by Rob Bennett
The average long-term return on U.S. stocks is 6.5 percent real.
That sounds good to millions of middle-class investors. I believe that it is the prospect of earning a return somewhere in that neighborhood that causes many to find appeal in the idea of using a Buy-and-Hold strategy to invest in stocks. If the average return is 6.5 percent real and an investor simply buys and holds, he will earn a lifetime stock return of something in the neighborhood of 6.5 percent real. On initial impression, it seems as if that should be so.
It’s not so.
The vast majority of middle-class investors following Buy-and-Hold strategies will earn a return significantly less than the average return of 6.5 percent real. We don’t have data telling us the lifetime return earned by most investors. My guess is that the number is about half of the average return number. The typical investor probably earns a lifetime return on stocks of a little more than 3 percent real.
Middle-class people do not participate in the stock market to an equal extent at all time-periods. They own far more stocks at times when stocks are priced insanely high (and when long-term returns are sure to be shockingly low) than they do when stocks are priced fairly or better (and when long-term returns are high or shockingly high). How do I know? What else could cause returns to rise to such irrational heights than added demand from investors who participated only to a small extent or not at all in earlier days?
Middle-class investors go with high stock allocations when stocks are a poor investment and with low stock allocations when stocks are a good investment. Thus, their lifetime return is obviously much less than the average return.
I said that Buy-and-Holders don’t earn the average return. Buy-and-Holders don’t change their stock allocations. How can I blame Buy-and-Hold for a phenomenon in which investors invest heavily in stocks only when stocks are a poor investment choice?
Buy-and-Holders stick with the same stock allocation only in theory. Buy-and-Hold become popular only during out-of-control bull markets. Buy-and-Hold has never been popular at the end of a secular bear market. How do I know? A bear market could never come to an end so long as Buy-and-Hold remained popular. Bear markets end when Buy-and-Holders capitulate and sell their stocks. It can never happen any other way.
To see why middle-class investors always sell their stocks by the end of bear markets, you only need to look at the percentage price drops experienced following wild bulls. The average price drop we have seen in the three secular bears of the 20th Century was 68 percent real. The average 20-year return following the three bull market tops was 0.7 percent real.
How many middle class investors can handle the loss of two-thirds of their accumulated life savings? How many middle-class investors can accept a return of 0.7 percent real for 20 years and still maintain hopes of being able to retire at a reasonable age? I don’t know the precise percentage but I think it is fair to say that the answer is a number closely approaching zero. For practical purposes, there are no middle-class investors who can afford to follow Buy-and-Hold strategies through an entire bull/bear cycle.
The promotion of Buy-and-Hold strategies encourages Buy-and-Hold investors to play a sucker role and buy stocks when the odds of seeing a good return are close to nil. And the discovery that the dream of seeing a long-term return of 6.5 percent real was an illusion drives them out of the market.
It has often been observed that: “Bear markets are God’s way of returning stocks to their rightful owners.” I am appalled by the cynicism but delight in the straight-talk description of one of the core investing realities. I only wish that middle-class people pondered the import of that quote prior to putting their money on the table.
Few middle-class investors will enjoy a lifetime return on their stocks of anything close to 6 percent real. Many will end up with a lifetime return less than they could have obtained in risk-free Treasury Inflation-Protected Bonds back when they were offering a return of 4 percent real. Stocks are not always the best choice for the long run. Stocks are during the times when books with titles like Stocks for the Long Run are popular the worst choice for the long run.
Still, the average long-term return on stocks really is 6.5 percent real. That’s an objective, mathematical fact. If few middle-class investors are obtaining that return, there are a small number of investors obtaining a lifetime return far higher than 6.5 percent real.
These investors fall into two classes.
One class is the group of investors following valuation-informed strategies. I’ve linked in earlier columns to research showing that Valuation-Informed Indexing beat Buy-and-Hold in 102 of the 110 rolling 30-year time-periods now in the historical record. Now we know why. By being willing to time the market, valuation-informed investors are able to keep their risk levels constant. Thus, the sky-high risk levels that apply for those who invest in stocks when they are selling at the sorts of prices that have applied since 1996 do not force them to sell at the worst possible time for doing so.
The other class of fortunate investors is the rich. A wealthy investor is far more likely to be able to take a 68 percent hit because, even after seeing two-thirds of the accumulated wealth of a lifetime go “Poof!” he may still have millions remaining. Those who stick with their stock investments through an entire bull/bear cycle really do obtain the 6.5 percent real return.
Also, wealthy investors tend to be better diversified than middle-class investors. Many middle-class investors have a high percentage of their retirement money in stocks. Wealthy investors are more likely to invest in real estate, art, gold, small businesses and collectibles, some of which may do well during a stock crash, thereby countering the hit to the portfolio sustained as a result of the stock crash.