Stocks for the Long Run is a best-seller by Jeremy Siegel and is the basis for the stock-centered portfolios that dominate in the U.S., even among retired investors. Siegel’s argument is that over the long-term stocks earn substantially higher returns than the alternatives. Stocks do have higher volatility. But because of the higher returns, investors are better off when they own stocks and don’t worry about the short-term volatility.
That argument has been challenged on several fronts, especially for investors in or near retirement. The downside volatility of stocks tends to be compacted into extended periods (secular bear markets). When one of those coincides with the end of one’s working years or beginning of the retirement years, the entire retirement plan can be thrown off. There might not be enough time for the long-term returns to get the plan back on track.
Another criticism comes from the academic world. One paper argues that there’s a great deal of uncertainty about stock returns. Decades ago there was no reason for stock investors to believe they’d earn such high excess returns or to expect them. Today, investors can’t confidently predict that returns from stocks will maintain the high excess returns over other assets they delivered historically. Here’s an article that reviews both sides of the argument but concludes that income-oriented investing in stocks delivers the best of the options.
Siegel’s argument that the expected return of stocks justifies their risks relies on the fact that U.S. stocks have delivered remarkably high (6% real) average annual returns going back as far as 1802. He assumes that this risk premium will persist and that we can estimate the expected future return of stocks on this basis.
Could investors have known ahead of time that the average real return from stocks would have been this high? Pastor and Stambaugh argue that they could not. Can investors plausibly use a very long period of history as the basis for an accurate expected return as we look into the future? Once again, Pastor and Stambaugh argue that this is not reasonable. Because of uncertainty about estimating expected returns, investors looking forward face a higher level of risk as the time horizon increases. In practical terms, this means that if we use an expected return that is too high, the impact of the estimation error grows in time due to compounding.