Let’s say you’ve worked hard to build your income and spend less than you earn, and you’re growing your savings with each passing month. Maybe you’re experimenting with new, borderline-uncomfortable levels of frugal living. Perhaps you’ve even started building a side hustle or two to boost those savings even more. Nicely done!
With all those dollars left over, you have a choice to make: where do you put them? If you’re still holding high-interest consumer debt, the answer is pretty easy. But once you’ve emerged into net worth-positive territory, the choices get more complicated.
We want our hard-earned money to grow as much as possible, of course, but we’re also concerned about mitigating downside risk. Putting 100% of our earnings into Powerball tickets might turn out to be a lucrative strategy, but we’d probably prefer something a bit safer – something without a significant chance of leaving us broke.
There are a million places we could put our money. We could hold it in actual paper currency. We could keep it in a cash-equivalent, like a bank account, CD, money market fund, or T-bill. We could invest it in stocks, bonds, real estate, commodities, or our neighbor’s new “network marketing” idea. Or we could even get really fancy and start trading foreign currencies, futures, options, and mortgage-backed securities.
Let’s simplify things by looking at just three basic asset classes. We’ll keep their identities under wraps for now, though I suspect you’ll have a good guess. Finances are ultimately about numbers, after all, and we don’t want our emotions clouding our judgment.
Because our goals are to enjoy safe long-term growth and preserve purchasing power, we’ll look at inflation-adjusted returns over a 20-year period, based on over one hundred years of historical data.
What do we find?
Investment Class A produced the highest average returns by far – with a mean return of 310% over a twenty-year period. If we had gotten lucky and invested at the best time, we’d have over $1,000 for every $100 we put in – a 10x return! Even in the worst-case scenario, our inflation-adjusted balance is still positive, though only up 5%.
Investment Class B generated attractive positive returns, though not to the same level of Class A. The worst-case scenario is concerning: a 35% drop in inflation-adjusted value over the two decades. Standard deviation is much lower, though, meaning our account value didn’t fluctuate as much along the way.
Investment Class C is the worst choice by far from the perspective of average returns. The mean return was a 14% loss. Volatility is low, so we might not lose sleep during the 20-year period, but only 25% of the time did Class C even maintain our original $100 purchasing power – hardly something to get comfortable with.
Which investment class or classes would you choose? More on that in a moment.
Daniel and I recently spent a weekend hanging out with one of my good friends. She had just taken a long sabbatical between jobs and was thrilled that we were also taking some time off to travel, explore, and get away from full-time work.
At some point, the conversation turned to finances.
“Are you planning on working while you travel to support yourselves?” our friend inquired.
“Not really. We might take a few side gigs here and there, but we’re mostly living on savings.”
“Where do you keep your money? A savings account?”
“No, I’m about 80 or 90 percent in stocks.”
“Really???” she asked, apparently astounded.
“Yeah, of course!” I laughed, perhaps being a bit too cavalier.
“Wow. My dad says he won’t touch the stock market anymore – that it’s way too risky and impossible to make money.”
I left the conversation at that, but I was tempted to offer a couple thoughts in reply:
First of all, one’s dad should probably not be trusted blindly with regard to one of the most important and impactful financial decisions an adult can make. Money plays a huge role in our lives from beginning to end; it’s worth taking a couple hours to study and form your own perspectives.
Second, impossible to make money?! The stock market is currently sitting at an all-time high (this was true at the time and is true within about one percentage point as I write this). Literally the only way you could have lost money investing the stock market index is by trying to time the market.
Of course, I understand where my friend and her dad were coming from. Most people don’t have the fortitude to buy and hold for decades. As soon as the market drops big-time (as it often does), they get nervous. They turn on the self- anointed TV “experts” predicting doom and gloom, and they sell, locking in massive losses. When they eventually put their money back in the market, they’ve already missed the recovery. This is probably why Fidelity supposedly found that their best-performing accounts were those of people who forgot they had money invested there. If you think you can do better, try your hand at this fun market timing simulator.
Or, perhaps the humdrum S&P 500 index just isn’t exciting enough. Surely, many people think, they can do better by investing based on an in-depth reading of the business section every day – or maybe a savvy friend’s latest stock tip. Instead of investing in the index, they bank their savings on individual stocks. The average result, sadly, is underperformance of the index. Some will fare much worse, having banked on the WorldComs and Enrons of the world. Even the professionals struggle, with 86% of actively-managed mutual funds underperforming their indices.
Back to the investment example we started earlier. Let’s work backwards, from C to A.
Investment Class C is cash, assuming an average 1% nominal return on our money. That’s a sweeping assumption, of course (interest rates will fluctuate over time with inflation and other factors), but the takeaway doesn’t change: from a long-term perspective, cash is a terrible investment. Even in an optimistic scenario, we can’t expect it to do much more than maintain its purchasing power. That’s why, contrary to many mainstream sentiments, I consider cash to be the riskiest holding – at least when viewed through a long-term lens.
Investment Class B is bonds. Bonds don’t deliver the best returns, but they’re more attractive than cash in protecting spending power, with much less volatility than Investment Class A.
Investment Class A, as you’ve surely figured, is stocks. The numbers show exactly what we’d expect: high average returns in exchange for a wild ride. You know what astounds me about these figures, though? Since 1871, in not a single twenty-year period has the stock market delivered negative inflation-adjusted returns.
The stock market – risky?
I just can’t accept that an investment class that has delivered positive 20-year returns in 125 consecutive cycles is high-risk. High-volatility, sure. The market has dropped massively time and time again and will continue to do so. But for level-headed long-term investors – those of us with 20, 30, 40, or more years to enjoy the ride and the fortitude to stay in the market when things look bad – year-by-year volatility ≠ risk. Over a long period of time, the stock market is actually our best bet.
Stocks get risky when we think we can consistently outperform averages based on our own hunches.
Stocks get risky when we think we can successfully time our moves in and out – buying low and selling high every time.
Stocks get risky when we watch our account balances every day, finger on the “Sell” button.
Stocks get risky when we take action based on media noise rather than our predefined investment strategies. That $1,096 figure – the best 20-year stock market return in modern history – began in 1980, the year after BusinessWeek published its now-infamous “The Death of Equities” cover story.
The risk isn’t really in the stock market. It’s in us.
Addendum: It’s easy to write all this stuff when the market is soaring to new highs, isn’t it? The moment of truth is when the market drops. I’d encourage you to revisit these sentiments when stocks are down 20%, 30%, or more. I’ll surely be doing the same.
Notes and C.Y.A. Disclaimer: All stock, bond, and CPI data referenced here are illustrative, sourced from the excellent Crowdsourced FIRE Simulator at cfiresim.com. This post represents my opinions and is for entertainment purposes only. The above examples are oversimplifications and do not account for individual life circumstances and investment criteria. I am not a financial advisor, just a guy with a laptop and an internet connection. For professional financial advice, consult a professional.