Are Equities A Good Long Term Investment?

by Mike Holman

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The Personal Financier wrote a very interesting post on the idea that long term equity investments are not risk free which is not a popular opinion for most investors.

A lot of the investment books that I’ve read often quote a long term equity return figure of 10% for equities. The idea is that while volatility will ensure that the short term returns will be all over the map, if you wait long enough then things will even out and you will get your 10%. If this was perfectly true then you should leverage every bit of money you can get your hands on and buy some equities (assuming that you are reasonably young).

Past returns of equities and stocks

The idea that you can get 10% annual return on equities is based on studies where they measured the equity performance of American stocks for a good part of the last century (about 80 years). As Bernstein pointed out in his Four Pillars of Investing book, this particular time period was a pretty good one for US securities. Another thing he points out is that if you include other countries in the world which went through various wars and natural disasters during that same time period, the world returns would be much lower. There is nothing wrong with looking at the past but you have to keep it in perspective and don’t write the 10% return in stone.

Fees

Another key point that a lot of investors seem to be unaware of is that the 10% return figure is a gross returns. In other words they did not include any kind of trading fees like you would incur on stock or ETF trades or the management fees that are charged on mutual funds, which is how most investors buy equities. In the U.S. it appears that most equity mutual funds charge about 1.5% per year which would mean a net return of only 8.5% – not 10%. Here in Canada, I’m proud to say that we have the highest mutual fund fees in the entire world and they average about 2.5% for retail funds which would bring out expected return down to 7.5%. Over the long haul, these lower returns will make a huge difference in the amount of money you have in retirement. Taxes are another issue but the assumption (which I think is valid) is that with proper financial planning, you shouldn’t be paying excessive taxes on your retirement funds withdrawals.

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How long is the long term?

Another misconception is the length of the “long term”. I’ve seen posts where people mention that equities are good for investment as long as you will be invested at least five years or ten years. It’s hard to imagine how someone can look at a return figure from an 80 year study and assume it applies for a ten year period. I don’t have an answer to this question but what I do know from my limited statistics knowledge is that the odds of meeting your expected return increase over time. This means that if you are investing for a 20 year time period and you are expecting a return of 7% then the odds of meeting or exceeding that return are higher than for a 10 year time period. By the same token – investing for a 40 year time period will increase your odds compared to the 10 or 20 year time periods.

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{ 8 comments… read them below or add one }

1 guinness416

Highest mutual fund fees! Highest cellphone bills! Highest airport charges! Wow Canada really is number one!

That’s all I got right now but I liked the post a lot, it’s an explication of a comment I’ve seen you leave a few places, right? It never seems to go down to well, people like that 10% assumption.

2 BenE

“This means that if you are investing for a 20 year time period and you are expecting a return of 7% then the odds of meeting or exceeding that return are higher than for a 10 year time period.”

This is not quite right. The odds of being over expectation remain the same. However, regardless of being over or under expectation, with time you are less likely to be far from the long term average. That is you are less likely to have very large gains or very large losses as the big movements have a tendency to cancel each other out during a long period.

3 Mr. Cheap

I *believe* the reason people throw the 10 year time-frame around isn’t because you can expect a 10% return, but rather that over a 10 year period you’re very likely not to lose money (as BenE says). If you look at the WORST 1 year return in the stock market (looking at an index), it’d be pretty bad. If you look at the WORST 10 year period its going to be a lot better (see http://finance.yahoo.com/funds/understanding_investing/article/100545/Stock_Performance_by_Decade). If I’m understanding this chart correctly, in only two decades did investors have a nominal loss.

I think if you expand it to 2 decades, there was never an overall loss.

Of course, factor in inflation and its less of a rosy picture…

4 Kyle

To me, the “long term” means 20 years at a minimum. Whether or not holding stocks for long periods of time is more risky or less risky depends on what you mean by “risky” to begin with. If you are talking about the possibility of suffering a nominal loss then yes, long-term investing is far less risky than short-term investing. But if you are talking about variability of results (i.e. how much money do I end up with after X years?) long-term investing is actually much riskier. The difference between earning 10% per year over 40 years and 8% per year over 40 years is huge. By that measure, long-term investing is riskier because short-term results are likely to have a much smaller standard deviation. So in that sense, investing because riskier the longer your time horizon.

5 Cash Instinct

Cash under the mattress looks so easy to manage compared to choosing an asset allocation, deciding how much return you plan to get in the long run, whether the risk of equities is under or over estimated, etc…

But you are sure to lose considering inflation with cash under the mattress, I know! ;)

6 Jordan Clark

The question I keep asking myself is now a good time to start investing a good chunk of retirement funds into a diversified portfolio of index funds? I know you can’t time the market, but I wonder if common sense isn’t right to wait a bit when the general sentiment is the US & Canada are on the brink of a recession, and the IMF says there is a 1/4 chance of a world wide recession.

Do you think returns would get close to the magic “10%” with an asset allocation with about 60% in the US & Canada if those countries under perform their previous 80 year history?

7 Four Pillars

Guinness – “We’re #1!, we’re #1!”

Ben – you are correct.

Jordan – I don’t have clue.

8 Dorian Wales @ The Personal Financier

First of all thanks for the kind mentiond. Feedback is always energizing.

I’d like to add something I view as very important (might answer Jordan’s question or wonder).

Keeping in mind we’re investing for retirement and not for quick money is very important. Even though no one promises 10% a year we must keep in mind they way most of us save.

The vast majority does so in timely contributions. I believe this is known as dollar cost averaging which literally constantly averages the rate at which we invest.

This method dramatically lowers investment risk and, as I hope we’ve all learned and implemented, potential return.

If you’re saving for retirement timely contributions won’t make you rich but they will decrease the risk of the investment significantly.

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