Commentary: Why You Still Need Stocks

In recent years, it has been drilled into everyone with a retirement savings plan or a mutual-fund portfolio that equities are superior long-term investments. After all, stocks in the postwar period have posted a compound annual return of 7.5%, after adjusting for inflation, vs. 1% for bonds. And as the bull market rocketed to new highs, the idea that bountiful returns came with a price of substantial risk became downright quaint. "Our firm has been preaching caution for about three years and feeling stupid," says Stephen Barnes, head of Barnes Investment Advisory in Phoenix.

No more. Since its July peak, the U.S. stock market is down sharply, and the carnage is far worse in emerging markets. The declines are a brutal reminder of something too long overlooked: Stocks are risky--it's the nature of the beast. "There is no free lunch, fountain of youth, or investment strategy that beats another by almost 7 percentage points with no extra risk," says University of Chicago finance professor John Cochrane.

MEAGER REWARD. Just what does "risk" mean in the stock market? Most people investing for retirement define it as the chance of having a meager reward--or an outright loss--when you need your savings to live on. Economists, however, use measures that essentially define risk as volatility. There's plenty of that now, in contrast to 1992 to 1995, when stock prices went straight up with few interruptions.

If all you had to do was wait out a correction or a bear market in anticipation of a lush long-term return, the risk of owning stocks would still be minimal. Indeed, the probability of doing poorly in stocks shrinks with time. But it doesn't disappear. Since 1871, there have been at least 20 rolling 10-year periods when bonds outdid stocks. Before 1900, stocks lagged behind railroad bonds and did no better than commercial paper.

Bonds outdistanced stocks during the Great Depression, too. "History has few starting moments that come anywhere near resembling the current level of market valuations," notes Peter Bernstein, a New York-based economist and investment adviser. "This suggests that equity investments from here are going to fall short of swollen hopes and conceivably fall short of bond returns."

So should you now steer clear of domestic and international equities? Not at all. In fact, many people are far from being overexposed to stocks. Last year, 40% of 401(k) plan assets were held in equity portfolios (another 21% was in company stock), says the Spectrem Group, a San Francisco financial-services research firm. Rather than shun equity risk, the right approach would be to include stocks in a portfolio diversified across a variety of assets.

For example, a portfolio that tracks the Standard & Poor's 500-stock index is down 0.6% on an annual basis this year. But a portfolio 70% in stocks and 30% in fixed income is up 1.3%, according to Ibbotson Associates, a Chicago-based financial research firm. Diversification is not simply creating a margin of safety. Since no one knows which markets will soar or sink, diversifying also gives investors an opportunity to catch the next big market upturn.

Going forward, stock returns may pale compared with those of the past 15 years. Still, if you can envision the U.S. economy remaining a leader among major industrial nations, you'll want to own stocks. If you believe the global economy will continue to expand--despite stomach-churning fits and starts--you'll want a slice of international equities.

Life, after all, is risky. Sure, you can put all your money in Treasury bills. They're risk-free, but that doesn't mean your portfolio will be. With their low return, T-bills may not generate enough income to provide adequately for your retirement. That's why you need to diversify. You'll expose parts of your portfolio to volatility and even outright losses. But that's the trade-off if you want higher returns for the long haul.

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