Somewhere along the line, it became conventional thinking to consider stocks as excessively risky for any investor without at least a decade until retirement or who isn't only concerned with the part of their portfolio tasked with providing a legacy. Many retirees have a significant portion of their retirement in bonds and CDs, and even some retirement planners recommend annuities and TIPS for the part of their portfolio they plan to spend while they're living.
As readers of my articles know, I'm nothing if not well informed about the historical behavior of stocks. And for the life of me, I cannot figure out how we came to this conclusion. The more conversations I have on the matter, the more I realize this point of view is rooted in a lack of knowledge about historical market behavior, a lack of knowledge about the long-term drivers of investment returns, an excessive focus on short periods of subpar returns on subsets of the stock market, and a generally pessimistic view of markets and the world. Let's take a few minutes and just unpack these misconceptions and misbeliefs for readers interested in a balanced discussion about the significant role that stocks should play in retirement.
If I were to ask you what the long-term returns on stocks have been in the "modern era" since 1970 (when high-quality data on foreign stocks became available), what would you say? 5%? 8%? 10%? Chances are, your guess understates reality. This is my experience, anyway.
Looking at just the S&P 500, we see a +10.3% per year return over the last 47 years. International developed market stocks have performed slightly worse, at +9.3% per year.
But these are just large company stocks. We know that smaller and more value-oriented stocks have produced much higher long-term returns. Indeed, a diversified portfolio of stocks, represented by the DFA Equity Balanced Strategy Index*, returned +13.6% per year. $1 invested in this diversified index grew to $400 by 2016.
We hear all the time that stock returns will be lower in the future than they've been historically. But if you know how fabulously well they've done historically, this forecast (even if it comes true, which most do not) is far from ominous. Even if a diversified stock portfolio has a 25% lower return in the future than it's had over the last half century, that still amounts to over 10% a year. The worst 20-year period for stocks since 1970 began in March of 1989. They still returned +8.2% per year over the next two decades. That worst-case scenario, compared to 2% to 3% yielding bonds today, doesn't seem half bad.
WHAT ABOUT JAPAN?
I could call this section something else, but I figured it made more sense to explicitly reference the very first question I'm likely to get from stock market skeptics.
Yes, an investment in Japanese large cap stocks since 1989 hasn't made any money. But that's not an indictment against stocks, that's just evidence that you need to be diversified. Why? Consider other stocks in the Japanese market since 1990 (longest available data). The DFA Japan Large Value Index returned +3.9% per year. The DFA Japanese Small Cap Index +2.2%, and the DFA Japanese Small Cap Value Index returned +4.9% per year. OK, so these aren't double-digit results, but they're not zero either.
Of course, every other market in the world has also done fine over this period. To pick just a few asset classes - the S&P 500 returned +9.4% per year, the DFA US Small Value Index +14.5% a year, and the MSCI Emerging Markets Index +8.0% per year. So long as you were diversified, even if Japan was part of your portfolio, you've done fine since 1989. The DFA Equity Balanced Strategy Index, for example, did +11.3% per year since then.
But I'm going to go a step further than Japan and admit that other markets, namely our own, have also gone through long periods of sub-par returns. And this fact doesn't change the long-term case for stocks either. In the 1970s, the S&P 500 had a -1.5% per year return net of inflation, and -3.5% annually net of inflation from 2000-2009 (the "Lost Decade"). A bad omen for stocks you say? Nope, just a further warning to diversify. Over the same periods of time, the DFA Equity Balanced Strategy Index returned +6.0% and +8.4% per year, both in excess of inflation (+13.4% and +7.5% on a nominal basis).
You've probably heard the warnings to diversify your portfolio so much it's lost meaning. Armed with this information, however, hopefully that advice regains some meaning. Almost every scary story you've heard about stock market investing is actually a tale of under-diversification. That's never a sensible strategy.
WHEN THE WHEELS FALL OFF
So the long-term performance of stocks has been incredibly good. Diversifying broadly has increased that return to nose-bleed levels of return. And diversifying has also helped you sidestep a lot of the poor outcomes that have plagued small segments of the global stock market. But what about bear markets? Everyone lived through 2008, so we know stocks can go down 50%. How can a retiree tolerate that kind of loss and live to tell about it?
First, we need to acknowledge that bear markets happen. From 1973-1974, the S&P 500 lost 37.4% and the DFA Equity Balanced Strategy Index matched that. In 1990, the S&P 500 slipped 3% but the diversified DFA Index lost 14.2%. 2000-2002 was the rare bear market where stock diversification helped - the S&P 500 lost 37.6% and the diversified DFA Index lost only 5.1%. And of course, in 2008, the S&P 500 fell 37% and the diversified DFA Index lost even more, 41.6%. But I've just listed every serious decline on stocks in a half century in four sentences. Let's consider this for a moment. The DFA Equity Balanced Strategy returned almost 14% a year since 1970, and investors would have had to suffer through 7 negative years? Only three were double-digit negative returns? Does that seem to you like a particularly tough pill to swallow? I'd say that's more than a fair risk/return trade off.
But armed with the inevitable, we're also better prepared to deal with it. First, knowing that bad things sometimes happen, but that all economic and political wounds eventually heal, you should be in a better position to sit tight when stocks begin to crater. Dare I say remain optimistic? And if you're spending from your portfolio, you might also consider sticking a few years of future income in short-term bonds so that you can sell them to live on while you wait for your stock portfolio to recover.
How many of the 7 negative years since 1970 for stocks also saw short-term bonds decline? None. How many years since 1970 have short-term bonds declined at all? None. They're super safe, very liquid, and the logical alternative to spending stocks or dividends during temporary periods of market distress (and, of course, the long-term returns stink).
And knowing that bear markets only last a year or two (or three in the case of 2000-2002, although the DFA Index only lost money in 2002), having 4 or 5 years of future spending in short-term bonds more than covers you when things go bad. If you're retiring with $1M, and you need $40k per year (or $50k) to live on, $200k (or $250k) in short-term bonds should be sufficient to avoid having to sell stocks when they're down. Put the other $800K (or $750k) in a diversified stock portfolio and sit on your hands. By not having to sell stocks at inopportune times, you're assured to get the full long-term returns that they've earned. As I said before, those returns have been really good, are likely to stay good, though with inevitable setbacks, and are a huge benefit to retirees who wish to achieve a rising income stream over the course of their lifetimes and leave a significant legacy to the loved ones they'll one day leave behind.
Are stocks too risky for retirees? Not a chance.
Source of data: DFA Returns Web
DFA Equity Balanced Strategy Index = 20% S&P 500 Index, 20% DFA US Large Value Index, 10% DFA US Small Cap Index, 10% DFA US Small Value Index, 10% Wilshire REIT Index, 10% DFA Int'l Value Index, 5% DFA Int'l Small Cap Index, 5% DFA Int'l Small Value Index, 3% DFA Emerging Markets Index, 3% DFA Emerging Markets Value Index, 4% DFA Emerging Markets Small Cap Index. Rebalanced monthly. Allocation and performance provided by Dimensional Fund Advisors.
Past performance is not a guarantee of future results. Index performance shown includes reinvestment of dividends and other earnings but does not reflect the deduction of investment advisory fees or other expenses except where noted. This content is provided for informational purposes and is not to be construed as an offer, solicitation, recommendation or endorsement of any particular security, products, or services.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.