Chapter 14

Toward a Better Theory of Risk

RISK CAN BE a temptress or a savage god. It beckons us to casinos or markets and sometimes provides us with amazing rewards that defy all odds. When we win, we often don’t pocket the money and walk away. Rather, we play on, too often giving back everything we’ve won and more.

History is replete with great generals who won repeatedly against staggering odds: think of Napoleon, Robert E. Lee, and Erwin Rommel. But the odds—that calculation that mixes the might of armies, the will of warriors, and the economic power of a nation’s industries—always came back one time too many and too powerfully and in the end overwhelmed them all. In the civilian world, the investment media feature interviews with money managers, analysts, and investment managers who have had a superb run of three months, one year, maybe even three years. Every word they utter, no matter how nonsensical, is taken as the new gospel—until the law of probabilities sinks their records and, as in vaudeville, the long hook comes out from the wings to pull them off the stage. New stars with similar spectacular short-term records replace them as the audience roars its approval. But the Great Show of defying risk goes on.

Most of us are more than a little ambivalent about risk. We love to see the underdogs triumph and repeatedly root for them, delighted when they upset the favorites, more so if an underdog is a team we like or bet on to win. But in markets we want none of that. We want to stay with the odds, the higher the better. The only objective, naturally, is to win. The trouble today is that with complex situations we often have difficulty determining what the odds really are.

It all seemed so simple under efficient markets. Mr. Risk, aka Mr. Volatility, was a real mensch. He told you exactly who he was and what he did, and for decades we loved him for telling us expressly how much risk we could take to fine-tune our portfolios as precisely as a violin virtuoso tunes his strings. We thought we had finally caged the risk devil that had run amok since the beginning of history.

But then things began to change. We are increasingly finding out in this new, more difficult investment world that Mr. Volatility is not the mensch he claimed to be. In fact, he began to seem more like a heavy, a wise guy who ordered investors around, threatening them when they asked why their returns weren’t what was promised if they followed his recommendations.

Let’s translate that into slightly more technical terms. As we’ve discussed, beta and other volatility measures were introduced as objective gauges of risk, promising no more messy, inaccurate human guesses, and beta in particular became the touchstone calculation of risk in efficient-market theory. That was all to the good, except for one small problem that became apparent from the long-term performance data of the stock market: greater (or lesser) volatility did not correlate with the actual returns. Mr. Volatility’s numbers just didn’t work. Oh, he was more than articulate, and he proposed an elegant theory that was so easy to understand that most investors happily anchored their portfolio strategies on it. But he encountered the same argument made by Thomas Huxley, who defended Charles Darwin’s theory of evolution against avid creationists more than 150 years ago. Huxley said back then of creationist thinking, “The great tragedy of Science [is]—the slaying of a beautiful hypothesis by an ugly fact.”

As if the data were not enough, we saw in chapter 2 that the untested economic theory of risk collides head-on with Affect research findings about risk behavior. Over a number of experiments, Affect research has found that risk and benefits are negatively correlated. Taking on higher risk results in lower, not higher, perceived benefits, and conversely, taking on less risk results in higher perceived rewards. These findings are the direct opposite of core EMH risk beliefs.

Finally, the headlong charge into aggressive stocks in mania after mania, stocks that were characterized as low risk but were actually highly volatile, certainly at least partially documents the validity of the recent findings in Affect research. From the beginning, then, this hypothesis of risk seemed unrealistic. And with time its problems only became larger. Once again, and from a surprising source, modern risk theory is being questioned.

Nonetheless, as we discussed, when the assertion that volatility is the best measure of risk couldn’t be proved, rather than giving up on the concept, its advocates started altering their calculations of volatility in the hope of finding a new correlation between the two. They continued to put forward new risk models, but, as we saw, none of them worked reliably, and at best the scientific methodology used was questionable. In the meantime we’re left with one of the most glaring problems of today’s investment world: that the risk analysis most investors rely on is . . . specious.

Toppling Stalin’s Statue

Most of us recall dozens of scenes of statues of Joseph Stalin being toppled throughout Eastern Europe after the Soviet Union collapsed in 1989. The smaller ones were knocked down by workingmen using ropes and chains, the larger ones with tractors or other heavy construction equipment. Russia’s future was unclear, but there was no turning back. As with the fall of communism, we must ask: if volatility is toppled, what will take its place? The essence of this chapter is to provide you with risk measures that will hold up under many differing circumstances.

Let’s start with some of the key elements that were ignored in the old risk paradigm. We’ll see the damage each of these has inflicted for hundreds of years, if not longer. More important, we’ll also see that much of the damage can be halted for both investors and the economy.

Yes, there is life after beta, and we can begin to put together some far better principles for today’s investor. Let’s start by looking at risk factors that, as we saw, caused significant damage to our portfolios in recent decades but have on the whole been ignored by investors to the present time.

