Investors are drawing the wrong lessons from Japan’s Nikkei 225 Index
JP:NIK
topping its 1989 high last week.
Many investment professionals claim this proves that stocks eventually produce a profit, if you just hold on long enough. In truth, the correct lesson to draw from Japan’s experience is that stocks are far riskier than most assume, and there are no guarantees.
Most investors ignore Japan altogether when concluding that stocks should come out ahead over investment horizons as short as a decade. There’s a belief that Japan’s multi-decade dry spell is an exception to the rule.
But it isn’t. Seven countries in addition to Japan have, at some point in their century or longer histories, produced a 30-year total stock-market return below inflation, as you can see from this chart.
The exceptional U.S. experience
Some investment professionals respond with what I call U.S. exceptionalism — in essence, the notion that the U.S. is different and is therefore immune to the historical precedents from other countries.
But the U.S. has its own experience with stocks failing to produce a gain over not just years, but decades. According to Edward McQuarrie, a professor emeritus at the Leavey School of Business at Santa Clara University in California, in one 75-year stretch of U.S. history — from 1909 through 1984 —the price-only S&P 500
SPX,
in inflation-adjusted terms, was no higher at the end than at the beginning.
Even if you believed in U.S. exceptionalism, therefore, you’d have to allow for the possibility that the price-only S&P 500 at the end of this century could be no higher than today in inflation-adjusted terms.
Where’s the risk?
In any case, there’s a theoretical reason to question the blind faith investors place in the argument that stocks always win if you hold on long enough, McQuarrie told me in an interview. According to that argument, of course, stocks make money over the long term in order to compensate for their riskiness. But, as McQuarrie asks, where’s the risk if stocks always make money over the long term?
You can’t have it both ways, he says. On the one hand, if stocks held for the long term are indeed risky, then that means there’s a possibility they’ll lose money over the long term. On the other hand, if you deny the possibility of a long-term loss, then stocks’ long-term risk is a lot lower — in which case, from a theoretical point of view, their expected return would need to be a lot lower as well.
“Cushion investment risk with a combination of stocks and U.S. Treasury Inflation-Protected Securities.”
As Japan’s experience teaches, stocks held for the long term are still risky. Consider simulations conducted by Elroy Dimson, Paul Marsh and Mike Staunton, all finance professors at the London Business School. Assuming stocks’ historical average returns and the standard deviation of those returns, they found that there is a considerable probability the stock market can lose over very long holding periods. In one simulation, for example, they calculated that, over a 40-year investment horizon, the probability of an inflation-adjusted loss is 15%.
TIPS to the rescue
One investment option that is available today but wasn’t during most of U.S. market history involves TIPS — the U.S. government’s Treasury Inflation-Protected Securities. The 30-year TIPS , for example, is currently yielding 2.19% above inflation, which means you can lock in a real return of more than 2% over the next 30 years.
To be sure, you’d have to tie your money up for 30 years to capture that return. But you can do almost as well by constructing a ladder of individual TIPS that mature each year over the next three decades, as I described in a column last November. In an email, Allan Roth, founder of Wealth Logic, an investment advisory firm, told me that a 30-year TIPS ladder established now could support a 30-year guaranteed inflation-adjusted withdrawal rate of 4.62%. (This withdrawal rate represents a combination of a return of principal and interest, of course. Roth says that the internal rate of return of the ladder is 2.1% annualized.)
You don’t have to invest all of your retirement portfolio in a TIPS ladder to take advantage of this opportunity. A conservative approach might be a combination of stocks and a TIPS ladder. If stocks do as well as they sometimes have in the past, then the stock portion of your portfolio will be much larger in 30 years when your TIPS ladder runs out. If stocks don’t do as well, then you will have been well cushioned from the full brunt of their loss.
Mark Hulbert is a regular contributor to MarketWatch. His Hulbert Ratings tracks investment newsletters that pay a flat fee to be audited. He can be reached at mark@hulbertratings.com.
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