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.
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.
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.