Liquidity: The First Horseman of the Financial Apocalypse

To begin, we’ll look at one of the most serious risks contemporary investors face: the improper understanding and treatment of liquidity. In chapter 5, we examined in some detail the major role the almost absolute lack of liquidity played in three major crashes, driving illiquid stocks and futures down sharply lower and resulting in market panics.

The lack of liquidity is anything but a new risk; it’s probably been around since the birth of markets. Just the whisper of a lack of liquidity in the nineteenth century in England and other countries was enough to make depositors rush to withdraw their funds from banks, often sending the banks into insolvency. And of course we’ve all read about the bank holiday of 1933, with the long lines of depositors, waiting to withdraw whatever money they still could.

The damage that lack of liquidity can cause, of course, extends well beyond banks. A recent example is loans to housing and real estate companies in the past few years. Because a good part of the credit received by home builders and other real estate companies is originated by banks or other commercial lenders, if loan levels are cut sharply or not renewed, the borrower is often in an impossible situation. He can either try to dispose of his inventory, at fire-sale prices, or, if prices have dropped dramatically, go into Chapter 11 bankruptcy or make a deal with a bank that is not much better. The same situation has also occurred in the past year with some commercial property loans.

Throughout 2007–2009, U.S. companies, particularly those with less than a hundred employees, where most jobs are created, were plagued by the problem both of not being able to hire because bank capital was unavailable for expansion and of being forced to cut back operations because they could not get the credit they had always relied on. Lack of liquidity, then, is far more than a subprime problem, although the subprime crisis magnified its effects immensely; it is an ongoing problem even for safer and healthier companies.

The damage we are primarily concerned with in this section occurs in periods of abundant monetary availability. In such periods banks and other financial institutions ease their lending standards significantly. The lending standards on subprime mortgages, as we now know, were wretched. Hedge funds and other lenders were supplied with large amounts of leverage on loans of very poor quality, and the lenders, at best, made cursory examinations of the toxic mortgages they were lending against.

We’ve seen this also with commercial real estate in periods of booming prices, such as the late 1980s and early 1990s, when bankers failed to adequately scrutinize the economics of major projects. Builders were given up to 105 percent of the cost of a project because of the intense competition by banks to issue these loans. Such real estate bubbles have occurred almost once a decade since the 1960s.

Their endings have all been remarkably similar: At some point the banks and other financial institutions woke up to the fact that projects would not be nearly as profitable as originally projected. Worse, they were highly illiquid, as nobody wanted to touch them except at a huge discount, and the borrower was often completely illiquid, as in the case of Donald Trump circa 1992. Financial institutions were stuck big-time as in the bank crisis of the late 1980s to early 1990s; President George H. W. Bush organized the Resolution Trust Corp. to take over insolvent banks and thrifts and raised capital for some struggling institutions. Bank stocks tumbled as much as 50 to 60 percent on the dollar, and the real estate market crashed.

With the repeal of the Glass-Steagall Act in November 1999, which resulted in far more liberal bank lending, the illiquidity problems began to become significantly worse. Yet most banks and many other classes of professional investors completely dismiss this serious threat from their risk screens.

Liquidity Does Not Beget Liquidity

As we’ve discussed, liquidity played the crowning role in the 1987 crash. A serious but little realized problem is that liquidity can vary sharply with changing market conditions. The efficient-market hypothesis assumes that “liquidity begets liquidity,” meaning that as prices fall, swarms of buyers will appear. However, there is no proof that this has ever been accurate, but a good deal of evidence that in periods of severe strain, liquidity dries up, in the face of sharp drops in price. Recall that this occurred with S&P 500 futures markets during the 1987 crash. Still, this untested EMH assumption is held as a cardinal principle of markets, even after the crashes we have discussed. Other crashes, as well as the flash crash of 2010 and the July–August/September 2011 panic, also clearly showed that liquidity does not beget liquidity. Quite the opposite: as a result of rapid downward movements in stock or index futures, liquidity can decrease sharply and, in worst-case situations, dry up almost completely, significantly increasing the magnitude of the downturn, as the above examples demonstrated. A new Psychological Guideline should prove helpful here.

 

PSYCHOLOGICAL GUIDELINE 28(a): Liquidity does not increase as stocks fall sharply; quite the opposite. In rapidly falling markets, liquidity can decrease significantly; the less liquid a stock or other financial instrument, the greater the negative effect this will have on its price.

PSYCHOLOGICAL GUIDELINE 28(b): Increasing liquidity normally occurs in rapidly rising stocks or other financial vehicles in a sharply rising market.

Leverage: The Second Horseman of the Financial Apocalypse

Leverage is on a par with liquidity for the damage it can render. High margin by itself has been a major cause of crashes. Like liquidity, leverage is difficult to handle because of the similarity of interactions with Affect and other psychological forces. As we have seen, when the two work in tandem, as was the case in the 1987 crash, in that of 2007–2008, and with Long-Term Capital Management, the results are disastrous. As Psychological Guideline 29 warns, leverage is a risk that the conservative investor should avoid.

