Observation #1 on Stock Investing Risks — The risk of investing in stocks is far greater at times of extremely high valuations (like today — this article was written in September 2006) than it is at times of low or moderate valuations.
The P/E10 value today is 26. Prior to the late 1990s, the U.S. stock market had visited this price level on only two occasions — the late 1920s and the mid-1960s. On those two occasions, we experienced wipeouts of middle-class portfolio values in the years to follow.
The moral? Stock investing risks are not distributed equally across all time-periods in which it is possible to own stocks. There are price drops at times of low and moderate valuations. But those are the sorts of price drops that most middle-class investors are able to withstand without experiencing too great a strain. The monster risks are the ones taken on by investors going with high stock allocations during times when the sorts of valuation levels that apply today are in effect.
It’s not a small increase in risk that applies when valuations go to nosebleed levels. I think it would be fair to describe the risk that applies today as a risk of a different nature from the risk that applies at moderate or low valuations.
William Bernstein made the point in his book The Four Pillars of Investing by telling us how low the DOW would need to drop if we were to see the sorts of price drops that we experienced on those two other daring journeys to the tippy top of the valuation mountain. The number (at the time he was writing the book, which was published in early 2002) was DOW 1400.
Observation #2 on Stock Investing Risks — The potential gains from owning stocks are less today too.
There are many cases in which taking on added risk of loss brings with it the compensation of an added potential for gain. It doesn’t work that way when stocks as a whole become wildly overvalued, though. At today’s prices, the downside risk of stock ownership is great, but the upside potential is small.
The lowest P/E10 value on record is 5. The highest is 44 (we hit 44 in January 2000, the top of the recent bull market). Prior to the recent bubble, the highest P/E10 value we had seen was 33. If we presume that stock valuations will remain within their historical valuation boundaries, there are a whole lot of possibilities on the downside but few on the upside. It’s theoretically possible that we could work our way all the way back to P/E44. But where could we be reasonably expected to go from there except down hard?
If the possibility of not earning a good return on your stock investment can be counted as a form of risk separate from the more frequently considered risk of losing a bundle, today’s stocks are a high-risk asset class in two important ways.
Observation #3 on Stock Investing Risks — The bear knows that crushing your portfolio balance requires first crushing your spirit.
The worst of the secular bears (those that follow strong secular bulls) are so unusual that few of today’s investors know what it is like to live through one. Many of today’s investors think of a bear market as something that lasts a year or two or three or four or five or six or seven or eight.
If only it were so!
The large bears seem to see it as their life purpose to take back most of the money that investors earned during the bulls that preceded them. It is only when they sell their stocks that investors give back their earnings, and many investors refuse to sell in a year or two or three or four or five or six or seven or eight. So the bear waits them out, giving them a taste of rising prices for just long enough to cause them to feel encouraged before crushing their hopes again. Only when most of the winners of the bull market days have sold at least some of their stocks does the market permanently change direction and begin its long climb back to the higher valuation levels.
There’s a good chance that the trip down and then back up again will not be a quick one. The purpose of a bear is to crush investor hopes and the largest of the bears understand that the best way to crush the human spirit is not with sudden shocks that soon pass away but with a slow-grinding financial pain that wears down the soul and the investment account both.
John Walter Russell examines some scenarios that reveal the nature of stock investing risks in a bear market in an article entitled “P/E10 Predictions Revisited.”
Observation #4 on Stock Investing Risks — You might swear off stocks altogether.
I’m a stock guy. I think that stocks offer the best path to financial freedom for most middle-class investors.
That’s why I feel strongly that investing advisors should tell the straight story about the risks facing the investors of today going with high stock allocations. If the bear ends up being not as bad as what you planned for, you will brush yourself off and walk away, and all will be well with the world. What you don’t want to have happen is for the bear to be far worse than you imagined.
That’s the sort of experience that causes people to swear off this wonderful asset class forever. It could happen to you. Going with a smaller stock allocation today might permit you to go with a far larger stock allocation at the beginning of the next secular bull. You want to be in on the fun all of your fellow stock enthusiasts are going to have then, don’t you?
Observation #5 on Stock Investing Risks — You stand to suffer personal embarrassment.
People like to talk about money topics as if all that is at issue is dollar bills. Dollar bills are easy to count, for one thing. It’s not as scary to talk about dollar bills as it is to talk about human emotions, for another.
