We all know what’s good about stocks. Stocks provide great long-term returns.
Is there anything bad about stocks?
There is. The bad thing about stocks is the price volatility. You never know where you stand. One day your net worth is $100,000. If the money is in stocks, the number a year from today might be $130,000 or $70,000. You just don’t know. That’s scary.
The thing that determines whether you will become a successful long-term investor or not is how you deal with the fear caused by price volatility. The most common way of dealing with it is through denial. No one literally denies that prices are volatile. But many block this reality out of their minds. They would as soon draw up a will as develop a strategy to deal with price volatility. They act as if they believe that dealing with the problem will cause bad things to happen to them.
There have been three times in the past when stock prices have been where they are today. The average price drop for those three occasions was 67 percent. What are you going to do if the value of your portfolio is cut by two-thirds? Do you have a plan?
Lots of people say “buy-and-hold is my plan.” I don’t think that works. It’s too pat. Your life is going to change in dramatic way if the value of your portfolio is cut by two-thirds; lose that high a percentage of your accumulated wealth of a lifetime and there are going to be fewer options left open to you in all areas of life endeavor. You really are just not going to let that affect you? Are you sure?
Remember, if things go this time as they have gone all the other times, most other middle-class investors will be abandoning stocks when prices drop. It’s easy to practice buy-and-hold when everyone is saying it’s a good idea. It’s not easy when everyone is saying that the best thing is to abandon stocks. That will be what most people will want to hear when most people are abandoning stocks, and most stock “experts” have made it a longstanding practice to tailor their advice to meet the current desires of most of their listeners.
I don’t think you are going to hold if prices drop by 67 percent or by anything close to it. I don’t say that because I think you are weak. I say that because I don’t think any reasonable person would hold onto an asset that had lost 67 percent of its value. People don’t do things like that, and for a perfectly good reason. Doing things like that is nuts. Who the heck can afford to lose 67 percent of his or her life savings? Who the heck can afford to take that sort of hit and not take some kind of action?
Buy-and-hold does not work. It is not realistic.
At least that’s so of the version of buy-and-hold that has been widely promoted for 25 years now
I propose a new approach to buy-and-hold, one with all of the advantages of the now popular approach but without the terrible failing that it cannot work in the real world.
The problem with the conventional approach to buy-and-hold is that it ignores the way the stock market performs. Stocks are not really one asset class. They are two, two, two asset classes in one.
When stock prices reach extreme highs, stocks are a dangerous asset class. There are always huge wipeouts of middle-class wealth when stock prices reach extreme highs. There are no exceptions in the historical record.
When stock prices are normal or low, there’s not much risk. Stock prices might go down a bit from moderate or low prices. But probably not too much. And, if they do go down a good bit, the price drop is not likely to remain in place for long. At least that’s always been the case in the past. Again, there are no exceptions in the historical record.
Here’s my plan for escaping the worst effects of stock-market volatility: Lower your stock allocation when prices reach extreme levels (like those that apply today). That way you are heavily in stocks most of the time and get to enjoy the wonderful long-term returns generally associated with stocks. But you miss out on those huge price drops characteristic only of stock markets for which prices have been permitted to get out of control.
Make sense?
It makes sense to me.
What doesn’t make sense to me is the negative reaction I sometimes hear to this idea. It is my view that that negative reaction is a signal of defensiveness. It is because investors trying to pull off the conventional approach to buy-and-hold don’t really deep in their hearts believe that it can work that it makes them anxious to hear about other strategies, strategies that could help them if they could chill out a bit and think things through without too much emotion getting in the way.
Do I believe in buy-and-hold? Sure. Stocks rarely get to the sorts of price levels that apply today. So it is going to be a rare event when you are going to need to lower your stock allocation to protect yourself from monster price drops. It makes all the sense in the world to hold your stocks through the moderate ups and downs that apply for investors who buy their stocks at reasonable price levels. When the monster price crashs become a live possibility (probability? certainty?), however, I think it makes all the sense in the world to take a little something off the table until our fellow investors come to their senses and pull stocks back to more reasonable price levels.
It’s just an idea, you know? I think it’s a good one. If you don’t, that’s of course fine. We can of course still be friends. I ask that you not get mad at me because I put the idea forward and that you give the idea some thought if your initial impression is that it might make sense.
Today’s Passion: The Investor’s Scenario Surfer lets you test how you would respond to various return patterns without requiring you to put actual money at stake.