A point worth repeating on leverage: buying the S&P 500 and other financial futures requires significantly less margin than buying the stocks themselves (7 percent initial margin on hedging S&P 500 futures positions versus 50 percent margin on S&P stocks). This is less than the 10 percent margin allowed in 1929, cited by Congress as a major factor in that crash. In fact, in 1934 Congress allowed the Federal Reserve to set margins on stocks. Since that time, margin requirements have been set by the Fed, from 50 percent to as high as 100 percent of stock purchases. Allowing the Chicago Mercantile Exchanges and other exchanges to set futures margins as low as 7 percent—5 percent prior to the 1987 crash—has encouraged both greater speculation and more volatility in markets, as shown by both the 1987 crash and the flash crash.

Liquidity and Leverage: A Deadly Combination

We are not likely to soon forget the financial panic of 2007–2008, in which liquidity and leverage played a major role in almost annihilating financial markets in the worst credit crisis in modern history. The combination of high leverage and enormous illiquidity almost wiped out the financial system. Leverage also played a major hand, working in tandem with the lack of liquidity, in crashes from 1929 through 1987.

HOW CAN YOU PROTECT YOURSELF AGAINST ILLIQUIDITY PROBLEMS?

Because of the numerous forms of illiquidity, there is, unfortunately, no catchall answer. In a crash, there’s not much you can do but ride it out. Normally stocks come back fairly quickly, when it is realized that the crash was liquidity-driven. This happened with the 1987 crash, when stocks regained virtually all of their liquidity-driven losses in a little over one year, and in the flash crash last year, when stocks gained back most of the losses the same day and the entire amount in a matter of months. In a liquidity-driven market crash, do not sell your stocks.

HOW CAN YOU DEAL WITH LIQUIDITY AND LEVERAGE?

Unfortunately, both liquidity and leverage are very tempting in rising markets and hard to resist, particularly if credit is easy. The more we like an illiquid stock or bond or a group of them and the better the returns, the greater the temptation to buy additional amounts, using more leverage to enhance the upside. Both using too much leverage and having too little liquidity seem to be by-products of strong positive Affect. It is almost like a psychological addiction for many thousands of investors, including hedge funds, banks, and investment banks.

The only way to defend against the liquidity and leverage problem is to strictly limit your leverage and your ownership of securities that are not liquid, particularly if the latter are in the same sector of the market. For most people it is a good idea to go cold turkey. A Psychological Guideline as good now as it was in the 1920s is:

 

PSYCHOLOGICAL GUIDELINE 29: The prudent investor should stay away from leverage or margin and hold only a small part of his or her portfolio in illiquid securities.

Following are some booby traps to avoid.

1. If you do decide to use futures, make sure you don’t get in over your head. First decide how much stock you want to buy or sell. If, say, it is $20,000, and the smallest contract available is $200,000, run for the exit or you will have to buy ten times the amount you actually want. You’ll be surprised at how many people sink themselves by not following this simple rule.

2. Be careful of packaged concept products, complex mortgages, and other intricate offerings by hedge funds, investment banks, or banks. They normally get big markups on these structured deals, which are often partnerships. Liquidity is notably poor in most cases. And their record is usually not good. Ask the banker or broker how much his firm intends to keep invested in each over time. Don’t be surprised if the answer is a touch evasive.

These products have a common denominator. They are almost all intriguing concepts that, you will be told, should earn higher returns. I never buy them because the fees are much higher than stock commissions, sometimes going up to 20 percent of profits with ample annual charges on top. More important, I don’t have a warm, fuzzy feeling that these deals will work out well. I’d advise you to stay well away unless you like financial products with no record, no liquidity, and high fees. Strangely enough, a lot of investors with a pretty high net worth latch onto these products. Hopefully you will not.

3. Tread cautiously when you buy little-traded issues either on your own or in a secondary offering. You can again run into liquidity problems that often cost. Make sure that when you buy there are at least a few market makers, and don’t take positions above a few percentage points of the daily trading volume.

4. Stay away from exotic derivatives such as European puts and calls written on U.S. stocks, often by a U.S. broker. These are normally both more expensive than trading derivatives on a U.S. exchange and far less liquid to sell if you decide to.

5. If you don’t understand a bond or a hedge fund, or any other security—don’t buy it. Forget the yield, no matter how alluring, and protect your principal; better opportunities will come that you will understand, and probably sooner than you think. Remember, the buyers of the subprime AAA and AA bonds lost as much as 70 cents on the dollar. That’s a heck of a lot to lose only to collect maybe an extra 2 to 3 percent a year in yield when the going is good.

Other Risk Factors

When the efficient-market risk theory put its focus exclusively on volatility, doing so wiped out important guidelines that had been followed for risk analysis for centuries. Prudent security analysis on risk, much of it codified by Graham and Dodd and other leading financial theorists, was cast aside or else not looked at carefully, because it wasn’t all that important, according to EMH believers. Why bother? they thought. It was all factored into volatility anyway.

