Why Dips in the Stock Market Don’t Matter
How Time Demolishes Risk
You’re at the blackjack table, with the vanilla-tinged cigarette smoke wafting through the casino, and the dealer flips herself an ace. Your cards add to 12. After ordering another free drink, what do you do?
You hit. And the next hundred times you come across this scenario, you hit again. There are books on blackjack that lay out every hand and the proper play because, although it’s a game of chance, there is a correct method of playing that will maximize your expected return. In this “dealer ace, player twelve” scenario, you have a 31% probability of busting, but that doesn’t mean you ever stand. When you hit, you will lose sometimes, but you are better off hitting 100% of the time with this hand than sometimes standing.
Likewise, stocks are always expected to perform better than bonds in the long run. I used the actual returns from the S&P 500 as a proxy for the stock market and 10-year T-Bonds for bonds since 1950. That’s 70 years of data, but not so far back that regulatory differences make it irrelevant.
If you invested for 10 years starting in 1981, you would have had a different ten-year return than if you had started in 1982. Each of these periods is a data point when we look at the distribution of ten-year returns.
When the stock market dips, news outlets jump on the action, even though the graphs that measure prices are expected to squiggle along the way. Every minute, day and year will differ. Those differences actually don’t matter though. Because you’re investing for the long haul, you need to consider risk with an equally long view.
Consider the following box-and-whisker plots for stock returns over time. Using these data points from the past 70 years, the box shows the range for 50% of the data. Half of the time, returns fell within the box. The top of the whisker is the maximum return from the past 70 years. Twenty-five percent of the time, returns fell between the top of the whisker and the top of the box. Similarly, the tip of the bottom whisker indicates the minimum return from the data, and 25% of the returns fell between the tip and the box.
Most people worry about the volatility of stocks, the long whiskers in the one-year boxplot. What this chart is telling us is that it is very hard to predict what the stock market will do next year, but you can actually be quite accurate with your prediction of how the market will fare over the next fifty years: it will go up. The S&P 500 squiggles minute to minute and even year to year, but it increases over the decades because technology, and thus productivity, is improving.
Just the act of investing for decades is enough to eliminate the majority of the long-term risk of investing in stocks.
As a long-term investor, you need to compare the long-term returns of asset classes and different allocations. In the next boxplots, note that stocks still have a wider range of returns than bonds, but the whole range eclipses the ranges for bonds and gold. Even when you compare the worst year to start investing in stocks to the best year to start investing in bonds, you would still come out ahead with stocks. The chart also presents split allocations to demonstrate that adding bonds to an otherwise stock-only portfolio dilutes its long-run returns.
A few percentage points make a substantial difference when you convert them to additional dollars over the decades. If you invested $100,000 and let it ride for 50 years, your expected value in a stocks-only portfolio would be over $16 million. The average value of a bond- or gold-only portfolio would end with just over $2 million. A portfolio of half stocks and half bonds, rebalanced every year, has an expected value in between, with $7 million. Stocks are the clear winner.
So why do financial advisors recommend bonds? They are playing the short game with your psychology. After all, you will not be tracking down the advisor after fifty years. Even if you did, you would have no legal recourse. An advisor is trying to keep your business year to year. Adding more things to your portfolio makes the advisor seem useful and prudent. Plus, they know that humans feel losses much more strongly than they enjoy gains. An advisor’s suit will appear as shining armor to you if they limit your downside in a market dip, even if it actually hurts you in the long run. They also do not have every type of asset class available to them. They cannot buy you a house to renovate and rent out. They have only public liquid assets in their toolboxes.
Bonds work well for not losing money, but they aren’t the best for gaining. They’re like a better form of a savings account. However, the portfolio of a seventy-year-old who is depleting her life savings should be full of bonds. She literally cannot afford to lose money in a year or she could starve. With financial independence though, there is no depletion stage — your portfolio will always be growing.
While stocks are the highest yielding liquid assets, they give kangaroos a run for their money in their ability to jump around. You can add less correlated high-yield asset classes to your portfolio to further stabilize your returns over time. Just make sure that those assets also have a high compound annual growth rate in the long term. Diversifying with low-yield assets, such as bonds, will only decrease your returns in the long run.
If you add low-yield assets to your portfolio to preserve your capital in the short run, you will lose out on great returns in the long term. For you stats folks out there, it’s the law of large numbers at work. For economists, it’s game theory. For investors, it’s dollars in the bank.
Unlike at the casino, the odds for investing are in your favor. If there were a table game that paid out $110 on average for every $100 you bet, you wouldn’t leave the table. Sure, you wouldn’t win every hand, but losing would have no material impact when you have piles of chips and time. With stocks, you’ve got years to play and, even when you get up to walk the Strip or watch Britney Spears crawl across a stage, your chips will continue to play for you.
So take your seat at the stock market table and say, “Hit me baby many times”.
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