Are Stocks Still Good for the Long Run?

Stocks, we have been told again and again through the years, are the best long-term investment. Prices go up and they go down, but give stocks enough time and they deliver returns that trounce those of bonds, real estate, commodities or any other asset class.

Ha! you say. Have you checked your 401(k) balance lately? Since the beginning of this decade, the stock market has been a money pit. At the market’s nadir in early March, stock investors had lost more than 50% since March 2000, if you factored in inflation. Things have improved since then–to a mere 40% loss.

So can stocks possibly still be the best long-run investment? Somewhat surprisingly, the answer turns out to hinge on what you mean by best and what you mean by long-run. The investment part actually remains pretty cut and dried. Over the past two centuries, stocks have done dramatically better for investors than have bonds or any other asset class. And while, to parrot the mutual-fund prospectuses, past performance is no guarantee of future results, there are sensible economic arguments why stocks should continue to perform best in the future.

But that does not mean that buying and holding a portfolio composed mostly of stocks–the standard investing advice of the past quarter-century–makes sense for all of us. In the past few years, the mantra of “stocks for the long run” has come under fire from some respected students of financial markets. Their two main critiques have to do with those terms long run and best. The first debate centers on whether you can count on stocks’ long-term advantage to work out over your particular investment horizon; the second is about whether an investment as risky as stocks belongs in a retirement portfolio in the first place.

The Case for Stocks

First, though, a little background on stocks for the long run. The notion goes back to 1922, when a bond brokerage in New York City hired Edgar Lawrence Smith to put together a pamphlet explaining why bonds–and certainly not stocks–were the best long-term investment. At the time, this was conventional wisdom on Wall Street. Bonds were for investment, stocks for speculation–and, in those pre-SEC days, for manipulation. But when he investigated the historical record, Smith recounted later, “supporting evidence for this thesis could not be found.” Instead, he discovered that over every 20-year span he examined but one, stocks handily beat bonds.

In 1924, Smith published the results as a book called Common Stocks as Long Term Investments. It was a sensation. Smith–a businessman of no great distinction up to that point–launched a mutual-fund company on the strength of his sudden fame and got an invite from John Maynard Keynes to join the Royal Economic Society. His argument was that stocks would continue to beat bonds because they a) were less vulnerable to having their value eaten away by inflation and b) allowed investors to share in the growth of the U.S. economy in a way that bonds and other assets did not. These two tenets were the indispensable theoretical underpinning of the 1920s bull market.

After that boom came to a crashing end in 1929 and the market continued to implode in 1930, ’31 and ’32, this theoretical underpinning at first seemed to have been demolished. The idea that stocks could be good investments became a joke and remained that–in the popular view, at least–for decades. Yet whenever anyone in later years re-examined the data on stocks’ long-run performance–major scholarly studies on the topic were published in 1938, ’53, ’64 and ’76–they reached the same conclusion Smith did. Even with the dire experience of the early 1930s factored in, stocks had proved an excellent long-run investment, with returns that far outpaced those of bonds.

Finance scholars also bolted a third plank onto Smith’s two reasons this was so and would continue to be: stocks were riskier than bonds, and stock investors were thus being paid a premium for taking on that additional risk.

In 1994 came the most influential of the stocks-vs.-bonds studies yet, Jeremy Siegel’s Stocks for the Long Run. The book, which laid out the records of stocks and bonds going back to 1802 and found stocks winning by a mile for almost every 30-year period over those two centuries, became a must-read for investors. Siegel–a professor of finance at the University of Pennsylvania’s Wharton School–became what one journalist described as “the intellectual godfather of the 1990s bull market.”

In 2000, that particular bull died in the tech wreck. But unlike Edgar Lawrence Smith, who faded into obscurity after the ’29 crash, Siegel has retained his reputation. That’s partly because his book (the fourth edition of which was published last year) is full of warnings that when he says long run he really means long run–say, 20 to 30 years. It’s also partly because in March 2000, just as the stock market was peaking, Siegel warned in a Wall Street Journal Op-Ed column that technology stocks were headed for a precipitous fall. But it’s mainly that, despite the market carnage of the past year and decade, Siegel’s basic argument that “stocks will remain the best investment for all those seeking long-term gains” hasn’t really been discredited.