We must now resuscitate those established principles of risk assessment, which are far more useful in determining many types of risk that volatility completely bypasses, including:

1. Lack of liquidity

2. Excessive leverage

3. Bond risk-control techniques

4. Stock risk-control techniques

It’s beyond the scope of this book to go through the lengthy list of stock and bond risk control measures. Many are presented in Graham and Dodd’s Security Analysis (6th edition, 2008) and other good books on the subject that can provide you with the fundamentals you need. The principles are very important and haven’t changed significantly over recent decades.

Next we’ll look at a new set of new risk factors that we should pay special attention to in the years ahead.

The Third Horseman of the Financial Apocalypse: Inflation

Let’s start this section with a quick review of the history of some of the risks out there and how they can destroy the unwary. Frank H. Knight, one of the cofounders of the Chicago School of Economics, in his seminal work Risk, Uncertainty, and Profit (1921),1 stated that there is a major difference between risk and uncertainty. Risk, according to him, was “a quantity susceptible of measurement,” while uncertainty is not capable of being measured.

By his definition risk applies to many types of gambling games, horse racing, betting on baseball and football, and many other activities—anything where the risks can be calculated. Uncertainty applies to situations where the gains or losses are indeterminate either on the upside or on the downside, such as the value of stocks in a revolutionary period, shorting futures or derivatives positions and leverage on real estate, or scores of similar situations.

By far the most dangerous new risk over the past sixty years has been inflation, which can attack our savings in many ways. In the past we did not focus on inflation, as rising prices have been pretty much a nonevent for centuries, with only a few flare-ups such as those during the Revolutionary War and the Civil War in this country and similar periods abroad. Inflation was a minuscule one-tenth of 1 percent from 1802 to 1870 and six-tenths of 1 percent from 1871 to 1925.2

When all major nations were on the gold standard, most government and many corporate bonds could be redeemed in either the national currency or gold at maturity at the holder’s option. Given that inflation was almost nil, the “prudent-man” rule was introduced by Justice Samuel Putnam of the Massachusetts Supreme Court in 1830 and has served as an important guideline for money management for 150 years. A prudent man did not speculate, according to Putnam, who directed trustees “to observe how men of prudence, discretion and intelligence manage their own affairs” and act accordingly. So it made the best sense to stay in bonds with a number of preferred shares and a sprinkling of blue-chip stocks.3

But risk is a cunning beast, and inflation is a major weapon it unleashes against our capital, stealthily sneaking through our defenses time and again. Inflation caught investors following Justice Putnam’s prudent-man edict flatfooted after World War II. Anyone who had put $100,000 into bonds at the end of that war would have $280,000 in 1946 purchasing power left today.4 However, that’s before income taxes, which averaged 60 percent between 1946 and 2010. After those two horsemen of the Financial Apocalypse—inflation and taxes—trampled over the bonds, investors or their estates who paid income tax in the top bracket would have had only 27 percent of their original 1946 purchasing power remaining in 2010.

The law is often decades behind economic and financial changes, and many investors and their managers still continue to believe in and follow Putnam’s seriously outdated principle, which was appropriate in his time. The truth is that following the prudent-man rule, which had worked so well for so long, devastated the savings of many millions of Americans after World War II. Risk, this time in the form of rapidly rising prices, leaped from the heart of Justice Putnam’s well-designed law to protect people’s capital and is now one of the greatest dangers investors have faced and will continue to face in the twenty-first century.

Let’s next turn to how we can best handle risk in the stock and bond markets.

Beyond the Prudent-Man Rule

Inflation permanently entered the investment environment for the first time after World War II. Nothing is safe from this virulent virus, although its major victims are the supposedly safest investments we own: savings accounts, T-bills, Treasuries, corporate bonds, and other types of fixed-income securities. Whereas a relatively small number of companies may flounder financially or go under in any normal period*80 and far more in a financial crisis such as we are currently moving through, the risk of inflation for most investors has proved more costly over time than credit risk. Rising prices after World War II have radically and completely altered the return distributions of stocks, bonds, and T-bills.

Are Stocks Riskier?

The wisdom of the ages, as we have seen from Justice Putnam’s prudent-man rule, has always been that bonds are less risky than stocks over time. A company’s bondholders, after all, had far less financial risk than the shareholders. If a company ran into financial problems, it could cut its dividend to shareholders, but it had to maintain interest payments and repay the bond principal when it was due. Otherwise, the company would go into default and the creditors would take everything the company owned before the shareholders got a penny. In the pre–World War II period, the major risk investors had to face was financial: the risk that a bond or a company would go under. The risk of inflation was an insignificant concern at that time.

The rapid inflation of the postwar period has turned all risk calculations topsy-turvy. While stocks have always had higher returns than Treasury bills or bonds over time, the disparities among the three classes of financial investment widened enormously after 1945. If an investor put $100,000 into T-bills in 1946, after inflation it would have increased to only $133,000 by 2010, a gain of only four-tenths of 1 percent annually. At that rate it would have taken about 160 years to double his capital. Bonds did only slightly better; $100,000 in 1946 became $280,000 by the end of 2010, for a return of 1.6 percent annually.*81 By comparison, investing $100,000 in stocks in 1946 hit the jackpot. It became $6,025,000, forty-five times as much as T-bills and twenty-one times as much as bonds (before-tax figures). After taxes the relative return for stocks over bonds and T-bills widens considerably, as both of the latter two categories have significant negative yields over time.

