Right up there with the idea that you can’t go wrong with real estate is the investing folk wisdom that equities are the place to be, especially long-term. Is this true? Most of that folk wisdom comes from the happy experiences of the baby boomers who started investing in the late 70s and early 80s and have had a huge rally ever since. The last 30 years have been, by any measure, a time of extraordinary growth fueled by a combination of emerging economies, cheap energy, a relatively stable U.S. financial and legal system, and U.S. comparative advantages in education and innovation. These advantages seem to be dissipating for reasons both too obvious and too complicated to mention.
If you look at other periods, particularly periods of macroeconomic turmoil, equities did not perform so well, often for a decade or more. Look at the chart below:
It took until the 1950s for the market to reach its 1929 high. The 1970s saw almost no DJIA growth. And this chart does not even correct from the mirage growth caused by artificial inflation, a phenomenon which has only gotten worse since the introduction of a fiat U.S. currency in 1971.
In principle, some variant on diversification is the best way to invest long-term. But diversification does not just mean diversification in equities. By way of analogy, bundled mortgage instruments were diversified only superficially: they depended on the housing market as a whole. Bundled equities, such as index funds, are also somewhat sector-dependent: they ultimately depend upon the growth of both the US economy and the world economy. But how do you invest in a shrinking economy where a great number of malinvestments must be liquidated? After all, it seems reasonable to conclude, we’re heading into a period of stagnation and decline that will last quite some time.
It is simply fool-hardy to tie up a great portion of one’s cash in equities based on models of long-run equity performance that conveniently cut themselves off at 1980 or thereabouts. As in all statistics, look at the scale and size of the X and Y axes. Most models promoting the long-run benefits of equities discard data showing 10 and 20 year cycles of equity stagnation during earlier periods of decline.
Real diversification should include real estate, bonds, cash, commodities and should be adjusted, especially during troubled times, to include the wealth-preserving insurance of tangible gold bullion.
Subscribe To This Feed
Thanks for posting the Adjusted Dow! I’d been looking for such a chart in vain.
I generally agree with your view on diversification, and in particular the myth that equities are always and inevitably, the most important part of a portfolio because “over the long run, equities out perform all other asset classes.”
This statement is in fact historically correct, and indeed, much monte carlo research into “ideal” portfolio mixes does support the notion that having some equity exposure is an important part of a durable portfolio.
That said, equities are not a homogenous asset class, and various theoretical models such as Fama/French would suggest that various sub-segments of the “equities” class are important components of a diversified portfolio, i.e., value stock, small cap stocks, and international stocks.
The financial services machine would love to sell the myth that diversified equity investing is the path to retirement, but recent market events should have taught everyone a few lessons, namely:
1. You probably aren’t as risk-seeking as you thought you were;
2. You need to have at least 30% fixed income, regardless of your age, and 60% allocations to bonds make sense as you approach retirement;
3. Investing is hard, and smart people make bad decisions all the time; and,
4. Social Security should never be privatized.
I think this most recent market turmoil should put the nail in the coffin of privatized social security. There are at least two reasons for this that I see. First, as noted, investing well is hard. Even smart, risk-appropriate investors take losses, sometimes large ones.
Moreover, there is a lot of research showing that one of the single most important drivers of retirement security is when you retire; if you happen to retire at the start of a bull market, you’re in clover for the rest of your life. If, on the other hand, you begin your golden years at the onset of a bear market, you’re going to eat pet food in your old age.
I’m not a fan of Social Security, but I’m even less of a fan of privatized investment decisions within the Social Security construct.
Since most old folks have (or should have) the bulk of their portfolios in fixed income rather than equities, wouldn’t a bear market be welcome once they retire?
“wouldn’t a bear market be welcome once they retire?”
I, for one, have no clue. But who does, really? What’s dawned on me since this fiscal implosion is the universal degree of horseshit that pervades our long-revered institutions.
The counsel is now more counterfeit than the currency.
We have the brightest minds; experts wide and far; they migrate from Harvard, Wharton, U. of Chicago and beyond. If there’s not a reknown professor, there’s an eminent banker. Dime a dozen.
Turn on any tv, read any paper or blog, and you’ll fast discover that the soi disant economic genuises are more widespread than deficit dollars. And each brings an equal value: zero.
I pray for this calamity to end less for its toxicity upon my purse, than for its inanity upon my mind.
Take my money and leave me in peace.
When you buy a stock index fund that mirrors the entire economy (like the Vanguard Total Stock Market) you may not trying to earn a “year-by-year” percentage increase but rather simply buying the entire US economy, becoming an owner of it. You then own the companies that produce the goods and services of our nation.
So the owner of the index fund merely owns the production; if we get wealther as a nation, you get wealthier. If not, not. I tire of the endless folk trying to make money via investing. Buy what you want to own, and then put whatever you want to keep safe in TIPS (inflation indexed US Treasuries).
Chris, your general point that we shouldn’t base investment decisions on patterns from selected portions of past market behavior is spot on.
Another important component of diversification and bet hedging is equities that pay dividends. You can find very attractive dividend yields in companies whose stock prices have been beaten up. The yields are often higher than those of any bonds short of junk.
It’s not quite that simple, of course. Dividends aren’t guaranteed. A company can cut, or even eliminate, its dividend. But doing that sends such a message of desperation that companies avoid it if they possibly can.
Some fairly easy research can help. Any site that gives company financials will include the payout ratio — the percentage of earnings paid as dividends. It should usually be less than 60 percent if you want to feel comfortable, except in organizations that are structured to pay out most of their earnings as dividends, such as real estate trusts. You can also find lists of firms that have paid a dividend for 50 years or longer.