September 2, 2019
I want to check the historical record, and see if I am correct in this assertion.
The day I tweeted the above, the 30-year U.S. t-bond was yielding 1.96%. That is, if you invest your money in such a security and held it for 30 years you’d see a return of 1.96% annually, minus any commission to pick up the bond.
True, if yields continue to drop, you can sell it at a gain. With rates so extremely low currently, bond durations (a factor of yield and time to maturity) are higher, so if you bought that 30 year yielding 1.96% today and yields drop by another 1%, that bond would temporarily gain in value by 25%.
The opposite is true though, if yields rise back to 3%; something highly probable to happen at some point over those 30 years. Let’s say that two years from now the economic situation is different and an equivalent bond with 28 years left on it yields 3%. That 1.96% bond you bought in 2019 will have lost nearly 20% of its value. If you hold the bond to maturity this won’t matter, you’ll still finish the 30 year term with the 1.96% annualized return you started at, but if you want or need to sell it along the way, it’s a mathematically guaranteed loss.
Anyway, the point of the above lesson on bond durations, and the inverse relationship between bond values and interest rates, is to illustrate the general unattractiveness of the main alternative to a 30 year stock investing strategy, as well as the tremendous amount of risk said alternative carries. A 30 year bond has very little upside (less than 2% annually over the long term, with a slight chance of a big short-term gain that can be traded) with significant downside risk if sold along the way. Now, how did stocks do over 30 year periods?
We know that the long term return of stocks, with dividends reinvested, is in the 8-10% range, depending on your starting point (whether 50 years, 100 years, 200 years), but how did they do over 30 year periods if you happened to start at the high point before a major market decline?
I chose 30 years because typically most investors have time horizons greater than 30 years, even if some don’t know it. Someone aged 30 definitely has at least 30 years to invest, as his/her retirement date is around 30+ years away. Even a retired couple aged 60 though should consider that they too may have a 30 year time horizon; 30 years until they reach age 90, which statistically at least one of them has a greater than 50% chance of reaching if both are healthy. They need their money to last 30 years and thus have a 30 year time horizon. Someone aged 80 might also have a 30 year time horizon, if defined benefit pensions fully cover their expenses and any money they have invested ultimately is meant to pass on to their beneficiaries.
So, 30 years is a long time to invest and you know you’re most likely going to get an annualized return close to the long term averages if investing for 30 years. What would be the absolute worst times to start out though; dates in history where your 30 year time horizon might be most hobbled by an immediate market decline?
The following market returns come via a very handy calculator I found online called The S&P 500 at Your Fingertips. Beyond what the typical long-term graphs show you, it calculates total returns (with dividends reinvested) and adjusts them to inflation. So, let’s have a look at some 30 year numbers, or in the case of some more recent calculations, to the end of July 2019 (August numbers not available at time of writing).
Had you invested all your money at the high point before the financial crisis, in October 2007, you would have seen the S&P 500 rise (eventually, after a sharp drop) from 1540 (then an all-time high) to 2996, or effectively nearly a double. The dividend yield on your investment rose from 1.77% to 1.89% and your total return would have been 8.06%. Inflation at 1.76% would have eaten away a bit of that, yielding you 6.19%.
Okay, let’s go farther back, to March 2000. Now we can see what an investment at a tech-bubble high would have done, followed by almost 3 years of negative markets and almost 20 years that included over a decade of range-bound markets, from 2000 to 2013. Now we see some weaker long-term numbers: your annualized return with dividends reinvested was only 5.84%, equal to 3.65% annually after inflation.
Let’s now look at the 30-year period from September 1987 to September 2017. This just perfectly exemplifies how completely inconsequential the October 1987 “Black Monday” crash was in the midst of an 18 year (1982-2000) secular bull market. Annualized rate of return was 9.46% with dividends reinvested. Over those years the cash dividend of the S&P 500 rose from $8.66 to $48.17. On a 30 year bond you get neither asset appreciation, nor an increase in interest over those 30 years! Adjusted to a modest 2.58% annual inflation rate, the real total return was 6.71% annually.
November 1968 was a high point leading up to the 14 year malaise that culminated in the infamous 1979 Businessweek article “The Death of Equities” that I referred to in my eponymous blog post last month. Had you invested all your money at that time, you would have been in for a lot of pain the first 14 years, thanks mostly to inflation, but by November of 1998 you’d be sitting pretty. The S&P 500, bound to the 100-range all the way until the early 1980s eventually tentuppled from 105 to 1144. Its cash dividend grew from $3.06 to $16.18. The index’s impressive total return of 12.26% annually had a whole 5.24% shaved from it though due to inflation, yielding a still decent real total return of 6.66% annually.
Finally, let’s go back to the absolute bubbliest of bubbles, September 1929, a period that followed a more than quintupling of the Dow Jones over the prior 8 years (the "Roaring 20s") that then saw the Dow lose almost 90% of its value over less than 3 years. If you look at a long-term chart of the Dow it took until 1955 for it to exceed its 1929 high of 381, and in inflation-adjusted terms, it was still a bit lower as late as 1962. Lucky for us, the aforementioned tool includes reinvested dividends, because dividends during that time period didn't drop as much as stocks did, averaging over 3%. From Sept 1929 to Sept 1959, the calculator shows an inflation-adjusted 0.25% annual return without dividends reinvested and a 5.76% total real return with. This huge difference can be attributed to the fact that many of those dividends were reinvested at very low market prices.
So there you have it. Empirical evidence that there really is no proper alternative to 100% stocks for a 30+ year investment time horizon.
With that stated, I do concede that often times we do include bonds in such a portfolio, and that is pretty much the starting point in a discussion of long term investor behaviorism. To keep things short, while the evidence is so glaring and in our face, many of us just don't conceptualize time and market movements over such long periods of time, and ultimately any allocation to bonds in a 30 year portfolio serves only the sole purpose of providing comfort to the investor, to prevent said investor from making a fatal, irrational, emotion-driven error along the way.
The cost of bonds in a portfolio, of course, is the dampening of returns over the long-term. I've stated this before in a recent blog post about the real cost of robo advice. I worry that a lot of younger investors, whose logical long-term allocations should be 100% stocks, are instead investing in balanced (typically 60% stock) portfolios due to the dearth of coaching around "risk questionnaires" at banks and robo advisors. Ironically, the cost of investing in the wrong asset allocation over the long term, at several full percentage points, can be a lot greater than the cost of paying for proper advice.
Reach out to me if you'd like a second opinion on your portfolio or are worried it might not properly be aligned with your goals.
Markus Muhs CFP, CIM
Images courtesy Pixabay and Wikimedia Commons.