We see, then, that since World War II, inflation and taxes have taken an enormous toll on T-bills, Treasury bonds, savings accounts, and corporate debt. Yet few investors put the major outperformance of stocks over debt securities into their risk calculations even in normal times. In spite of the far superior returns over the past sixty-five years, capital to the time of this writing (September 2011) is still flowing out of stocks and mutual funds into Treasuries, yielding only one-twentieth of 1 percent on the very short end to 1.9 percent on ten-year Treasury bonds and 2.9 percent on thirty-year Treasury bonds. In the final chapter we will look at why these flows into bonds and T-bills may prove disastrous.

Transforming Risk into Odds You’ll Like

Table 14-1 shows the inflation-adjusted returns of stocks, bonds, and T-bills for periods of one to thirty years since 1946. As the table demonstrates, the longer the holding period, the greater the difference in the returns of stocks, on the one hand, and bonds and T-bills, on the other. The first row in column 1 shows that stocks provided a 6.5 percent annual return after inflation, on average, over the entire 1946–2010 period. At the end of five years, capital invested in stocks increased an average of 37.1 percent, after ten years an average of 87.9 percent, and after thirty more than sixfold. With Treasuries and T-bills, the rate of increase moved up at almost a snail’s pace. After ten years, bonds (column 2), after inflation, expand initial capital by 17.2 percent, after thirty years by only 61 percent. The rate of increase for T-bills is lower yet (column 3). After a decade, capital, adjusted for inflation, would have increased by 4.5 percent, after two decades by 9.2 percent.

“That’s well and good,” you might say, “but stocks fluctuate. What are the odds that stocks will outperform bonds or T-bills over various periods of time?” Good question. It is one thing to see that stocks outperform over time, but, as John Maynard Keynes once remarked, “In the long term, we’re all dead.” How, then, do they perform for somewhat shorter periods, while we can still enjoy spending the gains?

Column 5 shows the percentages by which stocks beat bonds for periods varying from one to thirty years, and column 6 provides the same information for T-bills. As you can see, it’s a slam dunk for stocks after four years on average. Holding stocks, you have a 73 percent chance of doing better than bonds after inflation on average and a 77 percent shot at outperforming T-bills after forty-eight months, moving up progressively to a 94 percent chance at outperforming bonds and an 88 percent chance of beating T-bills in fifteen years. Beyond fifteen years, the odds favoring stocks surge to almost 100 percent against both bonds and T-bills. For longer periods, stocks are clearly the least risky of these three categories of investments.

Let’s look at how stocks and bonds have performed over other periods in the past. Table 14-2 shows the probabilities of stocks outperforming bonds and Treasury bills after inflation over different intervals between 1802 and 2010. Three periods are analyzed, 1802–1870, 1871–1945, and 1946–2010. In each period the probability of stocks outperforming bonds, stocks beating T-bills, and bonds beating T-bills is measured from one to thirty years. The table shows that the probabilities of stocks outperforming bonds or T-bills increase with time. More important, the odds were higher for the outperformance of stocks over Treasuries and T-bills for any period from one to twenty years in the post–World War II period than in the previous 145 years.

For five years the probability of stocks beating Treasury bonds rose from 65 percent in the two earlier periods to 74 percent after World War II. In the 1946–2010 period, stocks had a 100 percent chance of outperforming T-bills for all twenty-year periods. Stocks had an 87 percent chance of beating T-bills after twenty years over the 1802–1870 period; the chance increased to 99 percent for the 1871–1945 time span.

But wait—there is more.

Taxes: The Fourth Horseman of the Financial Apocalypse

Enter the fourth horseman of the Financial Apocalypse—taxes, riding down the owners of bonds and T-bills, and other fixed-income issues. Table 14-3 is identical in format to Table 14-1 but shows the returns after both inflation and taxes for stocks, bonds, and T-bills for periods of one to thirty years through the postwar period using the average top federal income tax rate of 60 percent between 1946 and 2010 over the entire period.*82 Stocks compound at 4.4 percent annually, adjusted for inflation and taxes. In ten years investors would have increased their capital by more than 53 percent, in twenty years by 135 percent. As Table 14-3 also shows, the returns on fixed-income securities after taxes drop even more dramatically. For all their allure, buying long-term government bonds is about as safe and profitable as having been heavily margined in stocks just before October 24, 1929. If an investor in a 60 percent tax bracket had put $100,000 into long Treasury bonds after World War II, he would have had only $27,000 of his original purchasing power left in 2010. That’s right, inflation and taxes would have eaten up 73 percent of the investment.5

The results are equally bad for T-bills, and being in a lower tax bracket doesn’t help the T-bill or Treasury bond buyer much. Finally, had the investor put $100,000 into blue-chip stocks, the supposedly “riskiest” investment, with the same 60 percent tax rate after inflation, the portfolio would have appreciated to $1.6 million over the sixty-five-year period. The capital invested in equities would be worth fifty-seven times as much as if placed in bonds.

