If you owned stocks during the final months of 2018, looking at your portfolio and investment account statements was almost certainly an exercise in pain management. Essentially, we all took ugly haircuts. Then came 2019, and for reasons that were no better than the ones that drove prices down, shares recovered for the best January since 1987 -- incidentally, another year investors don't recall with fondness. And all of these steep ups and downs may have some people thinking, "If only I could have sold before the worst of the declines and then bought back in at the bottom! Then I'd have made a fortune!"
It's a nice dream. Except it's not. It's the temptation that leads you down the return-destroying sinkhole we gently refer to as "market timing." But the even worse outcome is when people look at those sharp drops, don't pay as much attention to the rises that follow them, and -- thinking they are being conservative and careful -- allow fear to push them out of stocks altogether.
So, in this segment of the Motley Fool Answers podcast, hosts Robert Brokamp and Alison Southwick will lay out five simple reasons why everyone -- from those at the start of their careers to retirees -- should have a major slice of their portfolio in stocks. Long story short: It's the best way to earn bigger returns, and you're going to need them.
A full transcript follows the video.
This video was recorded on Feb. 5, 2019.
Robert Brokamp: Last year was not a banner year to be an investor. The market actually started up OK in the beginning of the year, but somewhere around September, October, things started falling apart. The market dropped about 20%. Many stocks dropped even more.
This year, it's been a little different, so as you may have seen in various headlines, we just concluded a January where the S&P 500 earned 7.9%, and the headlines were, "Best January since 1987."
Which struck me as interesting, because when you think of 1987 now, it's not known for its awesome January. It's actually known for a brutal October, including October 19th when the S&P 500 dropped 20.5%. A 20% drop in one day is the worst one-day drop ever.
Whenever you see the type of volatility we saw at the end of last year, but also in years like 1987, people start to wonder [if they should] try to time the market. We get these questions all the time when we prepare for our Mailbag episodes.
With all that volatility and uncertainty, we also get questions from retirees about how much [they] should I have in the stock market. Should they have anything in the stock market if they're living off their portfolio and it can drop 20% to 50%?
Longtime listeners already know the answer and that is no, you should not try to time the market, and yes, you should always own stocks, even if you're retired, and I hope to convince you with five reasons why you should own stocks forever, even if you're retired.
Reason No. 1: We're living longer. According to the Social Security Administration, back in 1940, which is the early years of people getting Social Security, the average 65-year-old male would live another 12.7 years and the average 65-year-old female would live another 14.7 years. Nowadays, both of those numbers have moved up 20 to 22 years. We're living a long time, and that's the average. That means half the people live longer than that. You're talking about a 1-in-4 chance of making it to 90 and a 1-in-10 chance of making it to 95.
There's two implications to that. First of all, our investment time horizons are getting longer, which means we have more time to ride out the down times in the stock market. We've talked about this before. The average bear market takes about three years to go down and go up again. Many have lasted longer than that. But if you're going to live possibly to your nineties, you have time to ride that out.
The second thing is the longer we live, the more we need stocks in our portfolio so that our portfolios last as long as we do. If you retire at 65 and you have nothing but cash and bonds, you increase the chances that you will run out of money, and we'll talk about that a little bit later. That's No. 1.
Reason No. 2: This is something we've talked about many times before, and that is stocks win over the long term. Looking historically over the past [since 1926], according to Ibbotson Associates, over one-year holding periods, stocks make money about 73% of the time; so, three in four years you're going to make money. Five-year-holding-period stocks make money 85% of the time, 10 years 95% of the time, 20 years 100% of the time.
Many people often think of their time horizon as retirement. Like I'm 45, for example, and I retire at 65. I have a 20-year time horizon. But you only have that time horizon for a small portion of your portfolio. You have money you're going to need when you're 70. When you're 75. When you're 80. You're talking decades, and historically stocks have made money and outperformed cash and bonds over most of those periods.
Reason No. 3: Stocks beat inflation over the long term. Investing is all about giving up consumption today in order to have consumption in the future. You're not spending today so you can spend money in the future, usually for retirement. Unfortunately, chances are those future expenditures are going to cost more than they do today, so you've got to make sure that you're investing in something that overcomes inflation or that at least keeps up with it.
And when you look at shorter-term time horizons historically -- like 5 to even 10 years -- cash, stocks, and bonds actually have about the same success rate. About 75% of the time those investments will keep up with or beat inflation. But once you expand it to 20 to 30 years, stocks have 100% record of beating inflation. Bonds [have a record of] about 90%, so still good, but not perfect.
The important thing to remember, there, is the other name for bonds is "fixed income," and why is that? Because if you buy a 10-year bond [say you put $1,000 in a 10-year bond], it pays you 3% every year. Over those 10 years you're going to get the amount of interest every year and after 10 years you're going to get your $1,000 back not adjusted for inflation. So every year you're losing ground to a certain degree. To keep up with inflation, you've got to have stocks in your portfolio.