It’s human emotions that determine what happens to the dollar bills. It’s scary talking about them, but we must talk about them if we are to make sense of the dollar-bill stuff.
People don’t invest in the way that they believe will earn them the most money. That’s never the sole motivation. People invest in ways that they think will make them feel good about themselves and about life.
Bull markets make people feel smart and proud. Bear markets make people feel like dopes and losers.
If you can’t afford to help your daughter with her college expenses because you weren’t smart enough to lower your stock allocation in time, you’re going to feel like a jerk. Think it over.
Observation #6 on Stock Investing Risks — One of the most painful risks of stock investing is missing out on attractive investing alternatives.
Many of the saddest stories heard while traveling through this Valley of Tears begin with the words “If only….”
Treasury Inflation-Protected Securities (TIPS) were paying a 30-year guaranteed real return of 4 percent in early 2000. You bought some, didn’t you?
Don’t feel bad. Almost no one else did either. Stock prices were soaring in those days. The government had to jack up the return on TIPS to absurdly high levels for a risk-free investment just to get a few people to place orders.
I purchased TIPS when they were paying 3.5 percent real. When I tell people that today, they say: “Wow, that sure was a smart move, whatever made you know to buy those?” The sad truth is that I should have bought some of the 4 percent TIPS. I knew it was an amazing deal. Like everyone else, I was looking for reassurance from my fellow humans before making the move, and the reassurance that 4 percent TIPS were a good deal came too late. By the time the rate had dropped to 3.5 percent, I worked up the nerve to grab hold of the gift the U.S. government had been trying to hand me for several years and mumble a soft “thank you, Uncle Sam.”
TIPS are today paying between 2.0 percent and 2.5 percent. That’s not as good as 4.0 percent or 3.5 percent. So some refrain from buying on the thought that they have already “missed out.” You missed out on 4.0 TIPS. But you haven’t missed out on TIPS paying between 2.0 percent and 2.5 percent. Buy some! See how it feels to be invested in something other than stocks!
Don’t be surprised if TIPS rates drop lower when stock prices are down and everyone comes to appreciate the value proposition that TIPS offer. Then there will be people bemoaning the fact that they “missed out” on TIPS paying 2.5 percent.
Stocks are a jealous mistress. You don’t need a jealous mistress, you need a nice, strong, dependable income stream from your investments. Look into TIPS to avoid the risk of feeling regrets over opportunities squandered.
Observation #7 on Stock Investing Risks — Compounding works in reverse too.
You’ve heard the one about compounding returns, right? The way I recall it is, if you save 39 cents today, it will be worth 17 million and change in 20 years if you only permit the miracle of compounding returns to work its magic. Something like that.
Okay.
Now, what happens if you lose one-half of your portfolio value because stock prices return to reasonable levels sometime over the next few years?
Please type in your stock portfolio value in the space provided — ___________.
Now, please divide by two. Type in the result of that calculation here — ___________.
Finally, multiply that number by 600 billion (to show how much you will lose by not having the miracle of compounding returns work its magic on the number of dollars indicated in the space completed above. Enter the product of that multiplication effort here — ___________.
You don’t want to lose (please enter the amount entered for the divide-by-two calculation here as well — _____________). Not just because it’s an awful lot of money for someone like you to lose. You also don’t want to lose it because it will be a loss that will keep on doing harm to your financial freedom dreams for many years to come. The same magic of compounding returns that can do you so much good if you invest responsibly can do you a lot of harm if you do not invest responsibly.
Observation #8 on Stock Investing Risks — The risk that counts the most is the risk of the loss of the time it took you to earn the money you now have invested in high-priced stocks.
Joe Dominguez, author of the book Your Money or Your Life, taught me the most valuable money lesson I have ever learned. Dominguez said that money is time. We trade the hours of our day for money. So what we really lose when we lose money is the time that we will have to trade away to get that money back.
If you earn $60,000 per year and save 10 percent, it takes you five years to accumulate $30,000. Lose $30,000 in a stock-market downturn, and you just gave up the fruits of five years of work effort. Not good.
Most Americans are too heavily invested in stocks today. I want to scare you into lowering your stock allocation (or at least into thinking about it enough to come to an informed decision that it is not the right thing for you to do). It’s not your money that is at stake, according to Dominguez. It’s your life.