It’s important to know that the stock market is likely to outdo “safer” investments over 20 or 30 years. But not all goals are that far off. And even for distant goals, most people will not be able to handle a grinding stock market decline without feeling an overwhelming urge to abandon their plan. Someone with a 30-year “rational” horizon may have a 5-year “emotional” horizon. (Day traders appear to have a 5-minute horizon, but day trading has nothing to do with investing.) This last is particularly unfortunate, as investment types and styles often seem to cycle in and out of favor over periods of 3 to 5 years, so that investments that underperform over a 5-year period might overperform over the next 5.
If you are saving for a specific goal that is approximately 5 years away (a house down payment, perhaps), you probably want to minimize the risk of a terrible loss without giving up too much potential gain. We all know that high returns without risk are fantasies. But by diversifying over different asset classes, we might not have to give up too much.
Consider — in real, inflation-adjusted terms — the worst 5-year results of the 20th Century for stocks, bonds, and cash investments. With appropriate thanks to Charles Ellis for providing this information in his excellent Winning The Loser’s Game, the worst compounded annual real rates of return over 5 years since 1901 have been:
Stocks: -11.62% (that is, losing 11.62% a year)
Cash: – 7.78%
The worst 5-year stock return would have turned $10,000 into $5,392 of purchasing power. The worst bond return turned $10,000 into a not much better $5,749. The worst return for cash cut $10,000 down to $6,670 (the cash was still there, and even grew with interest, but inflation cut its value).
Interestingly, these worst 5-year periods were not clustered around the 1929 crash, as you might have guessed, but 1915-1920. World War I ignited severe inflation. A basket of goods that cost $100 in 1915 cost $197 in 1920. That killed the stock and bond markets, as sharp inflation always does. But it also slashed the value of Treasury bills (which are what financial types like me mean when we refer to cash), because rates did not float back then as they do today. Today, if inflation ever came roaring back, the yield on Treasury bills would roar back, too. (Then again, these “worst” numbers are before tax. So after inflation and tax, you’d still be losing money at a significant clip, after tax, in Treasury bills, if inflation roared back, even if not quite as fast as in 1916.)
So do you still think stocks are too risky?
Well, OK. But the figure for stocks can be improved considerably by not limiting the investment to U.S. securities. When the U.S. market crashed between 1929 and 1932, non-US investments suffered a much smaller drop and a faster recovery. When Japan crashed after 1989, the rest of the world did quite well. Any investor in any country will be safer by splitting his investments between domestic and foreign securities.
I asked my pal Less Antman — known to regular readers of this column as “the estimable Less Antman” — to determine the performance of a stock portfolio split evenly between large U.S. stocks and large foreign stocks. According to his calculations, using data going back to 1926 (so that the crash of 1929 is included), the worst 5-year real return was -6.56%. Not great, to be sure, but a lot better than the -11.62% compounded annual loss when invested in the U.S. market alone. In this example, $10,000 would have shrunk to $7,123.
Diversifying your stock portfolio globally increases safety.
But I wouldn’t be too thrilled to lose $2,877 of my original $10,000 stake either.
With hindsight, Less reports, a blend of 55% cash, 45% global stocks (US and foreign), provided the “best” worst 5-year return: negative 2.53%, which only reduces $10,000 to $8,797. In other words, from 1926 to the present, the worst you would ever have done with that blend in any 5-year period was to lose about $1,200 in real purchasing power.
That’s a much better “worst” than just owning U.S. stocks and nothing else. A reasonable way to approximate such a blend would be to put half of the funds needed in 5 years into a money market or short-term bond fund, and split the other half between the Vanguard Total Stock Market (U.S.) Index Fund and the Vanguard Total International Index Fund. Or perhaps do it a third, a third, and a third.
But if it’s safety you seek, forget all this. There’s a much simpler way.
Tomorrow: An investment that guarantees you’ll beat inflation (before taxes, anyway)