In his best-selling book, Stocks for the Long Run, Jeremy Siegel declared that stocks are only risky if your investment horizon is short. But, says LARRY SWEDROE, this widely held view is dangerously mistaken. There are several examples in history of countries where investors waited in vain for a return on their capital. Indeed there are places where they’re still waiting today.
Buying stocks today is not the easy choice that it would be if we had a time machine and could go back into U.S. history.
—Terry Burnham, Mean Markets and Lizard Brains
Thirteen Days in October is the story of the Cuban Missile Crisis. Fortunately, the crisis was peacefully resolved. However, that outcome was not preordained. In fact, we now know that during a confrontation between the U.S. and Soviet ships, two Soviet commanders gave orders to launch nuclear weapons.
Noam Chomsky, professor at the Massachusetts Institute of Technology, described the event as follows:
“We learned that the world was saved from nuclear devastation by one Russian submarine captain, Vasily Arkhipov, who blocked an order to fire nuclear missiles when Russian submarines were attacked by US destroyers near (President) Kennedy’s “quarantine” line. Had Arkhipov agreed, the nuclear launch would have almost certainly set off an interchange that could have ‘destroyed the Northern hemisphere’,”as Eisenhower had warned.1″
History would have played out differently had Arkhipov not blocked the launch order. And while the history of equity returns for U.S. stocks has been extremely favourable, it is likely they would not have been as attractive if the events that played out from October 16 through October 28, 1962, had played out differently.
Long term stock returns
For the period 1926-2019, the S&P 500 Index returned 10.2 percent per year, 7.3 percent above the 2.9 percent rate of inflation. During the same period, long-term government bonds returned 5.7 percent per year before inflation and 2.8 percent after. It was returns such as these that led Jeremy Siegel, in his best-selling book Stocks for the Long Run, to declare that stocks are only risky if one’s investment horizon is short. Siegel presents the evidence on returns in the U.S. all the way back to the early 1800s to back up his claim.
The claim that stocks are not risky if one’s horizon is long is based on just one set of data (the U.S.) for one period (albeit a long one). It could be that the results were due to a “lucky draw”. In other words, if stocks are only risky when one’s horizon is short, we should see evidence of this in other markets. Unfortunately, investors in many other markets did not receive the kind of returns U.S. investors did. U.S. returns might just have been the result of what has been called “the triumph of the optimists.” Let’s go to the videotape.
New Year’s Day 1949
It is January 1, 1949, and U.S. investors are looking back on the last 20 years of equity returns. They find the S&P 500 Index had returned 3.1 percent per year, underperforming long-term government bonds by 0.8 percent per year — so much for the argument that stocks always beat bonds if the horizon is 20 years or more. And how did the world look to U.S. investors at that time? Did it appear to be an encouraging environment for investing in stocks?
In fact, the world looked like a very risky place in 1949. There had been two World Wars and the Great Depression, the Iron Curtain had fallen across Europe and the Cold War was heating up, trouble was brewing in Korea (which would again throw much of the world into war on June 25, 1950), and there was even the threat of nuclear war. The world looked so risky that the S&P 500 Index was trading at a P/E of 6.6 in January 1949!
It is only today that we know capitalism triumphed, the Korean War did not escalate into a global war, the Iron Curtain and the USSR collapsed, and capitalism and democracy spread over most of the world. It turned out to be a far less risky place than it appeared to investors in 1949.
The result was that U.S. investors enjoyed spectacular returns, partly as a result of the dramatic fall in the equity risk premium demanded by investors. For the period 1949-2019, the S&P 500 Index returned 11.5 percent per year, well above the 6.2 percent return on long-term government bonds, and even above its return of 9.8 percent per year from 1926-2019. But was this preordained?
Stocks are risky, period
While we do not know what U.S. equity returns would have been had Arkhipov not blocked the launch, it is probably safe to assume there would not have been a book called Stocks for the Long Run. The lesson we should learn is that while it is true that the longer your investment horizon, the greater your ability to take the risk of investing in stocks (because you have greater ability to wait out a bear market without having to sell to raise capital), stocks are risky no matter the length of your investment horizon. In fact, that is exactly why U.S. stocks have generally (but not always) provided such great returns over the long term.
Because investors know that stocks are always risky, they price stocks in a manner that provides them with an expected (but not guaranteed) risk premium. In other words, stocks have to be priced low enough that they will attract investors with a risk premium large enough to compensate them for taking the risk of equity ownership. In 1949, because the world looked like a very risky place in which to invest, the risk premium was very large (P/E ratios were very low).
Egypt and Argentina
If you are not yet convinced that stocks are risky no matter the investment horizon and that the U.S. may just have had the “lucky draw,” consider the case of investors in Egyptian equities. In 1900, the Egyptian stock market was the fifth largest in the world. Those investors are still waiting for the return of their capital, let alone the return on their capital.
Or consider that in the 1880s there were two promising countries in the Western Hemisphere receiving capital inflows from Europe for development purposes. One was the U.S.; the other was Argentina. One group of long-term investors was well rewarded, while the other was not. If an alternate universe (to use a Star Trek term) had shown up, the results might have been reversed, and Professor Siegel’s book might have been published in Spanish.
Finally, consider the case of Japan. In December 1989, the Nikkei index reached an intraday all-time high of 38,957. From 1990 through September 2020, Japanese large-cap stocks (MSCI/Nomura) lost 0.5 percent a year—a total return loss of 13 percent, without even considering 30 years of inflation that averaged about 0.5 per cent a year. That equates to a loss, in real terms, of about 1 percent a year — or a cumulative real loss of about a 27 percent . Do you think that long-term Japanese investors believe that stocks are not risky if one’s horizon is long?
Stocks are risky no matter the length of your investment horizon. Rational investors know that stocks are always risky. Therefore, markets price stocks in a manner that provides investors with an expected risk premium. Because the majority of investors are risk averse, the equity risk premium has historically been large.
Investors should never take more risk than is appropriate to their personal situation. It is also important to remember these words of caution from Nassim Nicholas Taleb: “History teaches us that things that never happened before do happen.”2 If the events of September 11, 2001, taught you nothing else, they should have taught you that.
With that in mind, you will be well served if you remember never to treat the highly unlikely (a very long or even permanent bear market) as impossible.
- Terry Burnham, Mean Markets and Lizard Brains (Wiley 2005), p. 169.
- Nassim Nicholas Taleb, Fooled by Randomness (Random House, 2005), p. 108.
LARRY SWEDROE is Chief Research Officer at Buckingham Strategic Wealth and the author of numerous books on investing.
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