Are Stocks Still Good for the Long Run? - TIME

Wow. The other day I reTweeted a tweet from Zvi Bodie. I did not have time to blog it then, but saved it. And just finished reading it and two follow-ups to it all I can say it that they are definite must reads! (and will be so for all of my fall classes!)

Are Stocks Still Good for the Long Run? - TIME by Justin Fox:

While now it is commony held that stocks have a higher expected return than bonds because of fact that stocks are more volatile (more risk, more return demanded), the article begins off by recounting that this was not always believed. After this interesting history, Fox brings the reader to the recent finding by Arnott that over the past 40 years stocks underperformed (albeit slightly and at a time when stocks had just fallen precipitously) bonds. (here is a post on that from last month.)

"...[after the 1929 crash the] idea that stocks could be good investments became a joke and remained that--in the popular view, at least--for decades. Yet whenever anyone in later years re-examined the data on stocks' long-run performance--major scholarly studies on the topic were published in 1938, '53, '64 and '76--they reached the same conclusion Smith did. Even with the dire experience of the early 1930s factored in, stocks had proved an excellent long-run investment, with returns that far outpaced those of bonds."

Much of the article is grounded on solid academic research including work done by Jeremy Siegel and others. This research suggests strongly that sometimes financial assets are mispriced and thus there may be significant relative performance differences for long periods of time where bonds outperform stocks (as in the 40 years that Arnott found).

So given what we know about mispricing and the historical performance of index funds vis-a-vis actively managed funds (unstated in article), one solution is to use a hybrid of indexing and picking. This suggests a strategy where rather than buying individual assets that have appreciated greatly (and are thus more likely to be overpriced) it is wiser to invest in assets that are out of favor (so called value stocks).

"He [Siegel] says the one significant change in his advice over the past decade has been an increased emphasis on "value" stocks with prices that are low relative to earnings, book value and other fundamental measures. Both Arnott and Siegel are boosters of a new investment approach called fundamental indexing, in which one assembles a portfolio weighted by earnings, dividends or the like in order to avoid the tendency inherent in conventional capitalization-weighted index funds to load up on the most expensive stocks.

An alternative solution, which Bodie has proposed many many times but has not yet caught on to a great degree, is to use TIPs and long term options. The logic behind this is that stocks are volatile (indeed more volatile in the long term than the short term) and largely because stocks do tend to be so risky, you can never be assured how they will perform over your investment horizon. Therefore, you should invest in TIPs to get the what you NEED for future and if you want to invest the rest in riskier scurities (long term options is Bodie's well reasoned choice) the extra for things you may WANT.

From the Time article and a follow-up piece from Time's Curious Capitalist blog.

"To Boston University finance professor Zvi Bodie, another frequent debating partner of Siegel's, this entire discussion is beside the point for most Americans. "He could be right," he says of Siegel's argument that stocks are a good deal right now. "I'm just more risk-averse than he is." Bodie, co-author of the perennially best-selling business-school textbook Investments, wrote a 2003 book titled Worry-Free Investing and has been trying ever since to steer personal-finance advice in a radically new direction. For most Americans, Bodie says, stocks are entirely inappropriate vehicles for saving for retirement. The reason they outperform bonds over time is the very reason they should be avoided: they're riskier. And if you're putting away money that you're going to need to live off in retirement, you shouldn't be taking any risk at all...."If your goal is to maintain your standard of living, then here's how much you should be saving and putting into TIPS," he says. "If you want to save more than that and speculate in the stock market, by all means, do it. But you need to recognize that you can't count on it when you do that."

In an email to Justin Fox as reported on Time's the Curious Capitalist blog, Bodie writes:

"If you doubt the rationality of the stock market, then isn't investing in stocks a crap shoot? How can you be sure that there is a positive risk premium? The historical evidence is far from conclusive. It depends on what time periods and what countries you look at. Even the experts disagree."

Bodie concludes:

Under such circumstances, shouldn't a rational investor follow the TIPS + calls approach that I advocate?"

The problem is, as Fox points out, that this will likely (albeit not necessarily) yield a lower return so

"To follow Bodie's advice, then, you're probably going to need to save a lot more money for retirement than you've been doing"

So what is the takeaway? With high long term volatility and the academic evidence pointing more and more to markets being less than perfectly efficient, it seems that Fox nails it when he end with

"Stocks are still the best investment for the long run. But maybe not for your long run."

Which again suggests that the investment world (at least individual investors worried about their retirement or other largely fixed future obligations) should give much consideration to Bodie's advice and use TIPs for the part that you "need" and then LEAPs and other risky securites for what you "want".

And lest you doubt that this is a new idea or that Bodie is just saying this after a bad period in stocks, here is from a 2004 FinanceProfessorBlog post.:

"So what is one to do? My favorite idea comes from Zvi Bodie who applies modern hedging theories to retirement planning. As he wrote in in 2001 Retirement Planning: a New Approach paper the first part of the plan is to assure some minimum standard of living (this is the minimum amount that you will need) by investing in "inflation-protected bonds and annuities as the way to guarantee a minimum standard of living in retirement.""

FTR His Worry-Free Retirement book is available here.

So if it is such a good idea why hasn't it caught on? I have thought about that a great deal. The best answer I have is transaction costs.