Stocks are not the Only Investment that Counts

Wednesday’s WSJ had a piece on Rethinking Stocks’ Starring Role. It’s about time.

Don’t get me wrong, stocks are an important asset class, maybe even the most important one. But they are just that, a large category of reasonable NYSE things a reasonable person might invest in, but not the only such category. Yet for generations, received wisdom has made it the center of individuals’ investing plans, the main course in the wealth accumulation dinner.

Why? ‘Cuz the stock market went up so darn much over the last fifty years or so. (Er, uh, recent events not included. Let’s say 1957 to 2007.) I know fifty years sounds like a really long time. Long enough that you might consider it to be approximately forever. If the stock market has gone up a certain percentage on average over that long a time a person is sorely tempted to think of that as the basic nature of the beast.

That’s not crazy. Generally, things that are true over fifty years are true forever. But not always. The Red Sox did win the World Series eventually. In the stock market’s case, it’s really not that hard to come up with a story about what happened in the last half-century that made the market go up in a way that is unlikely to be repeated.

In a nutshell, I think it is pretty clear in hindsight that the stock market was way too cheap in the mid 1950′s. I don’t mean cheap based on what we now know would happen in the coming decades, I mean really cheap based on what ought to have been obvious to investors at the time.

It took a long while, several generations in fact, for the market to get to a point where its valuation made sense compared to other asset classes. And it didn’t happen smoothly over the whole period, but in two great phases that changed the way we think about the stock market.

The first was the 1960s and early 1970s, when the accumulated prosperity of the post-war era pushed the market out of the doldrums in which it had been languishing since the 1920s. It was then that thoughtful people started doing research that showed that equities were a good investment as an asset class, something that was, remarkably, not widely understood before the 1960s. And institutional investors (a term newly invented at the time) started soberly putting money in the market. And those institutions had more than ever before to invest, as this was also the period of the rise of the private pension plan.

Then we had the legendary bull run of the 1980s and 1990s, the golden era of the mutual fund and the 401(k), when everybody and their brother decided the stock market was the engine that would propel them into a happy retirement. Until this time, investing in stocks was something associated with the country-club elite. (Although pension managers already commonly did it on behalf of ordinary folks.) By 2000, just about every American with money saved had a reason to check on the daily adventures of the Dow.

The stock market of today is not the same as the market of fifty years ago. It’s role in the economy and in our culture has massively increased. That change brought on a secular rise in the valuation of the market. And that rise is unlikely to be repeated over the next fifty years.

I’m not saying the market won’t go up in the future. On the contrary, I think corporations are pretty good at making money and will stay that way. Owning a piece of the action is bound to be profitable. But part of what made money for stock market investors 1957-2007 was not the growing American economy but a systematic change in what investors were willing to pay for stocks.

Given the risk level of the market, if you assume the 10% or so annual returns we got over the past 50 years, it’s hard not to conclude that stocks should be the centerpiece of your investment plan. But what if, and I think this is not an unreasonable idea, the right expectation from here on out is a lot less? What if it is, for example, 6%?

I’m not going to stick my neck out and say I think that 6% is the right number, but I will say that I think it’s not a crazy one. The 30-year Treasury is yielding 4.1%, so 6% would give a decent margin to compensate for the added risk.

But it would not be such a big margin that you would want to build your investing life around stocks. You’d want some, maybe more of it than other asset classes, but given the risk involved it would not be like stocks were a free lunch you needed to really load up on. And doesn’t that make sense at some level? Oughtn’t the great obvious asset classes return about the same on a risk-adjusted basis?

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