by David Dreman
2. Be careful of packaged concept products, complex mortgages, and other intricate offerings by hedge funds, investment banks, or banks. They normally get big markups on these structured deals, which are often partnerships. Liquidity is notably poor in most cases. And their record is usually not good. Ask the banker or broker how much his firm intends to keep invested in each over time. Don’t be surprised if the answer is a touch evasive.
These products have a common denominator. They are almost all intriguing concepts that, you will be told, should earn higher returns. I never buy them because the fees are much higher than stock commissions, sometimes going up to 20 percent of profits with ample annual charges on top. More important, I don’t have a warm, fuzzy feeling that these deals will work out well. I’d advise you to stay well away unless you like financial products with no record, no liquidity, and high fees. Strangely enough, a lot of investors with a pretty high net worth latch onto these products. Hopefully you will not.
3. Tread cautiously when you buy little-traded issues either on your own or in a secondary offering. You can again run into liquidity problems that often cost. Make sure that when you buy there are at least a few market makers, and don’t take positions above a few percentage points of the daily trading volume.
4. Stay away from exotic derivatives such as European puts and calls written on U.S. stocks, often by a U.S. broker. These are normally both more expensive than trading derivatives on a U.S. exchange and far less liquid to sell if you decide to.
5. If you don’t understand a bond or a hedge fund, or any other security—don’t buy it. Forget the yield, no matter how alluring, and protect your principal; better opportunities will come that you will understand, and probably sooner than you think. Remember, the buyers of the subprime AAA and AA bonds lost as much as 70 cents on the dollar. That’s a heck of a lot to lose only to collect maybe an extra 2 to 3 percent a year in yield when the going is good.
Other Risk Factors
When the efficient-market risk theory put its focus exclusively on volatility, doing so wiped out important guidelines that had been followed for risk analysis for centuries. Prudent security analysis on risk, much of it codified by Graham and Dodd and other leading financial theorists, was cast aside or else not looked at carefully, because it wasn’t all that important, according to EMH believers. Why bother? they thought. It was all factored into volatility anyway.
We must now resuscitate those established principles of risk assessment, which are far more useful in determining many types of risk that volatility completely bypasses, including:
1. Lack of liquidity
2. Excessive leverage
3. Bond risk-control techniques
4. Stock risk-control techniques
It’s beyond the scope of this book to go through the lengthy list of stock and bond risk control measures. Many are presented in Graham and Dodd’s Security Analysis (6th edition, 2008) and other good books on the subject that can provide you with the fundamentals you need. The principles are very important and haven’t changed significantly over recent decades.
Next we’ll look at a new set of new risk factors that we should pay special attention to in the years ahead.
The Third Horseman of the Financial Apocalypse: Inflation
Let’s start this section with a quick review of the history of some of the risks out there and how they can destroy the unwary. Frank H. Knight, one of the cofounders of the Chicago School of Economics, in his seminal work Risk, Uncertainty, and Profit (1921),1 stated that there is a major difference between risk and uncertainty. Risk, according to him, was “a quantity susceptible of measurement,” while uncertainty is not capable of being measured.
By his definition risk applies to many types of gambling games, horse racing, betting on baseball and football, and many other activities—anything where the risks can be calculated. Uncertainty applies to situations where the gains or losses are indeterminate either on the upside or on the downside, such as the value of stocks in a revolutionary period, shorting futures or derivatives positions and leverage on real estate, or scores of similar situations.
By far the most dangerous new risk over the past sixty years has been inflation, which can attack our savings in many ways. In the past we did not focus on inflation, as rising prices have been pretty much a nonevent for centuries, with only a few flare-ups such as those during the Revolutionary War and the Civil War in this country and similar periods abroad. Inflation was a minuscule one-tenth of 1 percent from 1802 to 1870 and six-tenths of 1 percent from 1871 to 1925.2
When all major nations were on the gold standard, most government and many corporate bonds could be redeemed in either the national currency or gold at maturity at the holder’s option. Given that inflation was almost nil, the “prudent-man” rule was introduced by Justice Samuel Putnam of the Massachusetts Supreme Court in 1830 and has served as an important guideline for money management for 150 years. A prudent man did not speculate, according to Putnam, who directed trustees “to observe how men of prudence, discretion and intelligence manage their own affairs” and act accordingly. So it made the best sense to stay in bonds with a number of preferred shares and a sprinkling of blue-chip stocks.3
But risk is a cunning beast, and inflation is a major weapon it unleashes against our capital, stealthily sneaking through our defenses time and again. Inflation caught investors following Justice Putnam’s prudent-man edict flatfooted after World War II. Anyone who had put $100,000 into bonds at the end of that war would have $280,000 in 1946 purchasing power left today.4 However, that’s before income taxes, which averaged 60 percent between 1946 and 2010. After those two horsemen of the Financial Apocalypse—inflation and taxes—trampled over the bonds, investors or their estates who paid income tax in the top bracket would have had only 27 percent of their original 1946 purchasing power remaining in 2010.
