The picture after 10 years: the one-in-nine rule of thumb

p.19 For investors with holding periods of ten years, historically the real returns on stocks were positive about 89 percent of the time, compared to only 68 percent for holding periods of one year (Chart 2). While on average investors had an annualized real rate of return of 6.6 percent, the average masked some very poor performing periods. Stocks did not keep up with inflation after ten years 11 percent of the time. In the worst-case scenario, an investor could diligently add $1 every month to the broad stock market index, reinvest all the dividends in the index for ten years, and end up with only 56 cents on the dollar, adjusted for inflation. In other words, in the worst case the cumulative real return was -44 percent.

Thus, after ten years you have one chance in nine (i.e. 100-89%) of not having a postive cumulative return, and the worse case can be brutal.

After 20 years: 98% success rate; limited worst case

p.20 For investors with holding periods as long as 20 years, stocks were a bit less risky. After 20 years of repeated investment, stocks beat inflation about 98 percent of the time. Over the 2 percent of the time when the real return on stock investments was negative, the worst loss was a cumulative 13 percent. Bond investors, in contrast, were able to beat inflation only 40 percent of the time. Over the other 60 percent of the time, their real returns were negative, and the worst loss was 48 percent (Charts 2 and 3). For holding periods of 20 years, stocks historically outperformed bonds 99 percent of the time (Chart 4). Over the other 1 percent of the time, stock portfolios underperformed bonds, sometimes by as much as 15 percent (Chart 5).

Nivarna after 25 years

p. 22 Stock investors with holding periods of 25 years typically were rewarded handsomely. Stocks always beat inflation over 25-year periods from 1926 to 2002, and they outperformed bonds 99.8 percent of the time (Charts 2 and 4). Bond investors, however, beat inflation only 34 percent of the time, and if their holding periods ended in the fall of 1981, they lost a cumulative 49 cents on ever y dollar they invested (Charts 2 and 3).

Conclusion

Shen’s article in effect estimates a 11% risk of a market decline taking place over any 10 year period; and it did in 2008. These were prophetic words, written before the fact, and therefore deserving of our great respect.

The article rightfully concludes that the historical data argue for caution when investors determine their asset allocation. We would say: be realistic how much risk you are prepared to take.

p.27 This article confirms the conventional wisdom that in the United States stocks historically have been safer than long-term government bonds for investors with long holding periods. But the article also shows that the conventional wisdom has only been true for investors who held their portfolios for more than 25 years. For practical purposes, that may be too long a holding period for most investors. Over the years, for investors who have held their portfolios for shorter periods, both stocks and bonds were exposed to substantial risks, and stocks did not necessarily outperform government bonds. This implies that in making asset allocation decisions, investors should think carefully about how long they will be able to hold their portfolios undisturbed and how much risk they are willing to bear.