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Over the long term, staying out of the stock market is more risky than being fully invested. This statement is certainly going to cause some controversy. How can I say that? At the time of this writing, in September 2008, the Nasdaq is still below 50% of the level it reached eight years ago, in 2000. We are also in the midst of a credit crisis of historic proportions with a number of venerable financial firms failing practically overnight. It is accompanied by a bear market with all major averages down over 30% from their highs several months ago. If that’s not risky, what is? The key to this claim lies in definition of what exactly constitutes “long term” and how you define “risk.” Let’s take these concepts one by one. Since 1900, the stock market returned an average of nearly 10% annually. The traditional competition to stocks, bonds and treasury bills, only returned about 4% during the same period. One dollar, invested in the stock market in 1900, would have grown to over $20,000 today. That same $1 invested into bonds would be worth only $60. Rule 2 states that compound interest is good. Indeed. The domination of the stock market has been rather consistent over shorter periods as well. As explained in Stocks for the Long Run by Jeremy Siegel, over any 5-year period, stocks outperformed other investment types over 70% of the time. For 10-year periods, this number rises to 80%. Over 20 years, it goes to 95%. Finally, over 30-year intervals, stocks have always outperformed other investment types. I would say that this defines the first element in my claim, namely that long-term should mean over 20 years or more. You may wonder whether a holding period of 20, or even 30, years applies to your situation. After all, chances are that you are not planning to hold a particular stock or a mutual fund that long. However, I am talking about the holding period of the entire portfolio, regardless of the number of changes you may make in it. And this holding period, in most cases, will run for several decades. Now, let’s take a look at risk. Traditionally, many people think of risk as the possibility of losing a substantial part of their investment. Looking again at performance of stocks vs. bonds and treasury bills, over any period of 10 years or longer, the maximum loss suffered by stocks was less than that suffered by bonds and treasury bills. Even in the worst 5-year period, the maximum loss from stocks was only one percentage point higher than that from bonds. In mathematical terms, risk is often defined as the standard deviation of average annual returns. Standard deviation measures how widely spread the values are from the average. Using this formal definition, again, over any period longer than 20 years, stocks carried less risk than competing investment types. The superior performance of stocks does come with a price of short-term volatility. Back in the 1800’s, Mark Twain said: “October is one of the peculiarly dangerous months to speculate in stocks. The others are July, January, September, April, November, May, March, June, December, August, and February.” Over a few months or even years, no one can argue that this danger is all too real. However, history shows that over longer terms, stocks are in fact less risky, if one sees risk as lost opportunity. In the long term, the risk of investing in “safe” securities and realizing subpar returns is far greater than the risk of short-term fluctuations in the stock market. © 2013 Laura Lowell This excerpt by Leon Shirman is Rule 3 from "42 Rules of Sensible Investing (2nd Edition)". Leon Shirman earned his Ph.D. in Applied Mathematics from the University of California at Berkeley in 1990. He turned his attention to investing in 1987, after a market crash that year. In 2011, he earned Chartered Financial Analyst (CFA) designation. He is now the Managing Partner of his investment company, Emerald Hills Capital. You can learn more about his book and others at http://42rules.com.
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