Investing

Why Stocks are a Risky Long-Term Investment

risk

Earlier this fall, the SEC accused a well-known personal finance expert, Ray Lucia, of misleading investors and ordered him to stop making false claims.

My reaction to this was twofold: (1) I’m glad my column is obscure enough that the SEC has no interest in me, and (2) this guy was advertising surefire investment gains based on a common fallacy promoted by lots of other smart people who should know better.

Maybe you believe in it, too. But you shouldn’t and here’s why:

The fallacy is that investing in the stock market is less risky over long periods than short periods. It’s not. It’s riskier.

This is not just my opinion; it’s a mathematical fact well known to academic finance experts and options traders, supported by historical evidence, and largely ignored by the public and financial advisors alike.

There’s a hole in the bucket

Ray Lucia’s investment strategy, used by his advisory practice and promoted on his radio show and in a series of bestselling books, is called Buckets of Money. It’s mostly aimed at people at or near retirement.

The concept is that you separate your retirement savings into three buckets for short-term, medium-term, and long-term (15+ years) spending needs.

The short-term bucket is invested in low-risk assets like short-term bonds, CDs, and savings accounts; the long-term bucket gets risky stuff like stocks and real estate.

(The medium-term bucket gets somewhat risky or more illiquid assets, like longer-term bonds and fixed annuities.)

The idea is that you withdraw your spending money from the first bucket and periodically replenish the first bucket from the second and the second bucket from the third.

If the market tanks, you can wait it out until it recovers, because you have bucket three hermetically sealed off from the rest of your money, and everyone knows the stock market always does well over long periods, like 15 years.

Now, to be clear, the SEC didn’t have any problem with the strategy itself; they accused Lucia of overstating how well it would have performed historically. But this “buckets” idea, which is also promoted by lots of people other than Lucia, is fatally flawed.

It’s flawed because there’s no guarantee the investments in the third bucket will perform well over 15 years or any period of time, no matter how long.

Moshe Milevsky, author of Are You a Stock or a Bond?, analyzed the bucket strategy in 2006, long before the SEC became interested in Lucia.

“If you are unlucky enough to earn a poor sequence of initial returns,” he wrote, “‘bucketing’ your retirement income is not a guaranteed bailout.”

“Great,” you may be saying. “I won’t put my money in buckets. Sounds complicated, anyway.”

Sorry, but if you combine all your assets into the same bucket, you’re probably still making the same mistake.

The risky long run

There are a variety of ways to explain why stocks are risky in the long run, and John Norstad investigated plenty of them in his classic paper, Risk and Time, which every investor should read (it’s free and it’s short).

The argument I find most persuasive is this: investors expect to earn more from stocks than from bonds because we demand a risk premium from stocks. If there were zero chance of making more money in stocks, no one would choose them over safer assets.

“Risk” is just another word for “bad stuff might happen.” Bad stuff happens all the time in stock markets. Plenty of stock markets in the history of the world have gone to zero and stayed there, usually because of war.

In more normal times, we have panics, asset bubbles, financial crises, recessions, and flash crashes. Part of the reason we expect high returns from stocks is because we know these things can and do happen, and we demand to be compensated for dipping a toe into such a risky pool.

And the longer we stay in the market, the more likely we are to experience a disaster. Just like the longer you stand on a sketchy street corner, the more likely you are to be mugged.

Understanding this isn’t the same as being a stock market bear. Taking prudent risks is what investing is all about.

You can believe that stocks have higher expected returns and that the general trend of the market is up (I believe both); you can invest in stocks (I do); and you can also understand that stock investing is risky and you have no idea how much money you’ll end up with at the end of a long investing career.

It could be much less—or much more—than you expect.

Here’s another way to look at it: let’s say you jump into the stock market for one day, and it’s just not your day. You lose 6%—a really bad day for stocks.

To really lose some money, though, you have to stay in longer. As Norstad points out, during the worst three-year period for stocks (1930-32), you would have lost 61%.

The market itself considers long-term investing risky. We know this by looking at options trades. (Feel free to skip ahead at this point if you really don’t want to read about options; I don’t blame you.)

You can “insure” your portfolio by buying a long-term put option against the S&P 500, which gives you the right to sell your stock for a certain price (the “strike price”) on a certain date.

If the market drops below the strike price, you can still sell without a loss; if the market is higher than the strike price, you sell at the market price for a profit.

Of course, you have to pay for the option, and the later the date on the option, the higher the price. Insuring against a market loss over a ten-year period costs more than insuring over a one-year period.

Why? Because stocks are risky in the long run.

Great, now what do I do?

Again, this is not an argument against investing in stocks. It’s an argument against the idea that stocks are a magical, long-term money factory. Even investors with long time horizons need a Plan B.

What happens if your stock investments don’t work out? What if they underperform your bonds over a 30-year period or longer? Would this ruin your retirement?

If so, you’re doing it wrong: you’re making a risky investment without thinking about what to do if the risk doesn’t pay off. No buckets and no amount of time can protect you from financial risk.

To paraphrase the computer from War Games, the only way to avoid stock market risk is to stay out of the market.

With bonds at record-low rates, that’s an unsavory proposition for most investors, including me. Fine. We just need to understand what kind of street corner we’re standing on.

Matthew Amster-Burton is a personal finance columnist at Mint.com. Find him on Twitter @Mint_Mamster.