Reliability is a concept that we typically appreciate more and more as we mature. Young people are typically attracted to things that provide lots of “flash and dash.” Those of us with more decades under our belts have been disappointed enough times that we no longer take so much for granted. Over the years, we acquire more appreciation for the things that don’t let us down.

Nothing in life is really guaranteed beyond the proverbial combination of taxes and death (followed in many cases by more taxes). However, some things are reasonably predictable. Savvy car buyers, for example, can stack the odds in their favor by purchasing makes and models that have proved more reliable than average. That data is readily available in Consumer Reports and other publications.

It’s harder for investors to know exactly what they can trust, because the market is so unpredictable and financial matters are subject to so many variables. However, we’ve done some interesting research that gives important clues.

I spent the better part of last year working closely with Paul Merriman on his new book, “Live It Up Without Outliving Your Money!,” which will be published by John Wiley & Sons in April. I’d like to share some material in that book that gives quantitative answers to three important questions serious investors should ask. Later I’ll touch on some of the other topics in Paul’s book that illuminate some things I believe you can count on.

We know that over time, equity funds have had higher returns than “safe” cash instruments. But stocks can tank too. So the first major question to address here is: How reliable is this “equity premium” from investing in stock funds instead of cash?

Likewise, we know that over long periods of time, small-cap companies have returned larger gains than large-cap ones. But how much can you count on those larger gains? Third, we know that value stocks have been more productive over time than the more popular growth stocks – but not always. How reliable is this value-stock premium?

Let’s start with stocks vs. Treasury bills. A good question is: How long must an investor wait to get the advantage of stocks’ higher return? Investors who know the answer have a real advantage over those who don’t.

Table 1 summarizes a study of thousands of computer trials using actual market data from 1926 through 2004. The study compared returns of the Standard & Poor's 500 Index with those of no-risk Treasury bills over various periods.

To understand the numbers in the table, start with the column labeled “1 year.” These figures came from studying every possible 12-month period from 1926 through 2004. For example, February 1941 through January 1942 is one of those 937 periods.

Going down that column, we learn that there was one 12-month period when the return from the stock index was 163 percentage points higher than that of T-bills. We learn that there was one period when the index’s return was 68.9 percentage points lower than that of T-bills. On average, the index returned 8.9 percentage points more than T-bills. Finally, the table says that the index outperformed T-bills in 67.8 percent of the periods.

This is more than just statistically interesting information. As a practical matter, it says that if you expect to need your money in one year, there’s about a one-in-three chance that you’ll do better in no-risk T-bills than in the S&P 500 Index. And of course it’s quite possible to lose your shirt in the stock market in 12 months.

The other columns in the table show that, in general, the longer you held the S&P 500 Index, the bigger the advantage of stocks over T-bills – and the greater the probability that stocks would in fact have a higher return. (The figures for periods longer than a year are cumulative returns, not annual ones.) Holding periods of 20 years and longer were 100 percent reliable in that respect.

The information in this table should be extremely relevant if you’re saving for an intermediate-term goal such as the down payment on a house or college tuition.

Imagine you were saving for a goal five years away. If your timing had been average, you would have achieved about 54 percentage points of extra return from the stock index. But if your timing had been the worst possible (which of course you could not have known in advance), you might have lost more than half your money in five years.

If that five-year goal is set in stone, as it would be for a son or daughter expecting to enter college, a prudent parent would not bet the tuition on the stock market.

I think the message is also pretty clear for investors accumulating money for retirement. If you have 15 years or more to go, the chances are extremely high that you’ll do better with stocks than with T-bills. Yet when you’re a few years away from retiring, you may not want to have all your money in the stock market. And if for some reason your expected retirement date cannot be postponed, you should be particularly wary of the stock market.

A similar table appears in Paul’s book comparing the returns from small-cap and large-cap stocks over the same 79 years, from 1926 through 2004. You’ll see this data here in Table 2.

You’ll see that in this long time period, you had to hold small-cap stocks for more than 10 years to obtain a two-in-three chance of outperforming large-cap ones. And not even a 25-year holding period gave you a 100 percent guarantee of doing better in small-cap stocks.

It’s clear that small-cap stocks were more productive, and that advantage increased with the length of holding periods. But it’s just as clear that the increased productivity was nowhere near certain except in the very longest periods.

The third topic of this study was value stocks, which we believe are an essential component of any properly diversified equity portfolio.

Table 3 tells that story.

These figures make a very strong case for value. With a holding period of 10 years or longer, value stocks outperformed growth stocks 92 percent of the time. Still, the premium was not quite guaranteed even with a 20-year holding period. That’s why it’s a good idea to include growth stocks in a portfolio, too.

Our available data for evaluating the reliability of international value stocks doesn’t go back as far as for U.S. stocks. But from 1975 through 2004, an index of international value stocks appreciated at a rate of 17.7 percent annually. An index of large-cap international stocks (mostly growth stocks) rose at a rate of 12.1 percent.

Though you can’t count on these relationships absolutely, they seem to remain steady. Their origins can be explained, as Paul has done in the article (available online at FundAdvice.com) “The Ultimate Buy and Hold Strategy.” Of course the future results of stock investing, small-cap investing and value investing won’t be exactly the same as those from the past. But we have no reason to believe the patterns of the future will be dramatically different.