Reason No. 4: Stocks pay bigger dividends. Most of the time, we think of the stock market as the price movements. Even when you hear the prices for the S&P 500 or the Dow, it's always the price. It does not reflect dividends; but, historically dividends have accounted for about 40% of the return for stocks and it varies by decade.
According to PIMCO, which is a fund company, in the nineties dividends only accounted for 15% of the return. In the first decade of the 2000s, dividends accounted for 135% of the return. How is that possible? Because the first decade of this century was one of those 10-year holding periods where actually stocks lost money and dividends were able to offset that.
Dividends are much more consistent, so since 1960, there have only been seven years when the dividends paid by the companies in the S&P 500 were cut, and only one year was that significant, and that was actually during the Great Recession of a decade ago, and the cut was like 20%.
So even though stocks go up and down in price all the time, dividends are pretty consistent. And not only are they consistent, but they outpace inflation. For an article a few years ago, I compared what it would be like to invest $100 in something that grows just at the rate of inflation vs. $100 in dividends.
Say it's 1960. You have $100. It grows just at the rate of inflation. By 2015, you had $800. Now what if, instead in 1960, you received $100 in dividends from the S&P 500? By 2015 you had $2,180.
So dividends, on average, beat inflation about 2% a year. That's great if you are saving for retirement, because most of us are reinvesting the dividends, which means we buy more stocks, which then pay more dividends, which allows us to buy more stocks. Over a long time you could actually end up with two to three times the number of shares you started with just by reinvesting the dividends.
But it's also good for retirees, because that's great income. It's inflation-beating income, and if you hold it outside of a retirement account, qualified dividends are taxed at a lower rate than ordinary income like the stuff you would get from CDs, bonds, and things like that. So it's tax-advantaged, inflation-beating income, which is just perfect for retiring.
Reason No. 5: Stocks enhance portfolio longevity and withdrawal rates. We've talked before about the so-called 4% rule in retirement. It came first from a study in 1994 by a guy named Bill Bengen. It was validated four years later by the so-called Trinity Study, a study by three professors at Trinity University. The study validated that if you take out 4% of your portfolio in your first year of retirement and adjust it for inflation, in all historical periods that has lasted 30 years. That's where that comes from. It would have lasted through the Great Depression, through the crash of the Nifty Fifty in the seventies.
These days, one of the most well-known researchers in withdrawal rates is a guy named Wade Pfau, and he updated the Trinity Study a few years ago with more recent historical information [looking at the returns of stocks and bonds from 1926 to 2014]. He looked at the success rate of different asset allocations for a 30-year retirement; the success rate being after 30 years you still had some money.
If you look at a portfolio that is all bonds and no stocks, you only had a 42% success rate. In other words, if someone retired and just held bonds, in 58% of historical periods, you would have run out of money. What if you add 25% stocks? Well, now your success rate jumps to 87%. It still failed 13%, but you improved. What about if you were 50% stocks, 50% bonds? That's the sweet spot. 100% success rate.
In case you're curious about 75% stocks? A 98% success rate, so still pretty darn good. What's the success rate of someone who retires and holds nothing but stocks? It's 93%, but no one wants to fail, so a 7% fail rate is still something to consider. But the evidence is clear that even retirees should have some stocks and could even stand an allocation up to 65% to 70% of stocks.
Now there's a lot of nuance to safe withdrawal rates, and we're actually going to have Wade as a guest on our show in a few weeks. He'll give us some other factors for determining the best withdrawal rate for you and how to invest in retirement; but it is clear that regardless of your risk tolerance and regardless of your situation, everyone should own some stocks for the rest of their lives.
The Foolish bottom line, here, is toward the beginning of this episode, we discussed 1987, and that has the distinction of being the year with the worst one-day drop in stock market history. But here's the interesting thing. Despite that drop, stocks still made money that year, because it did so well in the first two-thirds of the year. Before that year, the S&P 500 earned 5.7% including dividends. Since then -- since the end of 1987 -- the S&P 500 has returned 1,970% including reinvested dividends, which would have turned $10,000 into $197,000 over that 32-year period.
So the evidence is clear. As long as the future looks vaguely like the past, buying and holding a well-diversified portfolio of stocks is a clear moneymaking proposition.
Alison Southwick: So, as an "awfulizer," what is your plan? Obviously it's a super-complicated question.
Brokamp: Here's the funny thing, and I think I've mentioned this before. I'm an "awfulizer," so I tend to be conservative with my advice; but with my own portfolio, I'm very aggressive. It would be very conceivable for me to go into retirement with an allocation of 75% stocks. I will definitely follow that rule of having the five-year income cushion, where I put anything I need [absolutely need] out of the stock market for the next five years. But then I can go full stocks after that.