2012 Q3 Newsletter
Twenty-five years ago this month, I was a freshman engineering student on the campus of the University of Wisconsin enjoying all of my favorite courses: calculus, chemistry, and physics. For reasons completely unbeknownst to me at the time (but greatly appreciated now), the powers that be at my beloved alma mater included economics as an ingredient in my engineering curriculum. And so on October 19th, 1987 I remember sitting in the front of a lecture hall on Bascom Hill in an Economics 101 class when our professor entered the room.
As a wide-eyed nineteen year old, I had only a cursory understanding of the concept of stocks, bonds, and inflation. So my professor piqued my interest when he relayed the message that he had just heard on the radio (the Iphone of our day) that the stock market had fallen 25% since the opening bell that very morning. He said with a very telling sock-it-to-the-rich smirk on his face: “Anyone with $1 million invested in stocks has lost $250,000 in the past three hours.” As a college student with a $10 per week budget, the magnitude of those numbers were staggering to me. I remember thinking to myself how foolish those stock market investors must be. Why would they put their money at risk like that? Especially when my professor tells me how “prudent” investors can obtain a “risk free” 7.08% interest rate from Ten Year US Treasury Bonds?
Fortunately, history has taught me much more than any professor ever could. Note the performance of a $1,000,000 portfolio invested stocks versus bonds during the ensuing twenty-five years:
Keep in mind that the bond market soared during this time period as treasury yields fell from 9.0% down to 1.6%. Meanwhile, stocks suffered through the two worst bear markets since the Great Depression. Despite this, stocks still convincingly beat bonds in terms of both wealth accumulation and income generation. In fact, “prudent” bond investors saw the value of their portfolios’ income stream slashed by more than half.
When presented these numbers, even the most anxious of investors are forced to admit that equities have been a superior wealth accumulation vehicle to fixed income. They acknowledge that while adding money to a portfolio, one will likely do much better over the long term by accumulating shares of great companies as opposed to debt. For us, the inherent volatility in stock prices actually works to our benefit as it affords us opportunities to periodically purchase additional shares at discounted prices.
But the most eye-opening conclusion of this exercise is the unqualified necessity of including equities in the portfolios of retirees. Investors expecting “safe” fixed income (in any of its permutations…bonds, cash, CD’s, annuities, etc.) to miraculously sustain them through a typical twenty-five year inflation-adjusted retirement should be downright alarmed by these numbers. Even a twenty-five year bull market in bonds was not sufficient to counter the common sense notion that rising expenses will always eventually exceed a fixed income stream. Hoping for any other outcome is a fool’s game.
With bond yields near all-time lows, bond prices near all-time highs, and unprecedented bond mutual fund net inflows, an entire generation of bondholders has never experienced crashing prices during a significant interest rate climb. Unsuspecting retirees hoping to avoid the volatility of equities by fleeing to the “safety” of fixed income may very well be in for the shock of an investing lifetime as they discover that fixed income is far from riskless.
It is rare that we find information worth passing along that originates from the retail mutual fund community. However, to give credit where credit is due, I encourage all of you to take a minute to download Franklin Templeton’s recent easy-to-read brochure entitled Time to Take Stock: https://www.franklintempleton.com/forms-literature/download/TS-B. You will thank yourself twenty-five years from now for doing so.
Senior Portfolio Manager
Disciplined Equity Management