The law is often decades behind economic and financial changes, and many investors and their managers still continue to believe in and follow Putnam’s seriously outdated principle, which was appropriate in his time. The truth is that following the prudent-man rule, which had worked so well for so long, devastated the savings of many millions of Americans after World War II. Risk, this time in the form of rapidly rising prices, leaped from the heart of Justice Putnam’s well-designed law to protect people’s capital and is now one of the greatest dangers investors have faced and will continue to face in the twenty-first century.
Let’s next turn to how we can best handle risk in the stock and bond markets.
Beyond the Prudent-Man Rule
Inflation permanently entered the investment environment for the first time after World War II. Nothing is safe from this virulent virus, although its major victims are the supposedly safest investments we own: savings accounts, T-bills, Treasuries, corporate bonds, and other types of fixed-income securities. Whereas a relatively small number of companies may flounder financially or go under in any normal period*80 and far more in a financial crisis such as we are currently moving through, the risk of inflation for most investors has proved more costly over time than credit risk. Rising prices after World War II have radically and completely altered the return distributions of stocks, bonds, and T-bills.
Are Stocks Riskier?
The wisdom of the ages, as we have seen from Justice Putnam’s prudent-man rule, has always been that bonds are less risky than stocks over time. A company’s bondholders, after all, had far less financial risk than the shareholders. If a company ran into financial problems, it could cut its dividend to shareholders, but it had to maintain interest payments and repay the bond principal when it was due. Otherwise, the company would go into default and the creditors would take everything the company owned before the shareholders got a penny. In the pre–World War II period, the major risk investors had to face was financial: the risk that a bond or a company would go under. The risk of inflation was an insignificant concern at that time.
The rapid inflat
ion of the postwar period has turned all risk calculations topsy-turvy. While stocks have always had higher returns than Treasury bills or bonds over time, the disparities among the three classes of financial investment widened enormously after 1945. If an investor put $100,000 into T-bills in 1946, after inflation it would have increased to only $133,000 by 2010, a gain of only four-tenths of 1 percent annually. At that rate it would have taken about 160 years to double his capital. Bonds did only slightly better; $100,000 in 1946 became $280,000 by the end of 2010, for a return of 1.6 percent annually.*81 By comparison, investing $100,000 in stocks in 1946 hit the jackpot. It became $6,025,000, forty-five times as much as T-bills and twenty-one times as much as bonds (before-tax figures). After taxes the relative return for stocks over bonds and T-bills widens considerably, as both of the latter two categories have significant negative yields over time.
We see, then, that since World War II, inflation and taxes have taken an enormous toll on T-bills, Treasury bonds, savings accounts, and corporate debt. Yet few investors put the major outperformance of stocks over debt securities into their risk calculations even in normal times. In spite of the far superior returns over the past sixty-five years, capital to the time of this writing (September 2011) is still flowing out of stocks and mutual funds into Treasuries, yielding only one-twentieth of 1 percent on the very short end to 1.9 percent on ten-year Treasury bonds and 2.9 percent on thirty-year Treasury bonds. In the final chapter we will look at why these flows into bonds and T-bills may prove disastrous.
Transforming Risk into Odds You’ll Like
Table 14-1 shows the inflation-adjusted returns of stocks, bonds, and T-bills for periods of one to thirty years since 1946. As the table demonstrates, the longer the holding period, the greater the difference in the returns of stocks, on the one hand, and bonds and T-bills, on the other. The first row in column 1 shows that stocks provided a 6.5 percent annual return after inflation, on average, over the entire 1946–2010 period. At the end of five years, capital invested in stocks increased an average of 37.1 percent, after ten years an average of 87.9 percent, and after thirty more than sixfold. With Treasuries and T-bills, the rate of increase moved up at almost a snail’s pace. After ten years, bonds (column 2), after inflation, expand initial capital by 17.2 percent, after thirty years by only 61 percent. The rate of increase for T-bills is lower yet (column 3). After a decade, capital, adjusted for inflation, would have increased by 4.5 percent, after two decades by 9.2 percent.
“That’s well and good,” you might say, “but stocks fluctuate. What are the odds that stocks will outperform bonds or T-bills over various periods of time?” Good question. It is one thing to see that stocks outperform over time, but, as John Maynard Keynes once remarked, “In the long term, we’re all dead.” How, then, do they perform for somewhat shorter periods, while we can still enjoy spending the gains?
Column 5 shows the percentages by which stocks beat bonds for periods varying from one to thirty years, and column 6 provides the same information for T-bills. As you can see, it’s a slam dunk for stocks after four years on average. Holding stocks, you have a 73 percent chance of doing better than bonds after inflation on average and a 77 percent shot at outperforming T-bills after forty-eight months, moving up progressively to a 94 percent chance at outperforming bonds and an 88 percent chance of beating T-bills in fifteen years. Beyond fifteen years, the odds favoring stocks surge to almost 100 percent against both bonds and T-bills. For longer periods, stocks are clearly the least risky of these three categories of investments.
