Is it all over for stocks?

After a miserable decade, you have to ask whether some of the most basic assumptions about equities are just plain wrong.

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By Pat Regnier, Money Magazine assistant managing editor

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After huge market drops, stocks are finally trading at historically low P/E ratios.
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(Money Magazine) -- If you haven't second-guessed yourself yet, maybe you just aren't paying attention.

You always knew stocks would be volatile, but you've been taught that the market rewards those who stick with it long enough. So you put equities at the heart of your portfolio.

Well.... Over the past decade, which sure did feel like long enough, an S&P 500 index mutual fund has lost investors 15%. Looking to the future, it's hard to discern much better news. The global financial system appears to be broken, and the so-called smart money is hunkered down for hard times.

One way to tell: Yields on bonds issued by anyone other than the U.S. Treasury have been soaring, which means the market is seriously spooked about companies' financial health.

"Bonds are priced to say that we're headed for a depression - something as bad as the 1930s," observes money manager Rob Arnott of Research Affiliates in Newport Beach, Calif.

So yeah, you're feeling some doubt. We are too. In early November the writers of this story led a personal-finance seminar for a group of young professionals in San Francisco. The Dow had just dropped 5% in a day. (Again.)

We ticked off the usual advice: Don't panic. Don't try to time the market. Remember that you are in this for the long haul and stick to your plan. When we finished, a man in the front row raised his hand. "Just how bad would things have to get," he asked, "before you guys changed your advice?"

The glib answer is that falling prices just make stocks a better investment - they're on sale! But this is no time to be glib. After all, judging from the performance of target-date 401(k) funds, many investors only a couple of years from retirement have seen their nest eggs shrink by 25% or more this year.

The fact is, things are sufficiently bad that we here at Money have had cause to question some of the basic assumptions from which we've drawn our advice over the past 36 years of publication. So we decided to take a close, fresh look at the investment case for stocks in individual portfolios.

Nothing we found has us pronouncing the Death of Equities. Nor will we argue that today is a not-to-be-missed buying opportunity. To paraphrase F. Scott Fitzgerald, the sensible approach to equities in this market is to hold two (seemingly) opposed ideas at once:

Stocks look like a pretty good investment - certainly better than they were a year ago. You absolutely shouldn't get out simply because the recent return numbers are scary. The latest bad news about the economy shouldn't drive you away either. Much of that is reflected in prices now. Even for many not-especially-brave investors, it's time to consider buying, not selling.

That said, the virtues of equities have often been oversold. Not just in hindsight - that's simply too obvious to dwell upon - but also in theory. Too often, investment advisers and, yes, the financial press have pointed to robust historical returns to suggest that all but the most nervous of Nellies should be heavily into stocks.

But there's a fair chance that you've had, and may still have, too much of your portfolio in equities. This market has been teaching us all some big lessons about risk that you'd be wise to take to heart. If getting your risk exposure right means holding less money in stocks, so be it.

Why stocks are never a no-brainer (Not even in the long run)

It's become one of those things that everybody just knows: Stocks beat bonds over the long term. But let's take a moment to ask the dumb question: Why exactly should that be?

The answer, in a word, is risk. Or to put a finer point on it, relative risk. When a corporation issues a bond, there's a chance the firm could go belly up, but as long as that doesn't happen, it will pay you your interest and principal. And not a penny more.

Stock investors, on the other hand, aren't guaranteed anything. They are entitled to a share of profits that might grow and grow but also might turn to dust. The market usually sets a price on stocks low enough to compensate you for that added risk. Patrick Geddes, chief investment officer at Aperio Group in Sausalito, Calif., puts it elegantly: "You get paid for the strength of your stomach lining."

But don't make the leap from this to a slightly different - and dangerous - metaphor: the market as a roller coaster that, despite its gut-wrenching twists and turns in the middle of the ride, will always bring you back safely in the end. If it were true, the rational move would be to close your eyes and put every dime you don't need right away in stocks.

And many investors have come awfully close to doing that. According to the Employee Benefit Research Institute, about 40% of 401(k) participants within a decade of retirement age had 80% or more of their accounts in stocks at the start of 2007. Many of them will never get the retirement they had expected.

Whether you are saving for retirement or for your child's college education, you have to think very carefully about the true risks and rewards of stocks.

And to do that, you'll have to get past three big things that "everybody knows" about the lessons of stock market history.

