by David Dreman
The Treacherous T-Bill
Stocks may blow away T-bills and bonds over time, but, as we have seen, the focus of most investors, fiduciaries, and courts is still on shorter-term financial risk. The far more potent and universal risk of inflation and taxes is a secondary consideration at best. Academic risk theory also accepts the conventional wisdom by making the T-bill the risk-free investment. But financial academics, like most market participants, have not incorporated into their equations the fact that the largest risk factor today is the decrease in purchasing power of your investment through inflation.
When we adjust for inflation, supposedly risky assets such as stocks become far safer. The probability that investors holding stocks will double their capital every ten years after inflation and quadruple it every twenty, combined with the 100 percent chance that they will outperform T-bills and the 98 percent chance that they will outperform government bonds in twenty years, can hardly be called risky.*83 Conversely, the supposedly “risk-free” assets actually display a large and increasing element of risk over time. For that reason we must incorporate into a new definition of risk the effects of higher inflation on investors in recent decades, including contemporary markets, along with the other types of risk inherent in these investments.
A Better Way of Measuring Risk
What, then, is a better way of measuring your investment risk? While there can be many definitions, even in the business and investment worlds, a good starting point is the preservation and enhancement of your purchasing power in real terms. The goal of investing is to protect and increase your portfolio on an inflation-adjusted basis and (where appropriate) tax-adjusted dollars over time.
A realistic definition of risk recognizes the potential loss of capital through inflation and taxes and includes at least the following two factors:
1. The probability that the investments you choose will preserve your capital over the time you intend to invest your funds.
2. The probability that the investments you select will outperform alternative investments for the period.
Unlike the academic volatility measures, these risk measures look to the appropriate time period in the future—five, ten, fifteen, twenty, or thirty years—when the funds will be required. Market risk may be severe over a period of months or even a few years, but, as we have seen, it diminishes rapidly over longer periods.
Tables 14-1, 14-2, and 14-3 tell us how stocks stack up against bonds and T-bills after inflation and taxes and the probability that stocks will outperform them in any period of time. The careful reader might ask another question here: “Okay, I know the odds of stocks beating bonds and T-bills are increasingly high over time, but stocks have very good periods followed by years of lackluster results. What are my chances of capturing returns above those provided by bonds or T-bills?”
The answer is provided in Tables 14-4 and 14-5. Table 14-4 shows the probability of receiving stock returns as low as 50 percent of the average return for stocks in the postwar period (column 2) to as high as 150 percent of the average return (column 6) after inflation. The probability of returns above these levels is shown for periods of one to thirty years.
Table 14-4, column 1, shows the total portfolio value, or wealth relative, in academic jargon, for every period from one to thirty years, if you earned only 50 percent of the average return for stocks for each period through the 1946–2010 study, after inflation. This is a very severe worst-case situation, as will be explained shortly. Column 2 indicates what your probabilities are of earning more than 50 percent of the average return for any period between 1946 and 2010. The probabilities, with minor exceptions, of earning more than half the market return increase with time. Thus, holding a portfolio with a starting value of 100 in the first year, you have a 62 percent probability or better of returning above 3 percent (103, column 1) at the end of one year. After ten years, the portfolio has a 73 percent probability (column 2) of increasing more than 38 percent (138 in column 1); after twenty-five years, it has a 93 percent probability of returning 123 percent above your investment (223 in column 1). So cutting the market return by half, which has happened only several times in our market history during the Great Depression, still provides significant stock returns over time.
Next look at columns 7 and 8, which show the cumulative returns of bonds and T-bills. You can see that even if you receive only 50 percent of the stock market’s average return, you still do much better in stocks than in either bonds or T-bills for any given period. Again, this is a doomsday scenario, as the chance of making only 50 percent of the normal market return is near zero when you invest for as long as twenty-five years. You have a 93 percent (column 2) chance of doing better. But worst case or no, you still do better in equities than in T-bills or bonds.