With bonds or T-bills, it’s a dirge. The longer you hold them, the louder the organ plays. After ten years, both will cost you about 20 percent of your capital after inflation and taxes; after twenty years, about 35 percent; and so it goes. The last two columns again demonstrate the probabilities of stocks outperforming bonds and T-bills for periods of one to thirty years. After four years, there is better than an 80 percent chance that stocks will outperform bonds and T-bills, and the chance builds up significantly with time. By fifteen years, the chance is nearly 100 percent that you’ll do better in stocks than in government bonds and 98 percent that you’ll do better than T-bills. Investing in government securities, then, considered by most people to be almost “riskless,” is a loser’s game.

Common stocks, as Tables 14-1 and 14-3 indicate, though a more volatile asset in any short period of time, provide much higher returns than T-bills and bonds over longer periods.

Is There Something Wrong with This Picture?

As we’ve seen, the starting point of modern portfolio theory is the return an investor receives on a “riskless” asset, normally a Treasury bill. The investor then merrily selects a portfolio made up of risk-free and riskier assets, measured by their volatility, to get the optimum mix. The trouble is that the “risk-free asset” of the academic theory, the T-bill, is one of the riskiest assets over time.

It’s apparent that this assumption of academic investment theory is far removed from reality. Rational investors should be concerned with the probability of maintaining and enhancing their savings, adjusted for inflation and taxes, for retirement or other future needs. This is one of the greatest risks they face. The time horizon of the large majority of investors is not months, quarters, or a year or two away. It is many years away, because the need for funds to meet costs such as retirement, college tuition, and similar requirements usually far off in the future. After all, that is why the government set up tax-deferred pension funds, IRAs, and similar programs, which tens of millions of investors participate in. The investment objective for most people is to maximize savings as safely as possible for the time when they will need to draw on them.

The major risk is not the short-term stock-price volatility measurements, which have been shown to be specious. Rather, it is the possibility of not reaching your long-term investment goal through the growth of your funds in real terms. It is counterproductive for investors with investing time horizons of thirty, twenty, ten, or even five years to focus on short-term fluctuations. Shorter-term volatility measurements provide an illusion of safety while derailing the higher returns that are provided by holding equity or equity-equivalent products (real estate, housing, better-grade private-equity investments, and so on) over time. This leads to another important Psychological Guideline.

 

PSYCHOLOGICAL GUIDELINE 30 (a): To invest successfully over time, risk measurements should be established using longer-term rates of return for stocks, bonds, T-bills, and other investments. The performance benchmark should be appropriate for the time period the investments are anticipated to be held.

PSYCHOLOGICAL GUIDELINE 30 (b): Using short-term risk measurements as benchmarks for longer-term capital performance is likely to result in a significant shortfall in an investor’s returns. It is one of the most serious risks investors can take today.

The Treacherous T-Bill

Stocks may blow away T-bills and bonds over time, but, as we have seen, the focus of most investors, fiduciaries, and courts is still on shorter-term financial risk. The far more potent and universal risk of inflation and taxes is a secondary consideration at best. Academic risk theory also accepts the conventional wisdom by making the T-bill the risk-free investment. But financial academics, like most market participants, have not incorporated into their equations the fact that the largest risk factor today is the decrease in purchasing power of your investment through inflation.

When we adjust for inflation, supposedly risky assets such as stocks become far safer. The probability that investors holding stocks will double their capital every ten years after inflation and quadruple it every twenty, combined with the 100 percent chance that they will outperform T-bills and the 98 percent chance that they will outperform government bonds in twenty years, can hardly be called risky.*83 Conversely, the supposedly “risk-free” assets actually display a large and increasing element of risk over time. For that reason we must incorporate into a new definition of risk the effects of higher inflation on investors in recent decades, including contemporary markets, along with the other types of risk inherent in these investments.

A Better Way of Measuring Risk

What, then, is a better way of measuring your investment risk? While there can be many definitions, even in the business and investment worlds, a good starting point is the preservation and enhancement of your purchasing power in real terms. The goal of investing is to protect and increase your portfolio on an inflation-adjusted basis and (where appropriate) tax-adjusted dollars over time.

A realistic definition of risk recognizes the potential loss of capital through inflation and taxes and includes at least the following two factors:

1. The probability that the investments you choose will preserve your capital over the time you intend to invest your funds.

2. The probability that the investments you select will outperform alternative investments for the period.

Unlike the academic volatility measures, these risk measures look to the appropriate time period in the future—five, ten, fifteen, twenty, or thirty years—when the funds will be required. Market risk may be severe over a period of months or even a few years, but, as we have seen, it diminishes rapidly over longer periods.

