What do you, the hypothetical saver, want to achieve from your investments? I think a typical response for many ordinary investors is to target a specific rate of return, as this offers an easy way to forecast how much money needs to be saved and invested to meet some specific retirement goal.
For instance, a 25-year old might decide that they want to retire at age 65 with $800,000 in their IRA. They calculate that they will hit this goal by allocating $6,000 a year to their IRA (the annual tax-free maximum) and targeting a 5% annual average rate of return. However, in my opinion, this focus on yield has it exactly backwards.
Stocks vs bonds
Stocks have historically returned more than bonds on average. This was pointed out by Warren Buffett (Trades, Portfolio) in his 2019 letter to investors of Berkshire Hathaway (BRK.A, BRK.B), in which he referred to economist Edgar Lawrence Smith’s 1924 book "Common Stocks as Long Term Investments," the first systematic side by side comparison of equities and bonds.
In carrying out his research, Smith was surprised to learn that stocks historically returned more than bonds, as he had set out to prove the opposite. At the time, it was thought that stock investments were always speculative, as shareholders are not entitled to a company’s cash income in the way that bondholders are.
What does this have to do with targeting returns? Well, nowadays, most ordinary investors will put their hard-earned IRA allowance towards stock purchases, and part of the reason is that the investing orthodoxy has been turned on its head. Investment advisors will assure clients that “stocks outperform bonds” in the long-term, that “time in the market is more important than timing the market” and will increasingly advise them to invest in index funds that passively track the market.
He who dares, wins?
Now, while it is true in a general sense that stocks return more than bonds, this is only part of the story. Calculations of return mean nothing without an equal consideration of risk. No stock is so good that it is a buy at any price.
Last week, I wrote an article about how junk bond king Michael Milken was able to convince Wall Street that low-grade corporate bonds offered historically superior rates of returns to triple-A rated securities. However, this only held true while the prices of these bonds were depressed. A low-quality bond that offers excellent risk/return when trading at 40 cents on the dollar becomes a terrible investment when everyone is clamouring to buy it.
This brings us back to the question we started with: what metrics for success should investors focus on?
I believe that if you strain to achieve a specific rate of return, then it is only a matter of time before you overreach. Since its inception in 1928, the S&P 500 has returned an average of 10% every year, but does this mean that you will get 10% each year? Of course not. In fact, if you bought the index at the height of the dotcom bubble in 2000, you would have had to wait seven years for your investment to come back to the same level (assuming you did not cut your losses earlier). Investors who bought the Japanese Nikkei index at its peak in 1991 are still waiting for it to come back.
Thus, it is essential to always be cognisant of whether what you are buying is expensive, and don’t just focus on hitting an arbitrary goal year.
Disclosure: The author owns no stocks mentioned.
Read more here:
- Warren Buffett: What Is a Board of Directors For?
- Chamath Palihapitiya: The Government Should Not Bail Out Mismanaged Companies
- A Brief History of Junk Bonds, Part 2
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