Sure, there are some market seers convinced that Siegel and his work will eventually be consigned to the dustbin of history–because they think the U.S. economy has entered into an inexorable decline. But among Siegel’s fellow finance wonks, the debate isn’t about his basic premise. It’s about the lessons the rest of us should or shouldn’t draw from it.

The Case for Bonds

In April, Robert Arnott–a veteran money manager from Southern California and former editor of the finance wonks’ bible, the Financial Analysts Journal–penned a much discussed article for something called the Journal of Indexes. Arnott pointed out that while stocks still beat bonds over the long, long run, they actually lost out to 20-year government bonds from March 1969 through March 2009. That 40-year period is, by most standards, a pretty long run.

This wasn’t because stocks were a horrible investment during that time–$1 put into stocks in March 1969, with dividends reinvested over the years, was worth $280 after 40 years. But bonds did even better ($1 to $294). Siegel, who has debated Arnott on CNBC and elsewhere, sees this as evidence that bonds are now too expensive rather than an argument against stocks–and Arnott doesn’t entirely disagree. “I’d hate to have people read that and construe that bonds will win over the next 40 years,” he says.

But Arnott argues that the evidence does indicate that “the common interpretation that stocks should be the core of your portfolio always” is wrong. “The main message I would want to convey to John and Mary Doe investor is, Pay attention to the price you pay for an asset,” he says.

The message that price matters has been getting more prominence in Siegel’s work too. He says the one significant change in his advice over the past decade has been an increased emphasis on “value” stocks with prices that are low relative to earnings, book value and other fundamental measures. Both Arnott and Siegel are boosters of a new investment approach called fundamental indexing, in which one assembles a portfolio weighted by earnings, dividends or the like in order to avoid the tendency inherent in conventional capitalization-weighted index funds to load up on the most expensive stocks.

The main difference between the two experts really comes down to how confident each is that it’s possible to pick winners. Arnott makes a living trying to do just that–his firm Research Affiliates manages the PIMCO All Asset Fund, which switches money between asset classes as conditions and prices change. For the past few months, his favorites have been high-yield (junk) and investment-grade corporate bonds and convertible bonds. Siegel favors simplicity–and stocks. “My feeling is that stocks over the next 10 to 20 years are going to give above-average returns,” he says.

The Case for TIPS

To Boston University finance professor Zvi Bodie, another frequent debating partner of Siegel’s, this entire discussion is beside the point for most Americans. “He could be right,” he says of Siegel’s argument that stocks are a good deal right now. “I’m just more risk-averse than he is.” Bodie, co-author of the perennially best-selling business-school textbook Investments, wrote a 2003 book titled Worry-Free Investing and has been trying ever since to steer personal-finance advice in a radically new direction. For most Americans, Bodie says, stocks are entirely inappropriate vehicles for saving for retirement. The reason they outperform bonds over time is the very reason they should be avoided: they’re riskier. And if you’re putting away money that you’re going to need to live off in retirement, you shouldn’t be taking any risk at all.

Standard fixed-rate bonds can be devalued by inflation (a bond that pays 5% interest a year is a loser if inflation is 6%), but in 1997 the U.S. government introduced what Bodie considers the perfect risk-free investment, Treasury inflation-protected securities, or TIPS. The interest rate on TIPS rises and falls with the inflation rate. And as far as Bodie is concerned, all retirement-investing advice should come down to this: “If your goal is to maintain your standard of living, then here’s how much you should be saving and putting into TIPS,” he says. “If you want to save more than that and speculate in the stock market, by all means, do it. But you need to recognize that you can’t count on it when you do that.”

When I recount this to Siegel, he says, “I like TIPS, but you know what the yields are? Now it’s 1.79% for 10 years, totally taxable yield. Compared to 6% [earnings yield] in stocks, that’s a huge difference.” To follow Bodie’s advice, then, you’re probably going to need to save a lot more money for retirement than you’ve been doing. Stocks offer the promise of saving less and ending up with the same retirement income. As millions have discovered over the past nine years, though, it’s not a promise you can count on. Where does that leave us? Stocks are still the best investment for the long run. But maybe not for your long run.

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