Field of play
A cornerstone idea
Investors trying to develop their own investment philosophy need to begin with some cornerstone ideas. When I began reading about investing in the early 1970s, I read two books which referred to studies which showed that common stocks outperform bonds over the long haul. Since I did not expect to retire for many decades, I thought this a worthwhile principle to guide my retirement savings. My naïve conclusion was that I would be best off if I put all my retirement savings into common stocks. My other conclusion, based on my reading, was that there were market cycles which affected stocks and, if possible, I should try to take advantage of them.
For two years before this, my savings had been in a retirement savings fund sponsored by our national lawyers’ association and managed by a life insurance company. I cashed this in and moved the whole lot into a single, actively-managed mutual fund invested exclusively in Canadian common stocks. I left it there for ten years, never touching it or changing anything other than to add contributions from year to year. It performed very well. During this same ten years, I had, on the side, a small investment account with a full-service broker and set about trying my own hand with a limited amount of money. The dollar amount was limited in the sense that it was money I could always afford to lose in its entirety. After ten years I decided that what I had read ten years before had more of less been validated and that I should begin to manage our retirement savings myself. I have continued to this day.
Profits put back in the business
The reason stocks typically outperform bonds over the long haul is really quite simple. “…businesses retain earnings, with these going on to generate still more earnings–and dividends, too.” These are not my words. They are Warren Buffett’s.
On December 10, 2001 Carol Loomis’ report on the CNNMoney website contained an essay written by Warren Buffet based on a speech he had given the previous July. (Buffett W., 2001) It may be found at: http://money.cnn.com/magazines/fortune/fortune_archive/2001/12/10/314691/
The following are excerpts, as written by Buffett. He is referring to a book published in 1925 written by Edgar Lawrence Smith (no relation):
“To report what Edgar Lawrence Smith discovered, I will quote a legendary thinker–John Maynard Keynes, who in 1925 reviewed the book, thereby putting it on the map. In his review, Keynes described ‘perhaps Mr. Smith’s most important point … and certainly his most novel point. Well-managed industrial companies do not, as a rule, distribute to the shareholders the whole of their earned profits. In good years, if not in all years, they retain a part of their profits and put them back in the business. Thus, there is an element of compound interest operating in favor of a sound industrial investment.’”
“It was that simple. It wasn’t even news. People certainly knew that companies were not paying out 100% of their earnings. But investors hadn’t thought through the implications of the point. Here, though, was this guy Smith saying, ‘Why do stocks typically outperform bonds? A major reason is that businesses retain earnings, with these going on to generate still more earnings–and dividends, too.’”
A time for bonds
Having said that, there is a time for bonds. From 1998 to 2002 I held almost 100% of my portfolio in two-year bonds. It was a defensive move. There may be times when the present value of the expected future cash flows from even the most conservative bonds are higher than the present value of the expected future cash flows from stocks. An example of this would be during a stock bubble.
The return that can be expected from stocks is, in part, a direct function of price levels in relation to intrinsic value. When stocks are highly priced relative to fair value, the expected returns will be lower. If stocks are at bargain price levels, the expected returns will be higher.
Having said that, let me make it clear that I do not advocate for market timing. In the last fifty plus years of investing, there have only been two periods when I was not 100% allocated to stocks. For one of those two periods, with hindsight, I would probably have been better off to stay 100% in stocks. The last time our family’s retirement savings were not 100% in stocks was the fall of 2002.
Jeremy Siegel’s Stocks for the Long Run was published in 1998 shortly after Alan Greenspan’s famous warning to market participants about ‘irrational exuberance’. In 300 pages, with lots of statistics and charts, this best seller makes a convincing case for the outperformance of stocks over the long haul. It was published at a time when stocks were on a real tear. The stock market in the late 1990s was in a true generalized stock market bubble – the Dot Com bubble. An investor entering the stock market in 1998 on a policy of buying and holding for the long haul on the theory that stocks are typically superior for the long run would have been faced over the next fifteen years with a series of roller coaster rides of epic proportions. It is an understatement to say that this investor’s equanimity would have been tested to the limit.
Close to a worst case scenario
An investor placing all his investible assets in the S&P 500 index on December 31,1999 would have earned a compounded total return over the next fifteen years of 4.2% per annum. Over the same period, an investor in 10-year U.S. treasury bonds would have earned a risk free 6.2% compounded. This is a real case but also distorted. The date of December 31, 1999 was essentially the peak of the Dot Com bubble. The investment period also includes the Great Financial Crisis that broke in 2008. It may not be a worst-case scenario, but it is close.
After looking at these statistics, the intelligent investor will realize that there may be significant periods when stocks perform less well than the long-term averages of stock performance and significant periods when they perform much better. In an example cited by Benjamin Graham: “the annual rate of price advance between 1949 and 1970 works out at about 9% for the S&P composite (or the industrial index), using the average figures for both years. That rate of climb was, of course, much greater than for any similar period before 1950.” (Graham, The Intelligent Investor, fourth revised edition. 1973) p 30 The fourth edition of The Intelligent Investor speaks from the perspective of 1973, albeit with the wisdom of over fifty years market experience.
Here’s the kicker. Anyone investing in stocks in 1970 would have suffered mightily over the next five years. There was a brutal stock crash, one of the worst in 100 years.
A consistent policy on common-stock investment
So here is the lesson as articulated by Benjamin Graham. He says, referring to a table of stock performance over a period of one hundred years, and speaking from the year 1973: “Today’s investor cannot tell from this record what percentage gain in earnings, dividends and prices he may expect in the next ten years, but it does supply all the encouragement he needs for a consistent policy on common-stock investment.” (Graham, 1973) p 31
This thought is valid at all times in the stock market except in the advanced stages of a true generalized stock market bubble.
The truth is that it is impossible to know what return to expect from stocks. With bonds one can make a better estimate, but even with bonds one doesn’t know what course inflation will take. In the last couple of years bond investors have learned about the serious impact inflation can have on bond total returns.
In the 1970s bond investors suffered from inflation that devoured their returns. Governments and central banks failed to control inflation. Debtor governments, corporations and individuals were given a break and bond holders took a haircut to subsidize the borrowers. I say they took a haircut. It was not overt. It was a stealth haircut caused by inflation. Bonds are not an inflation hedge.
In the 2010s bondholders also took a haircut as a result of artificially depressed short- and long-term interest rates thereby again subsidizing debtor governments, corporations and individuals.
Many investors use bonds to limit volatility. But volatility is not your enemy. As discussed in other posts, it can be your friend. Investors should only be investing in bonds if they offer prospective returns that are superior to stocks.
Conclusion
The conclusion I have come to is that my naïve supposition from my reading in the early 1970s, as to the outperformance of stocks, is still valid. This idea continues to be a cornerstone of my investment philosophy. That said, successful investing is not easy. You have to read up on it and then develop experience over many years. It requires work and commitment.
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