By: Steven G. Blum
In Issue: September/October 2014
Wisdom dictates that your investment portfolio should be balanced by dividing it among a number of different asset classes. These include stocks, bonds, real estate, and cash equivalents (such as money market funds or bank accounts). Perhaps some exposure to commodities, inflation protected bonds, and a few other types of investment vehicles as well.
For those whose investments are definitely going to be for very long time periods, there is a strong argument that the lion’s share of their portfolio should be in stocks. Not only is the phrase “stocks for the long run” a kind of folk wisdom — and the title of my University of Pennsylvania colleague Professor Jeremy Siegel’s excellent book on the subject — it is also a reflection of economic theory and empirical evidence.
Keep in mind that stocks here refer to investments that involve ownership interests in public companies. No distinction is being made between individual stocks, mutual funds that hold stocks, stock ETFs, or other methods of owning stock investments. On the other hand, it is important to remember that not all funds or ETFs hold only stocks; many are invested in bonds or other underlying investment types.
What makes stocks so strongly suited to long-term investing? John H. Cochrane, a distinguished service professor of finance at University of Chicago Booth School of Business, explains it clearly. “Over the long run, a broad portfolio of stocks has substantially outperformed other investment classes including bonds and real estate. There is every reason to expect that performance to continue as stocks are a claim to real companies’ earnings.”
So why not just invest all your money in stocks or stock-based funds? The answer is plain to see: Any money you are likely to need in the near to mid-term future is not being invested for the long run. For example, if you have a teenager who will be starting college in a few years, the money put away for that purpose cannot be invested for a long time. Also, as you approach retirement it will be necessary to start using some of your investment assets for living expenses. And if you are already in retirement and you need the income now, there’s no time to overcome a drastic stock market setback. Retired folks must wisely temper stock-based investments with other less-risky investments.
What about stock investing for short periods, is that wise? The answer, in my opinion, is a resounding no. As Cochrane puts it, “Stocks are quite risky though especially at short horizons. They tend to do poorly in recessions and other bad economic times, precisely when short-horizon investors need their money. In part, you earn greater returns for bearing this risk and being willing to wait for better times. People who cannot take that risk shouldn’t invest in stocks despite the appealing long-run returns.”
Stocks for the short run turn out to be little more than gambling. Paying someone to play games of chance with your money is beyond foolish. This seems to be a lesson that each generation must relearn. Most of us can still taste the ashes of the 2008 market crash. But many can barely remember the sharp decline of 2002. The decline of 1990 was an unpleasant one. The one in 1973 and ’74 was almost as bad as our recent debacle. And, of course, the crash of 1929 and the Depression that followed it scarred an entire generation. The cycle of grave losses in financial markets is as perennial as the grass — but cannot be predicted in advance.
The solution is a simple one. For investments that will not be touched for very long periods of time, choose stocks for the long run. For money that will be needed to fund the activities of life, though, choose safer classes of investments. No stocks for the short run.