We’re living in strange times for investors.
People normally dump stocks when they go down, but lately they’ve been dumping them even as stocks have performed well. As for bonds, we usually think of them as a safer investment that can be used to reduce risk in a portfolio, but some are warning that bonds carry unusual risks in today’s conditions.
These thoughts are prompted by two recent articles that drew some attention. One, in the New York Times, highlights a “staggering” $33 billion in withdrawals from stock funds in the first seven months of this year. The article quotes an economist who says we would normally be seeing strong flows into stocks at this point in an economic recovery. The statement in the article that caught my eye was this one:
[T]he appetite for stock market risk among American investors of all ages has been declining steadily since it peaked around 2001, and the change is most pronounced in the under-35 age group.
These are, of course, precisely the people who should be most heavily invested in stocks. Today’s market volatility is of no consequence to them as they won’t be drawing on their savings for decades. The market’s poor performance over the last decade isn’t a reason to look elsewhere for growth. In fact, just the opposite is true, as investment returns from stocks have shown a tendency to be higher than normal after a period of lower than normal performance. If anything, this is a time to be boosting stock investments, not dialing back.
For an overview of stock investing I humbly recommend my book, That Thing Rich People Do: Required Reading for Investors. For a more detailed look at stock investing, including a discussion of reversion to the mean, where stocks tend to even out bad periods with good ones, read Jeremy Siegel’s classic Stocks for the Long Run, 4th Edition: The Definitive Guide to Financial Market Returns & Long Term Investment Strategies
As it happens, Jeremy Siegel is a co-author (with Jeremy Schwartz) of the other article that prompted these thoughts, this one in the Wall Street Journal (subscription required). Appearing on the Op-Ed page under the ominous headline The Great American Bond Bubble, this article compares bonds in 2010 with stocks in 2000. At the height of the stock bubble, many tech stocks sold at more than 100 times earnings. The rush to bonds has produced a similar result: with yields on many bonds below 1%, investors are paying more than 100 times the yield.
Bonds aren’t subject to the same risks as stocks, but even the safest bonds aren’t risk-free: they lose value when interest rates go up. (If you’re unclear why this would happen, read How Bonds Lose Value.) Interest rates are so close to zero now that it’s easy to imagine they’ll move higher before long. Siegel and Schwartz calculate that a modest rise in the 10-year rate from today’s 2.85 to 4% would produce a loss greater than three times the current yield.
The word bubble usually refers to an economic condition where investors overpay for something out of an unrealistic expectation of future profits. This isn’t why people are buying bonds, however. They’re simply looking for an investment other than stocks. That’s a mistake, these authors suggest, as bonds are unusually risky right now and stocks, especially those that pay high dividends, will in their view offer better income and inflation protection over the coming decade.
The most successful investors are contrarians, people who are, in Warren Buffett’s formulation, fearful when others are greedy and also greedy when others are fearful. By that token, this is a good time for anyone with a long time horizon to buy stocks. Ten or fifteen years from now it’s likely that plenty of people will wish they’d had more money in the stock market and less in bonds.
Don’t do this, though, if you lack the discipline to maintain your stock investments through a rocky period (and I promise these will come). If there’s one mistake bigger than having an overly timid stock allocation, it’s having a bold one you abandon as soon as the market takes a dive. A cost-efficient, diversified stock investment made in today’s market will pay off in the long run, but only for those with the stomach for a lengthy roller coaster ride.