The benefits of stocks, of value stocks and of small-cap stocks are all ones you can generally count on to help you make your money work hard on your behalf.

These forces are all on your side. But any savvy investor must recognize that there are some factors you can count on to work against you unless you counteract them. Paul’s book discusses a number of these “negative” forces. I’d like to touch on a few of them here, giving you suggestions for what to do about them.

** A whole chapter of Paul’s book is devoted to the effect of expenses on long-term investment returns. For the present discussion, this could be summarized this way: You can count on every recurring expense, no matter how small or seemingly insignificant, to pick your pocket and erode your investment returns.

Certainly some expenses are necessary, and you should expect to pay a reasonable price for good advice and management as well as for the real costs involved in opening, maintaining and closing accounts and keeping all the necessary records. But there’s a huge difference between paying 18 basis points (a basis point is one percent of one percent) annually for a fund that mimics a stock index and paying 80 or more basis points for another fund that has an actively managed but almost identical portfolio.

There’s a huge difference between two funds with completely identical portfolios and management when the no-load version charges expenses of 80 basis points and the Class C load version charges 198 basis points. In this example, the venerable Columbia Acorn Fund, you can absolutely rely on the load version to have lower returns than the no-load version, which is now closed to new investors.

** Something else you can count on to work against you invisibly and relentlessly is inflation, defined in Paul’s workshop materials as “the persistent increase in prices triggered when demand for goods is greater than the available supply.”

You can count on inflation to distort your views of value when comparing numbers over time. If you ignore it, inflation will lead you to make bad decisions. In 1970, many people concluded that if they could retire on a fixed income of $30,000 they were nicely set up for life. But inflation had different ideas. After a mere 10 years, by 1980, it would have required $63,685 to purchase the same amount of goods and services that $30,000 bought in 1970.

In other words, more than half the purchasing power of that attractive fixed income was gone in just 10 years. By 1990, it would have taken $101,056 to purchase what $30,000 did in 1970. By 2000, the figure was up to $133,144. At the dawn of the present century, a retiree who had retired on a comfortable but fixed $30,000 in 1970 would have had the equivalent of only $6,760.

Table 4 is included in the materials for Paul’s workshops. It shows that nominal returns, those you see on paper, are vastly over-rated when compared with real returns, those that are adjusted for inflation. In this 79 year period, the inflation rate was 3 percent.

Nobody knows what inflation will be in the future. As you can see in the following breakdown, the long-term trend indicates that inflation has become gradually greater.

1926 to 1950: 1.3 percent

1951 to 1975: 3.2 percent

1976 to 2004: 4.4 percent

I can guarantee one thing about inflation: You can’t stop it. The best you can do is recognize it and manage your exposure. In his workshop, Paul talks about three ways to do that: First, accumulate more money than you will need for retirement and any other major goal. Second, hold part of your wealth in stocks and/or real estate. Third, find securities that produce higher returns without higher risks.

** You can count on Wall Street to try to work hard to persuade you to do something different with your money. Every firm on Wall Street, and every advisor or salesperson who works for every firm, can give you “a better idea” for where your money should be.

Much of Wall Street is a transaction-oriented business; if you buy or sell a product, somebody gets a cut. Change is good for Wall Street. But if you do nothing and there is no transaction, nobody earns a commission.

** You can count on the fact that there will always be somebody who’s getting better results than you are. You may feel cheated. You may want to switch strategies as you look over your shoulder to see who might “beat” you. If you regard investing as a competitive race, you’ll never be the winner, and it’s predictable that you’ll hurt your cause. Wall Street may be happy, of course, because you’ll be likely to keep trying one thing after another, generating commissions and fees at every turn. The solution is to figure out what results you need, find the lowest-risk and lowest-cost way to obtain them – and then learn to be satisfied.

** You can count on commission-based advisors and salespeople to have a financial incentive to persuade you to invest in products that divert too much of your money away from you. I’m not saying they will necessarily do that. Some will put your financial interests ahead of theirs. But you can count on this: The highest commissions are paid on products that are hardest to sell. The hardest products to sell are ones that most people don’t want because they are complex, expensive and risky. The solution: Don’t invest in anything you don’t understand, and know exactly what commission you’re paying before you agree to it.

** You can count on your emotions to make you want to do the opposite of the right thing. You know the smart thing is to “buy low,” but when prices are low and have been going down, you won’t feel like buying. You know it’s smart to “sell high,” but when you own something that’s been going up, you won’t feel like selling.

The solution is to have a plan that’s been thoroughly thought out and is easy to follow, even when you don’t feel like it.

** This list has been pretty negative. But I’m happy to wrap this up with something positive that you can count on: mechanical, automatic systems to do what you should do but might not feel like doing.

For accumulating money, this means automatic savings using dollar-cost-averaging to help you buy more when prices are lower. When you’re managing money, it means automatic rebalancing. And when you’re withdrawing money in retirement, it means making automatic calculations of the proper amount, then sticking to a budget.

The best way to achieve these things is to choose an advisor very carefully. Paul’s book tells how. If you do that, you should be able to count on your advisor to do a better job of looking out for your interests than you’ll get from your emotions, from Wall Street or from the financial media.

 

 

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