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What is long-term investing, anyway?

November 26, 2008 08:59 IST

After Black Wednesday and Thursday, two days when the markets fell to 1997 levels, it's understandable that any investor who is told not to worry because stocks are long-term investments might want to punch their sage adviser right in the mush.

That's because people in the financial world seemingly try their darnedest to never explain what "long term" means except to say that cash needed for immediate expenditure shouldn't be in stocks. After that, a long investment horizon seems to mean two years or three or five or a decade--whatever will comfortably convince the investor to stay put long enough for losses to turn into gains. It amounts to saying "just hang on, it will get better."

The answer to what long term really means can only be expressed in terms of probabilities. In his updated "Stocks for the Long Run," Wharton professor Jeremy Siegel takes a stab at this by comparing stock and government and corporate bond returns, using 100 years of data.

In any single year, you'll get a better return from stocks than from Treasurys and corporates 60% of the time. Over five-year periods, a stock investor will beat a bond investor 70% of the time. So, your odds improve when you get to five years but not really by that much, just from six out of 10 times to seven. This implies that five years really doesn't count as long term, so two- and three-year spans are out as well.

According to Siegel, a stock investor's best odds are reached for periods of over 20 years. That's when stocks beat bonds 95% of the time. There's no point where stocks always win, though. There's always a chance that stocks won't outperform in the long term for some investors.

Mutual fund companies that offer target-date retirement funds design their asset allocations by using Monte Carlo scenarios that try to calculate the probability that an investor will run out of money before they die. T. Rowe Price, a big proponent of this method, has the most equity laden target-date funds available because their Monte Carlo simulations show that long-lived retirees need out-sized stock returns long after they've stopped working. Otherwise, inflation wins, and the cash runs out.

T. Rowe was the first to send retirees out of the workplace with more stock. The original target-date funds were quite bond heavy. The industry has since followed T. Rowe's lead, though no one has surpassed its aggressive allocations.

Now look what happens to some target date funds in outlier years, like 2008. Putnam Retirement Ready 2010 has a pretty conservative allocation for somebody who is going to stop working in less than two years. It has 60% bonds, 22% cash and 27% stocks. It's down 32% this year. That's far better than the S&P 500's 48% decline, but it's still awful.

Putnam's investors don't have time to make up losses like this before they retire. Without time, the odds no longer favor these near-retirees. Long term becomes immediate very quickly.

For investors with time to play the odds, the Forbes.com Investor Team discusses foreign stocks and small and mid-sized banks in the paragraphs that follow.

Farrell: I think the world is viewing the U.S. as being the one first out of the morass. And it wasn't until Bernanke made unlimited dollars available that we started to get credit markets to thaw. Even though they don't want it, they don't want the dollar to be the reserve currency, it is. They had Bretton Woods II, and some of the some European attitude was, let's re-regulate the U.S. The U.S. still has the capacity to lead the world out, and they universally accepted currency. If the market comes back, it will be the U.S. first.

Lowlicht: I just read The New York Times, and their headline was: "A Sea Of Unwanted Imports." There is so much backlog of inventory that these ports have become storage places, until these imports can be sold. You have to get through all that until you can take in more imports. There is almost a glut of goods sitting there.

Ervolini: From the behavioral side, what we know about chaos and stress is that it causes people's view of the world to change. They become narrow. They have trouble delaying anything. They will give up future opportunity to give up pain. That's why there is an overselling of stocks at the retail level and a heavy movement into money markets. There is a desire to get rid of the pain of dealing with the stock market. So, retail investors may lag redeploying overseas, until they get a good feeling about domestic markets. All of us felt pretty flush two years ago, and there was the desire to participate in global markets. It wouldn't be surprising if retail markets wanted to see a good experience in domestic markets first.

Lowlicht: If you feel stability at home, you project that. When we felt stable at home, we felt Russia was stable. Now, all of a sudden we're looking at Russia, like I wouldn't put money there. Our experience is now projected into other parts of the world.

I would argue the price in oil led to a massive increase in wealth to Russia, and when they were going toward the way we are, more of a democracy, they were a much poorer country. Oil went to $130 a barrel, they became wealthier and the tune changed. What I am saying is that as countries become wealthier, they become more brazen.

Farrell: The petro-currency is a good example of that. Russia went into Georgia and then was threatening Ukraine when oil was at $147 a barrel. It was backed up by a lot of cash.

[Ed. Note: Hudson City Bank is the bank that famously "lends to those who don't need to borrow" and trades at 20 times earnings--a huge multiple compared to other financials. Hudson City is one of the few public banking companies that has not had to participate in the Treasury bailout programs.]

Farrell: I'm not so current on small banks by name. But what I see is that they stuck to their knitting and didn't get involved in the securitization stuff. Because they were not big enough, so they avoided a lot of the problems. I don't know if they've seen much in the way of deposit flow. Deposits have flown to big banks that have been blessed by the government when it changed FDIC insurance to $250,000. The Bank of America's seen an enormous flood of new deposits. People would rather put money into great big banks than the small one they see every day. They will probably get a good stream of loan applications, because mortgage brokers are truly yesterday's industry. So now you go to your local bank to get a mortgage. And they probably had good credit standards.

Lowlicht: In the short term, I agree with that. It comes down to the Glass-Steagall Act. Glass-Steagall separated commercial and investment banking. But it was repealed in 1999, when big banks went into securitizing mortgages. Which in the end is what hurt them. The smaller and some mid-sized banks, for the most part, stuck to their knitting.

As far as big banks getting deposits, there will be some backlash, as there was with the big brokerage firms. Everyone told me when I went independent that at the big firms, I feel safer. My clients came with me anyway, and turned out to be better off with me. The whole banking area was getting bigger, and soon it becomes so big it's not manageable. In short term, there was a false sense of confidence.

Ervolini: I've heard of people moving money, even business accounts [to smaller banks]. Some smaller banks get federal and state insurance together. Once we're past the short term, it's going to be about marketing. Regional banks have an opportunity to take what's going on and create huge marketing from it. Whether they will or not is not clear. Once the dust settles, we'll be back to banks doing aggressive marketing.

Lowlicht: They need the reach. If you have a small, local bank and you do business in England, it's harder than if you had a multi-national bank. There is a trade-off. The local mom and pop businesses think locally. Someone global will think globally.

Ervolini: Some businesses might prefer to work with smaller or community banks for their basic services, such as cash management, payroll, etc. They might then look to bigger, more sophisticated financial organizations for 401(k) management or international funds wiring or letters of credit.

Emotionally speaking, however, we might see a trend where small to mid-sized businesses simply want a modest level of personal recognition. A smile and the use of their name when they enter a bank might mean more than a few basis points.

David Serchuk and Michael Maiello, Forbes.com
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