With stocks coming off their worst decade ever and the risk of recession rising, I’ve had many people ask me if it’s time to abandon stocks. While this feels like the right thing to do, don’t do it! Why? The greatest risk most people face is outliving their assets, and stocks combat this better than any other asset class. I’ve found in times like these, it’s easy for investors to forget about purchasing power risk and focus entirely on today’s headline, as if they had the time horizon of a fruit fly.
Taking inflation into account, the real return on “safe” assets like bonds and cash is negative at today’s rates. Since bond yields can’t go much lower, the only major move from here is up. This means that in addition to earning a negative real rate (including inflation), you also risk losing principal on the “safe” part of your portfolio. Alternatively, stocks are achieving an earnings yield over 8%, which is about 6% more than 10-Year Treasuries. This, combined with strong balance sheets, high cash positions, and low valuations makes stocks fairly appealing despite all the economic uncertainties.
Unfortunately, the price to be paid for this level of earnings yield is gut-wrenching volatility. Hard as this is to stomach, this isn’t as bad as it seems. If you are allocated properly for your goals and time horizon, you shouldn’t have to sell much at the bottom. For example, a balanced portfolio would likely yield 2.5% today. Sustainable portfolio withdrawal rates range from 3% to 5%, depending on an individual’s age. As long as annual withdrawals are in this range, the most that would need to be sold in a given year is 2.5% of the starting portfolio value.
I think another reason stocks are important is our changing world. With the rise of the emerging markets, millions of consumers are entering the middle class each year. As they earn more, they buy cars, houses, furnishings, appliances, and expand their diet. This increases the demand on natural resources, which will likely push prices ever higher. Companies adapt and take advantage of these changes in ways the consumer cannot. For example, they sell to all these new customers to get increasing revenues and profits, and can raise prices if necessary. If you own their stocks, this benefit flows through to you.
Over the years, I’ve seen many people make the mistake of thinking they can move to the sidelines until there’s more certainty. For sure, this is sometimes a good idea. Unfortunately, I usually see people make emotional decisions to sell stocks after they have already fallen. Then, they sit out until all is well with the world only to pay much higher prices when they buy back in. This is why studies by Dalbar Inc. continually show that the average investor vastly underperforms the market due to bad timing.
In the end, balance is essential. Approaches suggesting “all stocks” or “all bonds” are too extreme for most situations. Wealth preservation certainly calls for a healthy amount of bonds no matter how low yields go. Investors should also hold other asset classes such as cash, natural resources, real estate, and hedge funds. Further, valuations and the economic environment should be monitored to determine if adjustments are prudent.
I think the Wall Street adage “the hard trade is the right trade” is worth keeping in mind especially when emotions are high. At the moment, holding stocks amidst all the uncertainty is the “hard trade.” With earnings yields high and fixed income yielding so little, and long-term inflation risks stemming from a changing world, maintaining a meaningful allocation to stocks is the “right trade” today.