As you increase the number of years you hold stocks versus debt securities, the comparisons only get better. If you receive the market return over time, as we saw before, you score big; after fifteen years your portfolio would appreciate 157 percent, or six times as much as in bonds and over twenty-two times as much as in T-bills. After twenty-five years, your net worth would be three times what it would be in bonds and over four times that of T-bills, and so on. Not that you need to strike it rich with the types of returns we have just seen, but there is also a reasonable probability that your return can be above-market averages. If you return 150 percent of the market, as column 5 indicates, the returns bury those for bonds and T-bills. In this happy situation the investor receives almost eleven times the return he would on bonds in fifteen years and about fifteen times in twenty years.
There you have it. Once again, stocks provide higher rewards over time than bonds or T-bills even under poor circumstances and shoot out the lights under better conditions. The decision of where to place your money should not be difficult.
Introducing taxes in Table 14-5 (which is set up in an identical manner to Table 14-4) of course reduces the absolute returns for stocks but will reduce them significantly more for bonds and T-bills. Again, as the time periods increase, stocks substantially outperform bonds and T-bills under all the scenarios.6
Looking first at the average market return (column 3), we see that stocks outperform bonds (column 7) for ten years by 71 percent, with a 64 percent probability that stock returns will be higher. After inflation and taxes, bonds actually lose purchasing power.
T-bills do even worse over the same period. Over time, the increase in capital invested on $100,000 in stocks rather than bonds increases dramatically. In ten years, your investment is almost 90 percent ahead; in twenty-five years it is almost four times as much. In the interim, both bonds and T-bills have lost over 40 percent of their original purchasing power.
Last, let’s take a brief peak at what could happen to stocks if they outperform their long-term rates of return for a decade. Most investors believe this is very unlikely today, but a few, including myself, for reasons presented in the final chapter, believe it is a distinct possibility. If this impossible dream were to come true, your capital would increase by 89 percent in a decade, 159 percent in fifteen years.
Toward a Better Analysis of Risk
The evidence indicates that in the post–World War II inflationary environment, bonds and T-bills are no match for equity-type investments over time. I have tried to answer the question of how much risk there is in holding stocks instead of bonds and T-bills in two ways. First, I asked how often stocks would outperform T-bills or government bonds after inflation for periods varying from one to thirty years in the postwar period in Table 14-1 and after inflation and taxes in Table 14-3. We saw that stocks won in a breeze in both cases; the longer the time period, the more they outperformed. The probability that T-bills or bonds would provide inferior returns relative to stocks is large and increases after three to five years.
Second, I examined the risk of owning stocks if their returns dropped off sharply from their long-term norms in Tables 14-4 and 14-5. Once again, even if this happened (if, for example, sto
cks provided only 50 percent of their normal return over time), they still outperformed debt instruments by a significant amount after five years and by a more moderate amount up to five years.
Let’s now go back to the two measures we said should be incorporated into a good definition of risk:
1. The probability that the investment you choose will preserve your capital over the time you intend to invest your funds
2. The probability that the investments you select will outperform alternative investments for this period
The conclusion is obvious: stocks meet both these criteria. If we applay this standard of risk in the postwar period, stocks are the least risky investments over time. If you are in your thirties, for example, and have a goal of retiring at sixty-five, you should buy blue-chip stocks because you have a 100 percent chance of both enhancing your capital and outperforming bonds and T-bills. The probabilities are also high that you will outperform debt securities many times over. Though not as high, the odds are still very high for fifteen years and reasonably good at four or five years. From a risk perspective, bonds and T-bills give you increasingly short odds after only a few years. They are not the investments you want to build your future upon and have not been for almost sixty-five years.
What we see, then, is the development of a new approach to risk analysis that tries, before funds are invested, to more realistically appraise the risk of holding various types of investments over the time the investor might need. The analysis allows you to determine not only the odds that your returns will outperform or underperform other types of investments but also the probability of by how much. This risk measurement framework could also be adapted to valuing real estate, precious metals, or other investments, if you have the records of their performance over longer periods. If you choose to measure how you might do in Impressionist art, other art, or collectibles relative to equities, as an example, there is an index dating back to the 1960s from Sotheby’s, which Barron’s reports each week.
