Over long time periods Stocks have historically been a superior investment to both Cash and Bonds. The average real return premium to Cash has been roughly 6.60% and 4.5% versus Bonds over 30-year rolling monthly periods (Source: Bob Shiller Data, Morningstar Direct, Capital Advisors Ltd. Calculations).
Additionally, the longer you hold Stocks the greater probability you have of generating a positive and more stable return. In the US, real (above inflation) Stock returns have at worst been 2% and tend to stay between 4% and 8% over 30-year rolling monthly periods (Source: Bob Shiller Data, Capital Advisors Ltd. Calculations. S&P 500 Nominal Total Return Values since 1871).
However, in order to obtain these returns, you need to stomach a lot of volatility:
- There is roughly a 30% chance in 1 year you will have a negative return and still roughly 10% after 5 years.
- Additionally, the amount you’re down can be large – nearly 70% after 1 year and -17% annualized over 5 year..
(Source: Bob Shiller Data, Capital Advisors Ltd. Calculations. S&P 500 Nominal Total Return Values; Rolling Monthly Periods since 1871)
The question thus becomes how do you balance the positive long-run return of Stocks with the high near-term volatility? The key being you don’t want to sell Stocks at depressed values as doing so would make it nearly impossible to recover those lost funds. An answer to that question can in part be quantified.
In order to quantify that value though, you need an understanding of how long it has taken Stocks to recover from those depressed values:
Source: Bob Shiller Data, Capital Advisors Ltd. Calculations. S&P 500 Nominal Total Return Values. Bear Market = 20% Decline in Average S&P 500 Monthly Values. Count = 7 Bear Markets. Ret = Return during those Bear Markets. Mos = Months the market was in drawdown during those Bear Markets. Recovery = Prior Peak to Return to That Peak.
- On average, Post World War II Stock values recovered from bear markets after 3.3 years.
- However, it has taken as long at 6.2 years for Stocks to recover.
- I should also note that there are 10-year negative periods for Stocks Post WWII; however, Stocks recovered to their prior peak before falling again.
- Lastly, if we include the Great Depression that recovery time increases to 15.3 years.
Using that data, we can then back into what % of the portfolio should be allocated to Stocks. This is best explained in an example:
- Your investment portfolio is worth $4,000,000
- You have total annual expenses of $250,000
- You have inflows from Social Security and a Pension of $50,000
- The portfolio also has an income yield of about 2.0% = $80,000
- Thus, the net principal you need to drawdown on your portfolio = $120,000 ($250,000 - $50,000 - $80,000)
- Let’s assume it will take the Stock market at most 7 years to recover, as noted in the recovery values above. The key again being we don’t want to sell Stocks for those 7 years while they are below their prior peak.
- So, if we take the $120,000 in principal needed multiplied by the 7 recovery years that is the amount in more stable assets (Cash and Bonds) you should keep so you can maintain your spending by selling those assets while Stocks are in a drawdown.
- $120,000 x 7 = $840,000 in Cash and Bonds = $3,160,000 ($4,000,000 - $840,000) or 80% of the portfolio to Stocks.
- Once the value of the Stocks recovers, we can then rebalance the portfolio to add more Cash and Bonds to replace what was depleted when the Stocks were in drawdown.
The key to the above is staying disciplined and not panicking while Stocks are in a drawdown and selling. Thus, if you’re more risk adverse you can add more to Cash and Bonds to potentially decrease your drawdowns and thus increase the probability you won’t panic in a Bear Market.
Regardless of your risk tolerance, quantifying your allocation to Stocks using historical data is likely a good starting point to help meet your long-term financial goals, weather downturns, and potentially increase the return on your assets over the long run.
The views and opinions expressed herein are those of the author(s) noted and may or may not represent the views of Capital Analysts or Lincoln Investment. The material presented is provided for informational purposes only. Nothing contained herein should be construed as a recommendation to buy or sell any securities.
Past performance is not indicative of future results. Investors cannot invest directly in an index. Investing involves risk, including the loss of principal.
The above example allocation is hypothetical and does not take into consideration your risk tolerance. Please talk to your financial advisor before deciding your allocation to Stocks.
S&P 500: The index measures the performance of 500 widely held stocks in the US equity market. Standard and Poor's chooses member companies for the index based on market size, liquidity and industry group representation. It is market capitalization-weighted.
Cash = 30 Day Treasury Bill (T-Bill) is a short-term debt obligation backed by the Treasury Dept. of the U.S. government with a maturity of 30 days.
Bonds = 10 Year Treasury Bond is an intermediate-term debt obligation backed by the Treasury Dept. of the U.S. government with a maturity of 10 years. A constant maturity index is used.
Price data (average monthly close) per Bob Shiller from 1871 to 1928. Price data (month-end close) after 1928 per Morningstar Direct. CAPE, Dividend (Total Return), and CPI (Real Return) per Bob Shiller and calculated by CAL.
REAL = real rate of return is the annual percentage return realized on an investment, which is adjusted for changes in prices due to inflation
There are some risks associated with investing in the stock markets: 1) Systematic risk - also known as market risk, this is the potential for the entire market to decline; 2) Unsystematic risk - the risk that any one stock may go down in value, independent of the stock market as a whole. This also incorporates business risk and event risk; and 3) Opportunity risk and liquidity risk.
Standard deviation is a statistical measure of the range of performance in which the total returns of an investment will fall. When an investment has a high standard deviation, the range of performance is very wide, indicating that there is a greater potential for volatility