Everybody knows that stocks give you high-octane returns over the long run. Since 1926, the annualized return on blue-chip stocks has been almost 10%, according to Ibbotson. That works out to six percentage points above ultrasafe Treasury bills.

There are reasons, though, to suspect that the extra returns of the past - and especially the soaring gains of the '80s and '90s - were abnormally high.

To take just one: The real, inflation-adjusted performance of stocks has typically been lower abroad.

Why should foreign equities be a guide to the U.S. market? Imagine you were trying to predict the long-run future return on shares of Microsoft, says London Business School's Elroy Dimson, a leading authority on world stock market history. While you might be tempted to rely on the firm's past growth, that would be a wildly unreliable guide because your numbers would capture the firm's unrepeatable rise from tiny Seattle software firm to global technology giant. Instead, the industry or market history might be more useful.

Well, the broad U.S. market, says Dimson, is roughly analogous to Microsoft. We can't make the trip from emerging market in 1900 to economic colossus in 2008 again. So it's better to look at a wider range of experience. Looking at world asset-price history, Dimson figures a normal long-run return for stocks may be closer to 3.5 points above T-bills, not six. That's just one well-educated guess (plenty of smart people expect more), but it suggests that even optimists should diversify into other assets and keep a close eye on expenses that erode returns.

Everybody knows that stocks aren't risky if you plan to hold them for a long time. Over decades the odds get better and better that stocks will beat a conservative investment like Treasury Inflation-Protected Securities (TIPS). But there are big caveats to this.

"When you are thinking about tucking away stocks for the long run, you'd better know that the long run can be very long," says Jeremy Grantham of the Boston investment management firm GMO. For the U.S., the record for negative stock returns is 16 years.

Or consider Japan. Its market peaked in 1989 and still hasn't recovered. Isn't Japan a lot different from the U.S.? Sure, but our future could also be a lot different from our past. Remember that in the 1980s everyone thought the main difference between us and Japan was that they were the ones who were going to run the world.

The other problem - and this may seem counterintuitive - is that stocks really don't get any safer if you hold them longer, says Boston University economist Zvi Bodie. Although the probability that stocks will trail a safe asset like TIPS goes down over time, the potential consequences of such a shortfall get worse and worse.

Think of it this way: Say you could buy a security that could only rise 5% or fall 5% in any given year. Your worst outcome for one year, of course, would be a 5% loss. Yet in theory, your worst outcome over 10 years - however unlikely - could be 10 straight years of losses, for a decline, after compounding, of 40%.

"People are led to believe there's a free lunch, that you can earn a risk premium without bearing any risk," says Bodie. "That is fundamentally wrong."

The upshot, Bodie adds, is that investors should think less about time when deciding how aggressively to invest and more about their income sources. A young person with a secure job has a bond-like income stream and can afford to take more risks with stocks. Those with uncertain or soon-to-decline salaries - such as entrepreneurs or near-retirees - need more security.

Everybody knows that you can own more stocks if you are tolerant of risk. This one is perfectly true. But there's a catch: It's hard to predict how you'll handle risk until the bad stuff actually happens. In 2000 every other person you met claimed to be an "aggressive" investor. By 2002 aggressive-growth funds were selling like steaks at a vegan convention. Investors didn't regain their courage until last year - just in time for this bear (see the chart above right).

Much of this is psychological. Yet it is also true, as Brigham Young University personal-finance professor Craig Israelsen observes, that people overestimate how much of their money is really "long term." When a bear is coupled with a recession and job losses, investors find themselves wishing they had more emergency cash.

As a result, the returns of hypothetical history aren't what investors actually get. A study by Ilia Dichev of the University of Michigan found that stocks on the Nasdaq gained an annualized 9.6% from 1973 to 2002 - but investors in those shares earned just 4.3% on average.

"People are bad timers, getting in and out of stocks at the wrong times," says Dichev. That argues for staying put now. But if you've already sold shares because you found out the risk was more than you could stand, don't berate yourself. You've just learned what your true risk tolerance is. The trick is to correct this once and for all.

So if you think your new, lower allocation to stocks is something you can live with, commit yourself to it even if the market rebounds. It may help to write down your new plan, your current reasoning and perhaps the emotions you've been feeling and stick it in an envelope marked "Open at Dow 12,000." You want to persuade the future you to not get carried away again.

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