While this approach to risk can certainly be fine-tuned, it allows you to more accurately assess your exposures in the postwar investment world, one very different from any investment environment in the past.
What we’ve clearly seen from the tables is that since 1945 we have entered a new world of investing. Inflation and higher taxes have an immediate and lasting effect on holders of fixed-income securities.*84 This situation did not reduce stock returns in the early postwar years but actually saw them increase because of rapidly rising stock prices and dividends. From the middle of 1949 to the end of 1961, the Dow rose 355 percent.
In summary, then, there is a very important lesson about risk to learn from these events, which we’ll make an investment Psychological Guideline.
PSYCHOLOGICAL GUIDELINE 31: There has been a permanent shift in the structure of risk because of higher inflation and taxes that strongly favors equity investments, real estate and housing, and other investments that benefit from it, and puts bond and other fixed income at a major disadvantage over time.
This change, as noted, has been going on for well over sixty years, but because psychologically we focus on much shorter time periods, it is hard to react to the current dynamics of risk.
Second, because stock performance is volatile, we don’t pick up the full scope of this sea change in risk psychologically, even though many of us know that inflation affects stock prices positively over time. As a result, many people don’t see the conclusions clearly. Let’s also make this a Psychological Guideline:
PSYCHOLOGICAL GUIDELINE 32: The changed economic environment unambiguously indicates that the longer we hold equities or other investments that outperform inflation, the better off we will be financially over time.
The findings almost jump out of the tables in this chapter.
A further Psychological Guideline is in order here.
PSYCHOLOGICAL GUIDELINE 33(a): Try to ignore near-term market fluctuations; if you intend to be invested for a five-year or longer period, the true risk is in not owning stocks or similar investments that appreciate faster than the rate of inflation over time.
PSYCHOLOGICAL GUIDELINE 33(b): Unless yields are very high, don’t consider bonds, savings accounts, or other low-interest fixed-income securities as longer-term investments. They are high-risk vehicles with the odds heavily against them; the longer they’re held, the greater the risk. Consider them only as a repository of cash for short- to intermediate-term needs.
Although the tables make this crystal clear, conventional wisdom changes all too slowly.
Professor Knight’s distinction between risk and uncertainty holds a very important lesson for us here. The performance of the stock and bond markets is uncertain for any short period of time. But over time the uncertainty turns into risk. Risk is our friend if the odds are heavily in our favor, as they are with stocks. What we must remember is that for stocks and similar investments, risk turns into an increasingly high probability of winning over time.*85
Focusing on short-term periods, rather than the period the capital is intended to be held, will result in subpar returns. The investor should focus optimally on the time for which the stock portfolio is likely to be held, rather than on its short-term volatility.
The following Psychological Guideline encapsulates these findings.
PSYCHOLOGICAL GUIDELINE 34(a): Inflation and taxes sharply reduce your risk in owning stocks over longer periods of time.
PSYCHOLOGICAL GUIDELINE 34(b): Inflation and taxes sharply increase your risk in owning Treasuries, other bonds, and savings accounts over longer periods of time.
Richard Thaler of the University of Chicago, one of the pioneers of behavioral finance, once told me he wished that stock quotes were not published every day. His reason was that overexposure, particularly in bad times, precipitates hasty and often foolish decisions. If people treated stocks like real estate, where they can’t get a quote every day, they’d be far better off. Thaler was right. If we could clearly focus on the long-term probabilities and not be thrown off course, sometimes badly, by month-to-month or year-to-year events, we would all very likely be much better off.
These results are something to ponder carefully, especially as our final section will try to do a little crystal-ball gazing and reasonably project what is likely to lie ahead for investors. Notice that I’ve said “reasonably.” This is still a world of surprises, and the last thing I ever want any investor to do is to think that the future is a settled bet.
Part V
The Challenges and Opportunities Ahead
Chapter 15
They’re Gambling with Your Money
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