Take the long view. That’s standard advice in investing, and it makes sense. After all, if you’ve salted money away for a serious purpose like retiring or buying a house or paying for a child’s education, you really don’t want to focus on how the stock market has done today or on what it might do tomorrow. You need a longer perspective.
But there’s a fundamental problem with this otherwise sound guidance: How long is the long view? And what do you do if the basis of your long-term thinking changes radically from year to year?
These aren’t just theoretical questions. Because of a quirk in the calendar, such a cognitive shift has happened recently. And it suggests that the long view needs to be much longer than five years.
Consider the five-year annualized returns of the stock market, which have undergone an astonishing improvement over the course of just one calendar year, from a net loss in the five years that ended in 2012 to a hefty double-digit annualized gain in the five years that ended in 2013.
These five-year numbers often color the thinking of not just ordinary investors but sophisticated strategists as well. Open a year-end report for your 401(k) or IRA, and you may now see the 2013 numbers for your own investments and for comparable benchmarks. Along with more recent returns, those 2013 five-year returns are appearing on financial websites, and in mutual fund reports and brokerage letters. And they are used by consultants for pension funds and other institutional investors in formulating asset-allocation and risk-management strategies.
Yet these five-year perspectives are very changeable. At the end of 2012, stocks’ five-year record was dismal. Now, it looks fabulous. What’s remarkable is that three of the years in each of those five-year records are exactly the same.
“This is an anomaly in market returns that’s occurred because of the calendar, and the extreme moves in the market that have taken place since the financial crisis, and it can be very misleading if you don’t look at it carefully,” said David Kelley, chief global strategist at J.P. Morgan Funds.
Before considering what it might mean, let’s look at how such a big change occurred in the five-year data. The numbers tell the story, if you examine them carefully.
At the end of 2012, the annualized five-year return of the Standard & Poor’s 500-stock index, without dividends, was a negative 0.6 percent. That means that if your portfolio mirrored the index, you lost some of your money (although, to be sure, dividends would have given you a small annualized gain of 1.7 percent).
The main reason for these depressing figures was that the market hadn’t fully recovered from the devastation of 2008 and early 2009. That period was a nightmare for the markets and the economy. In 2008 alone, the S&P 500 dropped 38.5 percent, without dividends. After such losses, many investors came to an understandable conclusion: that the market was an inhospitable place. And they walked - or ran - away from it.
But at the end of 2013, if you relied solely on the five-year trailing numbers, you would have had reason to kick yourself for being out of the stock market. That’s because the annualized five-year return had climbed to 15.4 percent without dividends, and 17.9 percent with them. If you had invested in the index over those five years, you would have more than doubled your money.
Why did the five-year return change so much in just one year? First and foremost, on Dec. 31, 2013, the entire ghastly year of 2008 was effectively wiped off the books, from the standpoint of the five-year return. That tally started near a market low in 2009, and the results of 2013 became part of the record, too. And 2013 was spectacular, with a gain of 29.6 percent for the S&P 500 without dividends, and 32.4 percent when you include them.
In short, the five-year view in 2012 and 2013 produced two very different narratives. The view backward at the end of 2012 was a cautionary tale about the risks of stock investing. The five-year view just one year later was all about the rewards of risk-taking.
Which one should you rely upon for guidance?
Neither is enough if you’re trying to be a long-term investor. A much longer time period seems in order. For example, the stock market has tended to outperform the bond market in the past. (That’s probably because investors demand a premium for the greater risk involved in stock investing, according to prevailing theory.) This has been true, on average, for many decades - but it wasn’t true during the financial crisis. In order to count on a long-term trend like this, you may need to stay in the markets for 20 years or more - maybe for a lifetime, or even several lifetimes. That may not be easy to accept.
James W. Paulsen, chief investment strategist at Wells Capital Management, happened to drop by last week from Minneapolis, and we discussed some of these issues.
“The sad truth,” he said, “is that over shorter periods, there’s really no certainty that the market will behave the way it has in the past, which is why you need to stay very broadly diversified in your investments and why most people need to go for the really, really long term.”
Five-year returns may tell you what worked in the past, but the conclusions to be drawn from that may be counterintuitive.
“Success means market prices have already risen,” he said. “When prices are high, it may mean that you should be looking for something else.”
Professional strategists live in a world where such price distinctions are crucial. But for the long-term investor, basic diversification and asset allocation may be enough, he said.
“If you follow the basics, that’s 80 percent of it,” he said. “Guys like me are trying to improve your returns for what’s left after that.”
At least this much is clear: The long view may need to be very long indeed. Sometimes a five-year span isn’t nearly enough.