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Tuesday, 22 June 2010

One Big Thing We Don't Know About Stocks

Carl Richards is a certified financial planner and the founder of Prasada Capital.

The only reason we invest in stocks is to earn more than we would get from cash or bonds. The amount you are supposed to earn by taking the additional risk of owning stocks is called the risk premium. If you don't get paid more for taking the risk, you should put your money in bonds.

Over the last 207 years you got paid 2.5 percentage points more each year (on average) to invest in stocks than you did in bonds.

But you know what they say about statistics, right? In the real world, we have to deal with the fact that like all averages, this one has some serious problems. Sometimes the risk premium is higher than 2.5%, and sometimes it goes away or is hugely negative (say, in a bear market).

Until recently, most of us thought of bear markets as those three to five year periods where you grit you teeth and hang on. But recent experience is more painful than that.

In an article by Robert Arnott in the Journal of Indexes, he highlights multiple 20, 30 and even 40 year periods where we would have been better off in bonds. In other words, the risk premium did not exist.

This starts to get ugly when we admit that we have no idea when these types of prolonged bear (or sideways) markets are coming. Where are we right now in the cycle? I have no idea, and I wouldn't bet my life savings on anyone who claims to.

So earning this mythical risk premium of 2.5% is largely a function of timing, and it's not the kind of timing we can control. This is the purely random luck kind of timing: When you were born, when you sell your business, when you retire or receive a large lump sum to invest. And if the risk premium is a function of timing, and timing is a function of luck, it doesn't take much to realize that earning the mythical risk premium is a function of pure luck, too.

This is why so many of us who have been investing for 15 years feel like we are about back where we started, even if we did everything right ( assets allocated, properly diversified, didn't bail out at the bottom and so on).

Let me clear, I am not saying that the risk premium is dead, or that we should run out and sell everything. But I am suggesting that with the Dow bouncing around 10,000, it might be time to consider what you define as long term. Ask yourself if you can you live through a prolonged period where you earn no risk premium at all, and make adjustments accordingly.

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