Swedroe: Stocks, Bonds & Risk

Followers of my writings know the perspective I provide isn’t based on opinion, but is grounded in the academic research. However, what do you do when the research seemingly offers contrasting recommendations?

Complicating matters is that, in the following case, we have a conflict between two highly regarded academics, professors Jeremy Siegel and Zvi Bodie.

Questioning The Data On Stocks
Jeremy Siegel’s “Stocks for the Long Run” recommends that equities dominate portfolios for investors who have a long horizon. His recommendation is based on the view that stocks are the less-risky investment when horizons are long. Zvi Bodie argues that equities are too risky over the long term; thus, Treasury inflation-protected securities (TIPS) should dominate retirement portfolios.

Siegel presents evidence showing that, the longer the time horizon, the more likely it is stocks will outperform bonds. He shows that, over very long horizons, stocks have always outperformed bonds.

One problem with this view is that his data are based on one unique history, that of the United States. In addition, there is really only reliable data going back 90 years or so, not the almost 200 Siegel uses. Clearly, an “alternative universe” might have shown up.

Insufficient Horizons

And the bear market of 2008 demonstrated that even 40 years may not be a sufficient horizon to be sure stocks would outperform bonds. From 1969 through 2008, the S&P 500 Index returned 8.98%, barely outperforming the 8.92% return on 20-year Treasury bonds.

Another problem with Siegel’s view is that, while it is true that stocks—because of the presence of the equity risk premium—are likely to produce a higher ending net worth, owning them, regardless of the length of the horizon, also increases the odds of a very poor outcome.

In fact, the longer the horizon grows, the greater the risk that a “Black Swan” will appear, perhaps causing a portfolio to fail and leaving investor without the resources to support their desired lifestyles in retirement. This is the point Bodie makes in both his paper, “On the Risk of Stocks in the Long Run,” and his book, “Worry-Free Investing.”

While the evidence demonstrates Bodie’s view is closer to the “truth”—particularly his view that TIPS should be viewed as the risk-free investment—the issue isn’t black or white, because neither risk nor investment horizon should be the only determinant of your asset allocation.

One reason is that risk is not necessarily a bad word. In terms of investing, risk and expected reward are related. That is why stocks have an equity risk premium. This, then, raises the issue of how to decide on the right asset allocation.

Looking At Asset Allocation

The right way to approach the asset allocation decision is to base it on three criteria: your ability, willingness and need to take risk. While the ability to take risk is impacted by the investment horizon (the longer the horizon, the greater the ability to wait out bear markets), it is also impacted by the stability of your earned income and how it correlates to the risks of equities. The more stable your earned income, the more equity risk you can take.

The willingness to take risk—what I call the stomach-acid test—depends on how great of a loss you are able to take and avoid panicked selling while being able to sleep well and enjoy life amid dealing with the stress that bear markets create.

The need to take risk is based on the rate of return necessary to achieve your financial goals as well as your marginal utility of wealth. The higher the rate of return required, the greater the required allocation to equity risks. The lower the marginal utility of wealth, the less risk one should accept.

Trade-offs Abound

When setting your asset allocation, you will face trade-offs. The higher the equity allocation, the greater the odds will be of achieving a large estate. However, large equity allocations also increase the odds of a portfolio failing (you’re alive without financial assets). Using a Monte Carlo simulator can help you analyze the problem and determine both the right asset allocation and the right withdrawal rate for your personal situation.

When making the asset allocation decision, I urge you to think of it in terms similar to Pascal’s wager. Pascal's wager is a suggestion posed by the French philosopher Blaise Pascal that, even though the existence of God cannot be determined through reason, a person should wager as though God exists. The reason is because the consequences of being wrong in each belief are very different.

Capital Preservation, Or Accumulation?

In terms of investment strategy, if you have already achieved sufficient wealth to support a quality lifestyle, you have a choice between focusing on the preservation of capital by having a low allocation to risky assets, or trying to accumulate even more wealth by having a large allocation to risky assets. While it is likely that a high allocation will result in greater wealth, you can be wrong. And the consequences of going from “rich” to “poor” are intolerable for most people.

The lesson from Pascal’s wager is that the consequences of decisions should dominate the probabilities of outcomes, no matter your estimate of the odds. That is why the prudent strategy for investors who have reached the point where their marginal utility of incremental potential wealth is low is to dominate their portfolios with high-quality fixed-income assets. There are some risks that are just not worth taking.

If you are deciding which side of Pascal's wager you want to take with your portfolio, I recommend you consider this important insight from author Nassim Nicholas Taleb, who stated in his wonderful book “Fooled by Randomness”:

Alternative Histories

“One cannot judge a performance in any given field by the results, but by the costs of the alternative (i.e., if history played out in a different way). Such substitute courses of events are called alternative histories. Clearly the quality of a decision cannot be solely judged based on its outcome, but such a point seems to be voiced only by people who fail (those who succeed attribute their success to the quality of their decision).”

The bottom line is that you should consider choosing a portfolio that ensures not only that you have a strong likelihood of achieving your financial goals, but also that the worst-case outcomes are acceptable. One of the worst (because it can be a mistake that you cannot recover from) and most common errors that investors make is to fail to consider the possibility of very bad outcomes.

If you have little or no flexibility in when you retire, how much income you will need in retirement and what assets you can draw upon if a severely negative outcome appears, you should think about limiting your exposure to risky assets.

Larry Swedroe is the director of research for The BAM Alliance, a community of more than 140 independent registered investment advisors throughout the country.