Tables 14-1, 14-2, and 14-3 tell us how stocks stack up against bonds and T-bills after inflation and taxes and the probability that stocks will outperform them in any period of time. The careful reader might ask another question here: “Okay, I know the odds of stocks beating bonds and T-bills are increasingly high over time, but stocks have very good periods followed by years of lackluster results. What are my chances of capturing returns above those provided by bonds or T-bills?”

The answer is provided in Tables 14-4 and 14-5. Table 14-4 shows the probability of receiving stock returns as low as 50 percent of the average return for stocks in the postwar period (column 2) to as high as 150 percent of the average return (column 6) after inflation. The probability of returns above these levels is shown for periods of one to thirty years.

Table 14-4, column 1, shows the total portfolio value, or wealth relative, in academic jargon, for every period from one to thirty years, if you earned only 50 percent of the average return for stocks for each period through the 1946–2010 study, after inflation. This is a very severe worst-case situation, as will be explained shortly. Column 2 indicates what your probabilities are of earning more than 50 percent of the average return for any period between 1946 and 2010. The probabilities, with minor exceptions, of earning more than half the market return increase with time. Thus, holding a portfolio with a starting value of 100 in the first year, you have a 62 percent probability or better of returning above 3 percent (103, column 1) at the end of one year. After ten years, the portfolio has a 73 percent probability (column 2) of increasing more than 38 percent (138 in column 1); after twenty-five years, it has a 93 percent probability of returning 123 percent above your investment (223 in column 1). So cutting the market return by half, which has happened only several times in our market history during the Great Depression, still provides significant stock returns over time.

Next look at columns 7 and 8, which show the cumulative returns of bonds and T-bills. You can see that even if you receive only 50 percent of the stock market’s average return, you still do much better in stocks than in either bonds or T-bills for any given period. Again, this is a doomsday scenario, as the chance of making only 50 percent of the normal market return is near zero when you invest for as long as twenty-five years. You have a 93 percent (column 2) chance of doing better. But worst case or no, you still do better in equities than in T-bills or bonds.

As you increase the number of years you hold stocks versus debt securities, the comparisons only get better. If you receive the market return over time, as we saw before, you score big; after fifteen years your portfolio would appreciate 157 percent, or six times as much as in bonds and over twenty-two times as much as in T-bills. After twenty-five years, your net worth would be three times what it would be in bonds and over four times that of T-bills, and so on. Not that you need to strike it rich with the types of returns we have just seen, but there is also a reasonable probability that your return can be above-market averages. If you return 150 percent of the market, as column 5 indicates, the returns bury those for bonds and T-bills. In this happy situation the investor receives almost eleven times the return he would on bonds in fifteen years and about fifteen times in twenty years.

There you have it. Once again, stocks provide higher rewards over time than bonds or T-bills even under poor circumstances and shoot out the lights under better conditions. The decision of where to place your money should not be difficult.

Introducing taxes in Table 14-5 (which is set up in an identical manner to Table 14-4) of course reduces the absolute returns for stocks but will reduce them significantly more for bonds and T-bills. Again, as the time periods increase, stocks substantially outperform bonds and T-bills under all the scenarios.6

Looking first at the average market return (column 3), we see that stocks outperform bonds (column 7) for ten years by 71 percent, with a 64 percent probability that stock returns will be higher. After inflation and taxes, bonds actually lose purchasing power.

T-bills do even worse over the same period. Over time, the increase in capital invested on $100,000 in stocks rather than bonds increases dramatically. In ten years, your investment is almost 90 percent ahead; in twenty-five years it is almost four times as much. In the interim, both bonds and T-bills have lost over 40 percent of their original purchasing power.

Last, let’s take a brief peak at what could happen to stocks if they outperform their long-term rates of return for a decade. Most investors believe this is very unlikely today, but a few, including myself, for reasons presented in the final chapter, believe it is a distinct possibility. If this impossible dream were to come true, your capital would increase by 89 percent in a decade, 159 percent in fifteen years.

Toward a Better Analysis of Risk

The evidence indicates that in the post–World War II inflationary environment, bonds and T-bills are no match for equity-type investments over time. I have tried to answer the question of how much risk there is in holding stocks instead of bonds and T-bills in two ways. First, I asked how often stocks would outperform T-bills or government bonds after inflation for periods varying from one to thirty years in the postwar period in Table 14-1 and after inflation and taxes in Table 14-3. We saw that stocks won in a breeze in both cases; the longer the time period, the more they outperformed. The probability that T-bills or bonds would provide inferior returns relative to stocks is large and increases after three to five years.

Second, I examined the risk of owning stocks if their returns dropped off sharply from their long-term norms in Tables 14-4 and 14-5. Once again, even if this happened (if, for example, stocks provided only 50 percent of their normal return over time), they still outperformed debt instruments by a significant amount after five years and by a more moderate amount up to five years.

