Two of the most widely accepted principles of Personal Finance are pretty simple and are actually the foundation of most of the advices to live a rich life. You know them very well. But are they reliable?
But before we get there, let me tell you about a cartesian moment I had this week-end. Blame it on Houston heat, it feels like summer is here already, but during my post-breakfast self-reflection (ie. digestion), I had a doubt. Not as deep as doubting my own existence, but still.
My doubt: How much of the principles of Personal Finance should we accept, without challenging them?
I mean, experts have told us that there was no proof that cigarettes are related to lung cancers. Another type of experts told us that the housing market could never drop by 20%. Some cinematographic experts also claimed the last James Bond was the best movie of the franchise.
So, yeah, experts can be wrong too…
The Long Term View
These days, there are really 2 main principles in Personal Finance that govern much of the decisions we make.
Warren Buffett bet 1M$ that low cost index funds will beat hedge funds. He’s crushing them.
First, since you can’t beat the market, the smartest investment is tracking the market, at the lowest cost possible. If you can’t beat it, follow it, as close as possible. Jack Bogle and Warren Buffett have been the most prominent defenders of the idea, which explains the success of low cost indexing like Vanguard. It also explains why Warren Buffett is betting 1M$ that a low cost index fund tracking the S&P500 will beat a selection of hedge funds. So far, he’s crushing them. Mathematically, that makes so much sense, I can’t argue with that one.
(For more information on this bet, watch the Berkshire Hathaway shareholder Live Stream meeting and skip to 2:42:20)
The second, maybe less intuitive, but definitely more important, is that markets always go up in the long run. This is hugely important because it means that regardless of the amount of pain required to save up and invest today, we can trust that the future returns will be worth it. If that wasn’t true, the whole idea of investing falls apart.
In a way it makes a lot of sense.
As long as people consume stuff, as long as productivity increases, as long as we live longer, as long as the global population keeps growing and we all live in a market economy, there will be an ever growing market of people to buy stuff. Easy.
Does that mean we’ll all be golden if we keep our money invested for 30 years? Is 30 years long enough to guarantee large profits to fund my awesome retirement lifestyle? 20 years? 10 years?
How long is “in the long run”?
Up, Up and Sideways
One group of folks that would have felt really hurt with this premise are Japanese investors. As if this was a coincidence, this week is a perfect example.
On May 2nd 2016, the Japanese’s stock market index Nikkei closed at 16 147 points. It more than doubled in the recent years and it is now cooling down a little. But 30 years ago, on May 1st 1986, the same index closed at … 16 739, or 600 points higher.
Yes, that’s right. The Japanese equities market closed 3.5% below its level of 30 years ago. Look at that chart:
I really feel bad for the Japanese investors who invested in the stock market to prepare for their retirement. They surely had no idea the stock market would go sideways for 30 years, but after so many years of staying invested, it would have been reasonable to expect more than a 3.5% decrease.
Japan might be the most extreme case, but it isn’t the only one.
Take the UK’s FTSE index for example. Like most indices, it enjoyed a very successful 80s, 90s and peaked in 2000. The index is today at its 1999 level and has gone mostly sideways for the last 17 years.
The US Stock Market isn’t exempt from these droughts either. The returns since 2000 aren’t exactly stellar. Another example, in the 14 years between Nov 1968 and July 1982, the S&P500 progressed just 1%.
A recent study from The Economist summarizes it well:
As of February 2013, the longest period of negative real returns from US equities was 16 years. But it was 19 years for global equities (and 37 for world ex-US), 22 for Britain, 51 for Japan, 55 for Germany and 66 for France. Such periods are much longer than most small investors would have the patience to wait.
Key Take Aways
While it seems true that the stock market always goes up, in the long run, I think it’s important to realize how long that can be and add some caveats:
- Trusting that the market always goes up means accepting loooong periods of flat returns. Somewhere between 16-19 years for an internationally diversified portfolio, potentially much more for individual countries / markets. Ideally the prolonged period of low returns would be at the beginning of your investment journey. If you have a long time horizon of 20+ years, this should be less of an issue.
- Historically, the US stock market has performed better than international markets. But it could very well underperform in the future. Someone said that the only sure thing in finance is that ‘things tend to revert to the mean’. When an industry outperforms others, it tends to under perform later on. Diversifying a portfolio internationally with non-US stocks (developed countries, emerging countries) would help hedge bets.
- If you plan to retire on the 4% withdrawal rate, have plenty of buffer. If the stock market remains flat for 10 years instead of growing at 7-8% a year, the withdrawals would eat out the portfolio a lot quicker than planned. Who wants to go back to work once they are retired? Have plenty of buffer in your portfolio and have a backup plan.
- Diversify your asset classes. Stocks might be part of the portfolio, but other assets like bonds and real-estate could help smoothen the ride if the stock market were to go sideways for a prolonged period. Review your asset allocation and understand how much weight is placed on certain classes.
- Rebalance your portfolio. Stocks can be flat but other asset classes might not be. Since 2000, both stocks and bonds have evolved in different directions and this volatility can generate great returns with portfolio rebalancing. A regular portfolio review (eg. every 6 months) when your asset allocation is off (eg. +/- 5%) helps buying low and selling high, whichever asset is cheap/expensive. Thanks to our reader John for suggesting this!
It is tempting to see the last 16 years in the US market as a sort of stagnation, opening up to a bull rally as it’s done in previous periods. I personally don’t relate to this possibility and I think the market is more likely to correct. I however remain invested long term, especially with my oil & gas stocks, but I wouldn’t be surprised if the next few years aren’t returning much.
What about you?
- Are you invested in the long term and Why?
- Have you gone through a recession while you already had a large portfolio invested? How did that go?