How Risky are Stocks in the Long Run?

October 7, 2014

by Michael Edesess

What is the risk that equity investments won’t turn out as well in the long run as we would like them to? This is obviously a very important question. We are often assured that stock investments will eventually pan out because of “mean-reversion.” However, mean-reversion in securities prices is ill-defined, oversimplified and little more than a physics metaphor. Moreover, some of its presumed effect might be explainable by other means. Reassurances of superior long-term equity performance must, therefore, either derive from less technical justifications, or investors must maintain a secure safety net to guard against poor long-term performance.

Can we rest easy with our equity investments, or do we need to be unceasingly vigilant?

With equity investments, as opposed to fixed income, there is no contractual assurance of receiving any of one’s investment back at all, let alone a positive return. This in itself suggests good reason to be nervous. And yet, we tell each other constantly that we should not be nervous.

We have become accustomed to assuming that diversified investments in equities will do well in the long run. If a time comes when equities drop in value and the sentiment of the market is dark, we assume the “rational” response is not to sell but to hang on because the market will recover in due time.

There are two seemingly very good reasons for making that assumption. One is that if equities don’t provide a good return over 30 years, then something must have gone disastrously wrong. We assume that either this will not happen, or if it does, then no investment strategy will work.

The second reason for making that assumption is that the equity market has recovered again and again from bleak periods in the past – at least the global market did, even if occasionally a national market didn’t.

The Bodie-Siegel debate

Responses to the question of whether equities will perform well in the long-run have ranged from very reassuring to not very reassuring at all. As David Blanchett, Michael Finke and Wade Pfau point out in a Sept. 23 Advisor Perspectives article, the reassuring end of the spectrum has been associated with Wharton Professor Jeremy Siegel, while the not-very-reassuring end has been represented by Boston University Professor Zvi Bodie.

The two professors present completely different types of evidence. Siegel, in the 5th edition of his bookStocks for the Long Run, makes his argument based on the fact that although stock prices have fluctuated wildly at times from year to year, real returns on stocks were remarkably consistent and very attractive over three long periods of years (1802-1870, 1871-1925 and 1926-2012) – around 6.5% each period, give or take about a tenth of a percent.

Bodie, on the other hand, invokes modern portfolio theory to show that the risk to the value of one’s assets when investing in stocks compared with investing in bonds increases the longer they are owned. This is because the cost of insuring against a shortfall in equity investments relative to bond investments increases over time.