Start Right | Finish Well

A recent New York Times article showed that a little known secret of investing is that historical returns can vary dramatically depending on starting and finishing times for the period of time in question.  Pick the wrong year, or decade, or even twenty year period, and you can fail to keep up with inflation.  But if you start right and finish well, selecting an opportune point of entry and have an optimum exit strategy, the market can be a wonderful place to invest.  The NYT chart shows clearly that the long-term assumption that "stocks earn 10%" is a dangerous presumption.  Investors who buy and hold are often frustrated if they think that "time in the market," alone, is a sufficient buffer against disappointment.

The stock market matrix chart was prepared by Crestmont Research and is a wealth of information, albeit in the form that only a chart geek (like me!) could love.  Take a look for yourself.  It's a work of art, in my opionion.

What investors should take away from viewing the chart is the question of what is a realistic return expectation?  One obvious point is that the chart has a lot of red color, and red represents time periods when stocks fail to keep up with inflation - and deep red probably means they failed to keep "up" at all!  There's a reason why we call it "red money" in our practice.  It requires active management, to coax more green into the mix, and those periods where anybody can make money in the stock market don't happen as often as we would like.

Ed Easterling, a Corvallis, Oregon-based investment advisor, observes in the article that, "market returns are more volatile than most people realize....even over periods as long as twenty years."  This is particularly true for investors who adhere strictly to a buy-and-hold strategy, whether - as we are known to observe - they are passive "by choice" or "due to inattention."

The 20-year median real return (the return above the level of inflation) is 4.1%.  If inflation increases at a 3% rate, which might be a reasonable long-long-term assumption, then a passively managed stock portfolio might be expected to return 7.1%.  That's not quite the 10% that many planners assume, and well under the presumed 20% rates of return that investors held during the technology bubble, when unrealistic thinking and irrational exuberance were the norm for investors and investment bankers, alike.

I'm not writing this to discourage investors from buying stocks.  Given the negative real rate of return facing bond and money market fund investors, stocks might be one of the best games in town - particularly if the companies in question can maintain pricing power.  However, stock investors need to go in with their eyes wide open.  Financial advisors who spout platitudes about how a long-term time horizon erases the risk, or how "time in the market" turns this risk profile upside down, are doing a disservice to their clients.

The best thing that can be said about stocks, in light of this chart, is that as bad as it looks, the bond chart probably looks worse!

 Douglas B. May, CFA, is President of May-Investments, LLC and author of Investment Heresies .

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