by Rob Bennett
I believe that stocks are a less risky asset class than certificates of deposit (CDs). This is certainly not the conventional belief. But I believe that a perfectly reasonable case can be made that this is so.
I am not saying that this is so for Value Investors, who pick individual stocks. For Value Investors, I would say that the amount of risk being taken on depends on the amount of effort and intelligence being put into the stock-picking process. There’s not much risk in stock picking for Warren Buffett and for those who follow his principles effectively. There is a good bit of risk to stock picking for those who decide which stocks to put in their portfolios according to what they see on television.
So the risk of stock picking is dependent on what sort of investor you are. There’s high risk for some, low risk for others.
Indexers don’t need to worry about all that goes into picking stocks effectively. They earn lower returns than effective stocks pickers. But they are today able to do so in a virtually risk-free way.
There’s only one significant and unavoidable risk that applies for indexers: The possibility that the U.S. economy may not be as productive in the future as it has always been in the past.
It could be that our best days are behind us (I don’t personally believe this to be the case). But a big drop in productivity would do so much damage to all of us that I don’t think it’s right to think of this as being a risk particular to indexing. A dramatic drop in productivity will hurt CD investors. All invested money is less valuable in a less productive economy. The fact that productivity might drop is not a good reason for moving money from stock indexes to CDs to keep it safe.
How about stock price volatility? Buy-and-Holders say that stocks provide high returns because prices are volatile and that price volatility translates into risk.
I agree with Warren Buffett re this one. It is silly to equate volatility with risk. Upward price movements justified by economic fundamentals are a wonderful thing. Upward price movements justified by economic fundamentals increase volatility but they do not increase risk according to any reasonable definition of the word.
The idea that volatility equals risk is an academic construct. It’s an idea that academics like because it permits them to quantify risk to an extent they could not if they defined risk in more practical and useful and accurate ways. And quantifying things is what academics in this field do. Using this silly definition of risk gives them greater influence while greatly confusing the general public’s understanding of investment risk.
I like Buffett’s definition of risk — the chance that you will lose money. That’s what we really should be talking about.
Can indexers lose money?
If they ignore valuations, yes. Indexers who ignore valuations can lose gobs and gobs of the stuff. And always do, according to the historical stock return data.
But how about Valuation-Informed Indexers? There has never in U.S. history been a time when buying index funds in a valuation-informed way produced poor long-term results. So long as productivity remains at the levels that have always applied historically, it is impossible for the rational human mind to imagine how there ever could be one. Indexers lock in the market return. So long as productivity remains roughly consistent with what we have seen in the historical record, the risk that Valuation-Informed Indexers will earn much less than that in the long term is slight.
This can be reduced to numbers. A statistical analysis shows that looking at the P/E10 level that applies on the day you buy a stock index tells you 78 percent of what you need to know to know your 20-year return. Risk is uncertainty. Valuation-Informed Indexers possess 78 percent certainty as to their long-term stock return. That’s not too much uncertainty or too much risk.
How about those invested in certificates of deposit?\
The risk there is not great. CDs are a fairly stable asset class. But my assessment is that the risk for CD owners is greater than the risk for Valuation-Informed Indexers.
The big risk for CD owners is the risk that inflation will eat into their expected returns. You could buy five-year CDs paying 5 percent with the expectation that inflation will be 3 percent and inflation could spike to 6 percent, leaving you with a negative return.
Inflation is built into the numbers for indexers. The average long-term return for stocks is 6.5 percent real. At a time of 6 percent inflation, stocks would need to provide a nominal return of over 12 percent for the average long-term return to apply (as it must if productivity remains roughly equal to what it has been in the past).
So the risk for Valuation-Informed Indexers is slight. And the big risk for CD owners does not apply for Valuation-Informed Indexers.
I am not anti-CD. I have invested in CDs heavily at times when stock prices have been so high that indexes are likely to provide a poor long-term return (this has been the case since 1996). But I do that as much because CDs provide higher returns than stocks in such circumstances as because they are less risky. Stocks are of course exceedingly risky at times of high prices but there is of course no law requiring us to invest in them at such times . So this risk is an optional risk which the investor may or may not elect to take on, not a necessary characteristic of the asset class.
Index funds are a less risky asset class than CDs for those willing to take valuations into consideration when setting their stock allocation. That’s my sincere take, in any event.