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103

* A 50% bracket is used for comparative purposes; however, lowering it to 40%-45%, which will be the effective rate on short-term gains including state income taxes in a number of large states (23%-26% on long-term gains), will not affect the results significantly.

As you increase the number of years you hold stocks versus debt securities, the comparisons only get better. If you received only 50% of the market retum for 10 years your portfolio would be worth 40% more than in bonds and 47% more than in T-bills. Whats more there is a 76% chance (column 4) that you would do better than that. If you receive the market retum over time, as we saw before, you score big. After 15 years (column 5), you would almost triple the retums from bonds or T-bills. Moreover you have a 64% chance of reaching or surpassing this figure (column 6). After 25 years, your net worth is over 5 times what it would be in debt instmments, and so on.

Not that you need to strike it rich with the types of retums we have just seen, but there is also a reasonable chance you could outperform the market over time. If you did so, as column 7 indicates, the retums bury those in bonds and T-bills. In this happy situation the investor almost quadraples die retum of debt instmments in 15 years, and about quintuples them in 20 years.

There you have it. Once again stocks provide higher rewards over time than bonds or T-bills even under poor circumstances, and shoot out the lights under better conditions. The decision of where to place money should not be that difficult.

Table 14-5 is identical in format to Table 14-4, but also includes income taxes.* Once again a portfolio of stocks, after taxes and inflation, does better than bonds or T-bills whether you get 25% of the average retum on stocks or 150% for any period they are held. Taking the lowest retum on stocks-25% of the market average-for 5 years, the portfoho increases by 6% (1.06, column 1), whereas portfolios of bonds and T-bills lose 9% and 8% respectively (.91 column 9 and .92 column 10). Moreover, as the frequency distribution shows, you have a 67% chance of being at or above this retum (column 2). Again, as the time periods increase, stocks substantially outperform bonds and T-bills under all the scenarios.

I have tried to answer in two separate ways the question of how much risk there is in holding stocks instead of bonds and T-bills. First, we asked how often stocks would outperform T-bills or govemment bonds after inflation for periods varying from 1 to 30 years in the postwar period in Table 14-1, and after inflation and taxes in Table 14-3. We saw that stocks won in a breeze in both cases; the longer the time period the



Holding Portfolio for 1 year 5 years 10 years 15 years 20 years 25 years 30 years

25% of Market Retum

50% of Market Retum

100% of Market Retum

150% of Market Retum

Average Stock Portfolio Value

1.01

1.06

1.14

1.23

1.35

1.49

1.67

-

ability* (59%) (67%) (76%) (71%) (69%) (73%) (82%)

(3) Average Stock Portfolio Value

1.02

1.12

1.27

1.46

1.69

1.98

2.34

-

ability* (57%) (65%) (71%) (69%) (63%) (61%) (63%)

(5) Average Stock Portfolio Value

1.04

1.24

1.54

1.92

2.38

2.96

3.67

-

ability* (55%) (51%) (61%) (63%) (61%) (49%) (43%)

(7) Average Stock Portfolio Value

1.07

1.36

1.81

2.37

3.07

3.94

5.01

Pmb-

ability* (53%) (45%) (45%) (47%) (45%) (43%) (41%)

(9) Average Bond Portfolio Value

(10) Average T-bill Portfolio Value

* The probability that a portfolio will be above the value shown.

more they outperfomied. The risk of T-bills or bonds providing inferior retums to stocks is large and increasing after 3 to 5 years.

Second, we examined the risk that stock retums would drop off sha ly from their long-term norms in Table 14-4 and Table 14-5. Once again, we saw even if this happened (if, for example, stocks provided only 25% of their normal retum over time) they still outperformed the debt instmments by a significant margin after as little as 5 to 10 years.

Lets now go back to the two measures that we said should be incorporated into a good definition of risk:

1. The probability that the investment you chose will preserve your capital over the time you intend to invest your funds.

2. The probability the investments you select will outperform alternative investments for this period.

The conclusion is obvious-stocks meet both of these criteria. Using this analysis of risk in the postwar period, stocks are the least risky investments over time. If you are in your thirties, for example, and have a goal of retiring at 65, you should buy blue-chip stocks because you have a 100% chance of both preserving and enhancing your capital, as well as outperforming bonds and T-bills. The probabilities are also high that you will outperform debt securities manyfold. Though not as high, the

Tabk 14-5

Probability of Stocks Meeting Various Levels of Return 1.0 = Starting investment, inflation- and tax-adjusted 1946-1996



odds are still overwhelming for 15 years and reasonably good at 4 or 5 years. From a risk perspective, bonds and T-bills give you increasingly short odds after only a few years. They are not the investments you want to build your future upon.

What we see then is the development of a new approach to risk analysis, which tries to more realistically appraise the risk of holding various types of investments over the time the investor intends to invest his or her funds. The analysis allows you to not only determine the odds that your retums will outperform or underperform other types of investments, but also the probabilities to determine by how much. This risk measurement framework could also be adapted to valuing real estate, precious metals, or other investments, if you can find records of their performance over longer periods. If you chose to measure how you would do in Old Masters, other art, or collectibles relative to equities, as an example, there is an index dating back to the 1960s from Sotheby, which Barrons reports each week.

While this approach to risk can certainly be fine-tuned, it allows you to more accurately assess your exposures in the postwar investment world, one very different from any investment environment of the past.

We examined one last category of risk in the previous chapter: how financial investments react when an economic system breaks down through hyperinflation, such as has occurred in Latin America for decades; or in Germany in the early twenties; or when an economy is destroyed, as in Germany and Japan after World War II. Fortunately this kind of risk is not a consideration for domestic investments, but it can certainly affect your investments abroad. As we saw, the findings also strongly support the risk strategies we have developed in this chapter.

Now lets tum to market pitfalls. Have you heard these?

Small caps should make you major money over time.

Nasdaq, which billed itself as the stock market for the next 100 years, is a place you should keep most of your money.

You can always tmst the numbers, anybodys numbers, as long as theyre given to you in writing.



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