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What really matters: the risk of long-term loss

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Most investors often don’t realize it, but their investment horizons last a long time – at a minimum (!) until the day they die. Over such time periods stocks lose their risk of loss and offer by far the best real-world and inflation-adjusted returns. Bonds, by contrast, satisfy the need for reasonably constant, positive nominal returns but at the risk of inflation-adjusted losses of capital.


Given that one’s money should be invested until one’s last breath, most people have a very long time horizon, though many don’t realize it and behave in a short-term manner. When analyzing investment risk, it is therefore necessary to look at the size and probability of investment loss over periods measured in years and decades, not in days and months, as is often done (see blog entry from August 2014 “Volatility in the short term: not a worry for the value investor” ) . From this perspective, stocks are clearly risky. We all know that they can drop significantly over the course of one or two years, as we experienced in 2007/08. However, as the investment horizon lengthens, the risk of loss disappears and turns into a certainty of gain. It turns out that equities are the safest and most profitable asset class in the very long term.




Graph 1 shows the average annual returns (median) of world equities for a Swiss Franc investor for all holding periods between 5 to 90 years. The data comes from the renowned financial markets researchers Dimson, Marsh and Staunton of the London Business School and is shown on a real basis, that is, it reflects historical inflation. It has also been adjusted to reflect real-world investor experiences. It takes into account taxes (25% on income and 0.23% on wealth p.a.) and banking fees (0.20% p.a.), as paid by a modern Swiss investor. Please see our brochure on the base-surplus method for further information on these adjustments. The median, minimum and maximum annual average returns are shown, as are the probability of loss one standard deviation from the mean with the two dotted lines. Returns below the lower dotted line thus occurred with probability of 16% in the past.


As this line shows, there was a low but real probability of significant losses in the shorter periods, while there were no losses at all if the holding periods were 23 years or more, even after fees, taxes and inflation. At the same time, in the shorter periods there was a very large chance of gains, some of them quite big. Over time the minimum and maximum average returns converged to about 3.7%. This is the case, because the natural revenues and earnings growth of quoted businesses determines stock returns over time, smoothing out the short-term variability. In other words, annual returns are mean reverting, making for this convergence to a long-term annual average. While lucky investors experienced enormous increases in their wealth, the long holding period allowed the unlucky ones who caught periods of bad returns to benefit from some good years, too, and build capital. This insight, by the way, is the basis of our base-surplus-method for long-term investors on how best to build up and live off their wealth.


Bonds are not an alternative: losses are highly likely




Bond investors will reply that their asset class is the better alternative for risk-averse investors. We disagree. Graph 2 shows that bonds are by no means free of long-term volatility. We have again used real data, this time for an index that aims to capture the real world experience of a modern investor who buys five-year Swiss government bonds and holds them to maturity (again, please consult the base-surplus method for details). One can see at a glance that the median return was only barely above zero for all periods since 1899, as taxes and inflation ate away the value of the coupons. What’s worse, in over half the historical periods investors suffered real losses of wealth, and in a few cases the losses lasted a lifetime. The worst bond losses were not as large as the worst equity losses, but losses occurred more frequently, and there were no periods of large gains to offset them.




An examination of the relative returns of stocks and bonds underlines the conclusion that equities are the best choice for the long-term investor. Graph 3 shows the difference between equity and bond returns given identical starting periods. Again one sees that there was some probability of doing worse by holding equities for periods up to 35 years (any point below the zero line). But it is small for any comparison longer than about 17 years, when the negative standard deviation line crosses into positive territory, while the equity investor on an annual average earned around 4% more than the bond investor. Remember that the difference over 30 years between a yield of 1% and one of 5% means having a portfolio of CHF 100 grow to CHF 135 vs. over CHF 432 –. Over half the equity investors did even better than that! In other words, nothing other than holding stocks makes sense for the long-term investor. Needless to say, the case for stocks becomes even more compelling if one can earn a value premium.


Value investors need patience and the ability to suffer temporary losses


While very few people talk about such long time periods, in fact they are highly relevant. As we argued in the brochure on the base-surplus method, even a 65-year old man should plan with an investment horizon of 30 years or more, given that even men nowadays have a significant probability of living to an age of 95 or more.


However, all of this applies only to those people who have the frame of mind to tolerate periods of loss. As noted above, stocks do fall, sometimes dramatically, and losses can persist for many years. Even in nominal terms one needed to wait for ten years or more historically to come out ahead. Those who cannot experience such losses without distress should invest in bonds, which nearly always provide a positive nominal return, even if they often cause real declines in wealth.


–Georg von Wyss