(2) Do equities (stocks) guarantee good returns even in the longer run?

Very often I hear this reason from people who trade in stock market – “I am a long term investor, as equities always give a better return in long term” OR “I do NOT trade in short term, I invest for long term – equities give better returns in long term”.

Most of the times, this kind of justification come from people who have bought a particular stock, and now the value of that stock has come down. Hence, they are sitting on unrealized loss on their trade. It’s human nature to justify their own deeds – either by an explanation or by a counter action. I usually hear the explanation as mentioned above, and I’m convinced that the person quoting the reason has made a loss on his trade.

An honest confession I want to make here is that some 2-3 years back, I was also one of these losers quoting similar reasons J

My colleague, whom I’ve talked about in my past article , also quoted the same reason for the loss-making stocks in his portfolio.

Having worked in the pension fund industry for some time after my finance studies, I could get the understanding of the dangers of this kind of long term strategy. Try this: Search on Google the following term (without quotes) - “UK pension fund problems” and you will see a list of articles coming up on the results page. One of these articles is published by BBC and comes as the first result (http://news.bbc.co.uk/2/hi/business/2082800.stm)

Read this article carefully, and you’ll find the main reason being quoted is as follows: “But the problem has been exacerbated in recent years by dwindling stock market returns.”

This is the reason which is quite commonly quoted by the pensioners as well as the common man for the pension fund problems of UK. However, the reasons for pension fund crisis go beyond that. Let me demonstrate this with some historical real-time data instead of a hypothetical example. During this case-study, I’ll also refute two most commonly believed myths about the stock market.

Below is the graph that shows year-on-year average return on S&P 500 index (green bar graphs) and the red line indicates the risk-free 1 year bond return. (S&P index is US stock market equivalent for the Indian Sensex or Nifty). The graph is from 1975 to 2004:

Suppose that you believe in the commonly accepted principle: “Equities (Stocks) give better returns in long term” and you start investing in the equities market in the year 1975, thinking that in the long term you will make decent returns. This was what majority of the individuals did when they were working in 1975 and planning for their retirement, which was suppose to happen sometimes in 2003-04. Over the period 1975-2004, they regularly invested in equities following the same principle. However, at retirement, they found that most of their savings have gone down.

How??

Look closely at the green bar graphs for the period 2000 to 2004. The stock market has gone down consistently. This resulted in a total accumulated 60% loss on the stock holdings that people have been accumulating since 1975. Since they had to retire by 2004, they were relying on their “intelligent investment” in stocks. At retirement, they were not having any further scope to work and get salary – so they were forced to sell their holdings. All this resulted in a big mess for them, as their holdings had to be sold at the much lower market prices, due to the downfall of the stock market consistently for 4 years from 2000-2004.

This historical case demonstrated the dangers of investing in equities based upon the “long term better equity returns” concept. Remember, everything has a deadline – no investments can last or is secure forever. When you will need the money, you never know. Imagine how will you feel if have been saving your hard earned income continuously for last 30 years, and at the end when you’re about to retire you discover that the value of your savings has gone down drastically in the last 3 years of your investment period, and you’re left with only 40% of your money –rest 60% going in a loss?? This was the case with retirement planning investment, but the same can be extended to other similar situations as well –for e.g. Let’s say you just had a new born kid, and you started investing for 18-20 years period, so as to secure money for his costly college education (MBA/Doctor/Engineer), once your kid grows up. It is possible that you find that by the time you needed money, your stock holdings have come down in market value drastically.

This case refutes our first myth – the myth that equities (stocks) give better returns in long term.

Now let’s look at the red line which indicates the RISK FREE Bond returns (interest rates) for the same period 2000-2004. What do we see?

The returns from bonds have gone done consistently over this period. Also, we’ve already discussed that the returns from stocks have also gone down consistently. This refutes our second myth – the myth that bond returns (interest) and the stock market returns go in opposite directions – when one falls, the other rises and vice-versa. As it can be seen from the above graph, they both have gone down together, consistently for last 4 years.

In the beginning of this article, I’ve mentioned that the problems with Pensions funds were not just by the losses from the stock market. The additional reason being there were low returns from the bond market as well.

So, let’s not live under some false assumptions and commonly accepted principles. The case that I’ve presented in this article in NOT a hypothetical case, but it is what has happened in the past. Let us not believe that “This Cannot Happen” or “X is better in Short term and Y is better in the Long term”. Things happen randomly. Forget about the common man, even the highly sophisticated and educated financial investment managers and experts with decades of experience in the finance industry could not predict what we’ve seen in the period 2000-2004.

It’s risky - Play Safe, don’t get carried away by emotions.