Schroeder says
Rob, in your previous writings you advise investors to not totally abandon stocks. If I recall correctly, you recommend a minimum of 30 percent in stocks, even at today’s valuations, correct?
Given a 30 percent allocation to stocks, what sort of decline to one’s portfolio should a buy-and-hold investor expect? I don’t think it will be 67 percent, correct?
Schroeder
John Walter Russell says
The Scenario Surfer is a real eye opener.
Originally, based strictly on what has actually happened in the past, I was comfortable with a minimum stock allocation of zero at high valuations. The Scenario Surfer makes it clear that stock prices could go up from here, sometimes into a super bubble region. It is not very likely, but it could happen.
Now, I almost always set my minimum allocation to 20%.
Have fun.
John Walter Russell
Rob says
The Scenario Surfer makes it clear that stock prices could go up from here, sometimes into a super bubble region.
I ran out a scenario just this morning in which this happened. I started at a P/E10 of 32. It went from there to 44 (the high we hit in January 2000) and then just kept going. It went all the way up to 55.
Rob
Rob says
If I recall correctly, you recommend a minimum of 30 percent in stocks, even at today’s valuations, correct?
I think 30 percent makes sense for the typical investor. I’m at zero but that’s because of unusual circumstances. I can see an investor who is skilled at picking stocks going up to 50 percent without being in too much danger. I would like to know more about that Shiller allocation of 60 percent that you pointed us to, Schroeder. That number sounds high to me for these valuations. But, if it is Shiller’s choice, it seems to me that there must be intelligence behind it. I’m not going to be the one to say that Shiller is wrong.
Given a 30 percent allocation to stocks, what sort of decline to one’s portfolio should a buy-and-hold investor expect? I don’t think it will be 67 percent, correct?
With a 30 percent allocation, the overall portfolio loss would be 20 percent. That’s a significant hit, but I think it’s a hit that an informed investor can take. It’s not a permanent 20 percent loss. The 67 percent loss is what applies at the worst moment (the moment when the distance between the high value and the low value is greatest). So at most moments the loss will be a good deal less than that and in time there will of course be no loss at all but a gain. Also, the 67 percent number does not take into account the dividends that are being earned during the time when prices are dropping (this can be a long time — the 67 percent price drop isn’t likely to take place in only a single year or two). John did some research indicating that the real loss as measured with dividends included might be only 40 percent.
Rob
critter says
–I’m at zero but that’s because of unusual circumstances.–
Can you expound further?
Rob says
Can you expound further?
I’ve taken on a good bit of risk on the career side of my Life Plan. It doesn’t make sense for me to take on even more risk by investing in stocks at a time of high prices.
If prices were lower, the risk of stocks would be small enough that it would make sense for me to take it on in return for the likely return I would obtain. If I were not taking on lots of risk on the career side, it would make sense for me to invest at least a portion of my assets in stocks (probably 30 percent) even at today’s prices because future returns are not precisely predictable and doing so would cover me for those scenarios in which prices remain high for longer than they ever have before. But at these prices I do not think it makes sense for someone in my circumstances to own stocks.
Most of my money is in TIPS and IBonds paying 3.5 percent real. I like to see at least a 2 percent risk premium for taking on the risk of investing in stocks. So my intent is to hold off investing in stocks in a big way until the expected 10-year return exceeds 5.5 percent real. That’s a P/E10 value of 15.
I certainly would not advise the typical investor to wait until we reach that P/E10 level to move to a significant stock allocation. If your career risk is less, you want to be participating in stocks as soon as the long-term value proposition becomes compelling (that’s probably so at a P/E10 value of 18) and when the relative value proposition for stocks (the value proposition for stocks compared to what you can get from other the other asset classes available to you) is strong (TIPS paying 3.5 percent real are not available today, so the relative value proposition for stocks is greater for most of us than it is for me).
If you invest heavily in stocks at a P/E10 value of 18, you are likely to see a big price drop as all those who have followed the Passive Investing approach come to realize the mistake and bail out of their “buy-and-hold” positions. That shouldn’t deter you entirely because the long-term value propoistion is still there; stock prices will likely drop hard from a P/E10 value of 18 but they will come back in time. However, you should exercise caution in response to that reality. We usually return to a P/E10 level of about 7 after experiencing a bull market of the magnitude of the one that ended in late 1999. You don’t want to be too heaviliy invested in stocks for a trip from 18 to 7. You want to be gradually increasing your stock allocation as prices return to reasonable levels and then increasing it yet some more when prices reach the truly mouth-watering sub-fair-value levels.
Rob