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When will the end of the world end?
This week opened with an apocalyptic bang, as the Dow Jones
Industrial Average hit an intraday low of 7105.94 -- the index's
lowest level since Oct. 28, 1997. It rose Tuesday, then fell again
Wednesday. In response, pundits everywhere went picking through
their tea leaves one shred at a time, looking for the definitive
sign that Armageddon is over, so we can all go back to making money
again.
What history shows, however, is that the road to recovery from a
catastrophic bear market can be distressingly long.
Friday, finance professor Elroy Dimson of London Business School
will publish his periodic update of long-term investment returns,
which is eagerly awaited each year among the propeller-heads of the
investing world. Along with his colleagues Paul Marsh and Mike
Staunton, Prof. Dimson compiles vast amounts of reliable data on 17
stock markets around the world all the way back to 1900.
Naturally, the report this year focuses on bear markets. The
results shocked even me, and I don't startle easily. Consider this:
Prof. Dimson estimates that we'll have to wait nine more years
before the Dow average, including dividends, has a 50% chance of
hitting its 2007 highs.
The report also challenges the conventional wisdom that a run of
bad results in the past must be followed by good returns in the
future. Following the worst years, stocks outperformed cash over
the next five years by an annual average of 7.1 percentage points.
But after the best years, stocks outperformed by 6.8 percentage
points annually -- a statistical dead heat. 'If you were trying to
find a rule buried in this as to what investors should do to make
money,' says Prof. Dimson, 'it's kind of hopeless.'
The report hammers home another uncomfortable truth. The belief
that stocks become virtually riskless if you just hold onto them
long enough -- popularized a decade ago in books like Jeremy
Siegel's 'Stocks for the Long Run' and James Glassman and Kevin
Hassett's 'Dow 36,000' -- has been shattered by reality. No matter
how long your investing horizon may be, the risk of owning risky
assets can never go to zero.
Since 1900, there have been four global bear markets in which
stocks have fallen by at least 40%, adjusted for inflation. Two
have occurred in the past nine years alone. Stocks are risky not
merely because their returns are variable, but because they can
wipe you out at various points along the way. That's the price you
must pay -- often at the worst possible time, and never with a
moment's notice -- for the hope of higher returns in the end. That
hope is real and valid. It is also uncertain.
'More people are realizing that equities are still risky even over
long horizons,' Prof. Dimson says. 'So I think some of the reasons
that people were willing to pay a high price for risky securities
have been curtailed.' It may be a long time before investors are
again willing to value stocks at much higher than the long-term
average of 15 times earnings.
That's important. Expectations can be a major factor in stock
valuations for years; you don't always get what you foresee. In
1900, for example, many investors were in a triumphal mood, buoyed
by the trend toward peace and prosperity. But over the next five
decades, all hell broke loose, and global stock markets returned an
annual average of just 3.5% after inflation. In 1950, Cold War
pessimism was the order of the day, and many doubted whether
humanity itself would survive the years to come. But progress
prevailed; global stock markets gained 9% a year, adjusted for
inflation, over the next five decades.
The mood today is probably closer to the pessimism of 1950 than to
the optimism of 1900, which is itself a hopeful sign for the longer
term.
Nor are Prof. Dimson's findings quite as discouraging as they sound
at first. If there's an even chance that the Dow will nearly double
in nine years, that implies a total return of 7.1% per year, which
isn't exactly chicken feed.
Since 1900, U.S. stocks have averaged a 6% annual return after
inflation. If you knew nothing else -- and none of us do -- then
that should be your forecast of the return on U.S. stocks over the
long term. That's measured in decades. In the short run, as just
about every investor now realizes, anything can happen.
So now is the time to give your entire portfolio a liquidity test.
By 'entire portfolio,' I mean not just your stocks, bonds and
mutual funds, but all your assets and liabilities. Do you have
enough cash to support yourself (and your family) for six to 12
months if you lose your job? Can you comfortably cover any big
expenses (tuition, a house down payment, a wedding) that must be
paid in the next few years? Do illiquid assets like real estate or
a private business constitute less than half your wealth?
If your answer to any of those questions is no, then you should
think twice before sinking more money into stocks. That was true,
by the way, even before the bear market.
If, however, you aren't yet retired and can answer yes to each of
those questions, you should have no hesitation about staying in
stocks. In fact, you should buy more -- especially if your job
security isn't contingent on the health of the stock market. Say,
you're a tenured teacher, a member of the clergy, a prison
administrator, a funeral director or an Internal Revenue Service
agent.
As Prof. Dimson puts it, 'If your children will have a wedding in
the near future and you absolutely must pay for it, keep your money
risk-free. But if you want the chance of giving them a wonderful
wedding instead of just feeding a few guests, then you should take
the risk of investing in equities.'
Abraham Lincoln liked to tell the story of a king who ordered his
wise men to come up with a single sentence that would never be
false. Their solution, which Lincoln called both 'chastening' and
'consoling,' covered all possible contingencies: 'And this, too, shall pass
away.'
My dad, no slouch in the wisdom department, once shared with me his
version of the way to encompass all possible futures: 'Hope for the best, but expect the
worst.' Those, it seems to me, are good watchwords for
investors, regardless of whether or not the end of the world has
ended.
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