Let’s look at how stocks and bonds have performed over other periods in the past. Table 14-2 shows the probabilities of stocks outperforming bonds and Treasury bills after inflation over different intervals between 1802 and 2010. Three periods are analyzed, 1802–1870, 1871–1945, and 1946–2010. In each period the probability of stocks outperforming bonds, stocks beating T-bills, and bonds beating T-bills is measured from one to thirty years. The table shows that the probabilities of stocks outperforming bonds or T-bills increase with time. More important, the odds were higher for the outperformance of stocks over Treasuries and T-bills for any period from one to twenty years in the post–World War II period than in the previous 145 years.
For five years the probability of stocks beating Treasury bonds rose from 65 percent in the two earlier periods to 74 percent after World War II. In the 1946–2010 period, stocks had a 100 percent chance of outperforming T-bills for all twenty-year periods. Stocks had an 87 percent chance of beating T-bills after twenty years over the 1802–1870 period; the chance increased to 99 percent for the 1871–1945 time span.
But wait—there is more.
Taxes: The Fourth Horseman of the Financial Apocalypse
Enter the fourth horseman of the Financial Apocalypse—taxes, riding down the owners of bonds and T-bills, and other fixed-income issues. Table 14-3 is identical in format to Table 14-1 but shows the returns after both inflation and taxes for stocks, bonds, and T-bills for periods of one to thirty years through the postwar period using the average top federal income tax rate of 60 percent between 1946 and 2010 over the entire period.*82 Stocks compound at 4.4 percent annually, adjusted for inflation and taxes. In ten years investors would have increased their capital by more than 53 percent, in twenty years by 135 percent. As Table 14-3 also shows, the returns on fixed-income securities after taxes drop even more dramatically. For all their allure, buying long-term government bonds is about as safe and profitable as having been heavily margined in stocks just before October 24, 1929. If an investor in a 60 percent tax bracket had put $100,000 into long Treasury bonds after World War II, he would have had only $27,000 of his original purchasing power left in 2010. That’s right, inflation and taxes would have eaten up 73 percent of the investment.5
The results are equally bad for T-bills, and being in a lower tax bracket doesn’t help the T-bill or Treasury bond buyer much. Finally, had the investor put $100,000 into blue-chip stocks, the supposedly “riskiest” investment, with the same 60 percent tax rate after inflation, the portfolio would have appreciated to $1.6 million over the sixty-five-year period. The capital invested in equities would be worth fifty-seven times as much as if placed in bonds.
With bonds or T-bills, it’s a dirge. The longer you hold them, the louder the organ plays. After ten years, both will cost you about 20 percent of your capital after inflation and taxes; after twenty years, about 35 percent; and so it goes. The last two columns again demonstrate the probabilities of stocks outperforming bonds and T-bills for periods of one to thirty years. After four years, there is better than an 80 percent chance that stocks will outperform bonds and T-bills, and the chance builds up significantly with time. By fifteen years, the chance is nearly 100 percent that you’ll do better in stocks than in government bonds and 98 percent that you’ll do better than T-bills. Investing in government securities, then, considered by most people to be almost “riskless,” is a loser’s game.
Common stocks, as Tables 14-1 and 14-3 indicate, though a more volatile asset in any short period of time, provide much higher returns than T-bills and bonds over longer periods.
Is There Something Wrong with This Picture?
As we’ve seen, the starting point of modern portfolio theory is the return an investor receives on a “riskless” asset, normally a Treasury bill. The investor then merrily selects a portfolio made up of risk-free and riskier assets, measured by their volatility, to get the optimum mix. The trouble is that the “risk-free asset” of the academic theory, the T-bill, is one of the riskiest assets over time.
It’s apparent that this assumption of academic investment theory is far removed from reality. Rational investors should be concerned with the probability of maintaining and enhancing their savings, adjusted for inflation and taxes, for retirement or other future needs. This is one of the greatest risks they face. The time horizon of the large majority of investors is not months, quarters, or a year or two away. It is many years away, bec
ause the need for funds to meet costs such as retirement, college tuition, and similar requirements usually far off in the future. After all, that is why the government set up tax-deferred pension funds, IRAs, and similar programs, which tens of millions of investors participate in. The investment objective for most people is to maximize savings as safely as possible for the time when they will need to draw on them.
The major risk is not the short-term stock-price volatility measurements, which have been shown to be specious. Rather, it is the possibility of not reaching your long-term investment goal through the growth of your funds in real terms. It is counterproductive for investors with investing time horizons of thirty, twenty, ten, or even five years to focus on short-term fluctuations. Shorter-term volatility measurements provide an illusion of safety while derailing the higher returns that are provided by holding equity or equity-equivalent products (real estate, housing, better-grade private-equity investments, and so on) over time. This leads to another important Psychological Guideline.
PSYCHOLOGICAL GUIDELINE 30 (a): To invest successfully over time, risk measurements should be established using longer-term rates of return for stocks, bonds, T-bills, and other investments. The performance benchmark should be appropriate for the time period the investments are anticipated to be held.
PSYCHOLOGICAL GUIDELINE 30 (b): Using short-term risk measurements as benchmarks for longer-term capital performance is likely to result in a significant shortfall in an investor’s returns. It is one of the most serious risks investors can take today.