Ask Money

Stock Market Risk

Chris Farrell Apr 7, 2008

Question: I listen to your podcast every week and enjoy your show, but one thing continues to confuse me. Often someone states that investing in the stock market will return 7% or 9% per year over the long haul. That may be historically true, but what if this is no longer true? What, for instance, is the average return over the past decade? If it isn’t 7 or 9 percent, shouldn’t Marketplace Money at least consider that a long term investment in stocks may not necessarily result in gains? Yours, Rob, Erie, PA.

Answer: You’re right. Stocks have languished for long periods of time. For instance, in 1966 the Dow Jones industrial average was at 744 and in 1981 it was at 776. The stock market then turned up for a long-term bull market run.

Most people saving for their retirement have a meaningful definition of risk; it’s the chance of a meager and demoralizing reward from investing in stocks or, even worse, actually losing money “Stocks are risky because the good returns might not cancel out the bad ones. Instead, stock prices (or real stock prices) might deteriorate even over very long periods of time, impoverishing the investor. I do not expect this, but it could happen. That is what I mean by risk,” wrote Laurence B. Siegel, director, investment policy research for the Ford Foundation in an article several years ago “Thus risk is not short-term volatility, for the long-term investor can afford to ignore that. Rather, because there is no predestined rate of return, only an expected one that may not be realized, the risk is the possibility that in the long run, stock returns will be terrible.”

Still, doesn’t time also eliminate that risk? The probability of doing poorly in stocks does shrink with time; but it doesn’t disappear. Think of it this way. Stocks wouldn’t beat out bonds in the performance sweepstakes if there wasn’t a chance that bonds could do better than stocks for lengthy periods. Indeed, before 1900, stocks lagged railroad bonds and matched commercial paper returns. Since 1871, there have been many ten year periods when bonds outperformed stocks.

Nevertheless, the wrong lesson for anyone chastened by the recent global financial crisis is to steer clear of equities because they are too risky. The rewards are worth the risks. Put it this way: If you can envision in ten years time that the U.S. economy still remain a leader among the major industrial nations, full of dynamic companies and bold entrepreneurs, then you will want to own stocks. Similarly, if you believe global economy will expand despite stomach-churning fits and starts, then you’ll want a slice of international equities. The right lesson is diversifying your money across a variety of assets. Miguel de Cervantes in Don Quixote de la Mancha put it this way: “‘Tis the part of a wise man to keep himself today for tomorrow, and not venture all his eggs in one basket.”

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