Let’s now go back to the two measures we said should be incorporated into a good definition of risk:

1. The probability that the investment you choose will preserve your capital over the time you intend to invest your funds

2. The probability that the investments you select will outperform alternative investments for this period

The conclusion is obvious: stocks meet both these criteria. If we applay this standard of risk in the postwar period, stocks are the least risky investments over time. If you are in your thirties, for example, and have a goal of retiring at sixty-five, you should buy blue-chip stocks because you have a 100 percent chance of both enhancing your capital and outperforming bonds and T-bills. The probabilities are also high that you will outperform debt securities many times over. Though not as high, the odds are still very high for fifteen years and reasonably good at four or five years. From a risk perspective, bonds and T-bills give you increasingly short odds after only a few years. They are not the investments you want to build your future upon and have not been for almost sixty-five years.

What we see, then, is the development of a new approach to risk analysis that tries, before funds are invested, to more realistically appraise the risk of holding various types of investments over the time the investor might need. The analysis allows you to determine not only the odds that your returns will outperform or underperform other types of investments but also the probability of by how much. This risk measurement framework could also be adapted to valuing real estate, precious metals, or other investments, if you have the records of their performance over longer periods. If you choose to measure how you might do in Impressionist art, other art, or collectibles relative to equities, as an example, there is an index dating back to the 1960s from Sotheby’s, which Barron’s reports each week.

While this approach to risk can certainly be fine-tuned, it allows you to more accurately assess your exposures in the postwar investment world, one very different from any investment environment in the past.

What we’ve clearly seen from the tables is that since 1945 we have entered a new world of investing. Inflation and higher taxes have an immediate and lasting effect on holders of fixed-income securities.*84 This situation did not reduce stock returns in the early postwar years but actually saw them increase because of rapidly rising stock prices and dividends. From the middle of 1949 to the end of 1961, the Dow rose 355 percent.

In summary, then, there is a very important lesson about risk to learn from these events, which we’ll make an investment Psychological Guideline.

 

PSYCHOLOGICAL GUIDELINE 31: There has been a permanent shift in the structure of risk because of higher inflation and taxes that strongly favors equity investments, real estate and housing, and other investments that benefit from it, and puts bond and other fixed income at a major disadvantage over time.

This change, as noted, has been going on for well over sixty years, but because psychologically we focus on much shorter time periods, it is hard to react to the current dynamics of risk.

Second, because stock performance is volatile, we don’t pick up the full scope of this sea change in risk psychologically, even though many of us know that inflation affects stock prices positively over time. As a result, many people don’t see the conclusions clearly. Let’s also make this a Psychological Guideline:

 

PSYCHOLOGICAL GUIDELINE 32: The changed economic environment unambiguously indicates that the longer we hold equities or other investments that outperform inflation, the better off we will be financially over time.

The findings almost jump out of the tables in this chapter.

A further Psychological Guideline is in order here.

 

PSYCHOLOGICAL GUIDELINE 33(a): Try to ignore near-term market fluctuations; if you intend to be invested for a five-year or longer period, the true risk is in not owning stocks or similar investments that appreciate faster than the rate of inflation over time.

PSYCHOLOGICAL GUIDELINE 33(b): Unless yields are very high, don’t consider bonds, savings accounts, or other low-interest fixed-income securities as longer-term investments. They are high-risk vehicles with the odds heavily against them; the longer they’re held, the greater the risk. Consider them only as a repository of cash for short- to intermediate-term needs.

Although the tables make this crystal clear, conventional wisdom changes all too slowly.

Professor Knight’s distinction between risk and uncertainty holds a very important lesson for us here. The performance of the stock and bond markets is uncertain for any short period of time. But over time the uncertainty turns into risk. Risk is our friend if the odds are heavily in our favor, as they are with stocks. What we must remember is that for stocks and similar investments, risk turns into an increasingly high probability of winning over time.*85

Focusing on short-term periods, rather than the period the capital is intended to be held, will result in subpar returns. The investor should focus optimally on the time for which the stock portfolio is likely to be held, rather than on its short-term volatility.

The following Psychological Guideline encapsulates these findings.

 

PSYCHOLOGICAL GUIDELINE 34(a): Inflation and taxes sharply reduce your risk in owning stocks over longer periods of time.

PSYCHOLOGICAL GUIDELINE 34(b): Inflation and taxes sharply increase your risk in owning Treasuries, other bonds, and savings accounts over longer periods of time.

Richard Thaler of the University of Chicago, one of the pioneers of behavioral finance, once told me he wished that stock quotes were not published every day. His reason was that overexposure, particularly in bad times, precipitates hasty and often foolish decisions. If people treated stocks like real estate, where they can’t get a quote every day, they’d be far better off. Thaler was right. If we could clearly focus on the long-term probabilities and not be thrown off course, sometimes badly, by month-to-month or year-to-year events, we would all very likely be much better off.

These results are something to ponder carefully, especially as our final section will try to do a little crystal-ball gazing and reasonably project what is likely to lie ahead for investors. Notice that I’ve said “reasonably.” This is still a world of surprises, and the last thing I ever want any investor to do is to think that the future is a settled bet.