Last week we examined the likelihood that a portfolio of either cash, bonds, or stocks would lose money over different time intervals. Today we study the likelihood that such investments will either double or triple their future value. Although stocks offer a much better chance of doubling or tripling compared to bonds, over the long run the risks of the two investments are about the same. Retirees who expect to spend 10 years or more living off their retirement savings should take a long, hard look at these numbers before selling their all stocks and moving into bonds.
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But do we really have a firm grasp on the likelihood that our portfolio will achieve the kind of gains we expect and hope for? Are our expectations realistic? Time for another reality check.
Last week we quantified the risk we take when we invest in different classes of assets -- cash, bonds, or stocks. Specifically, we examined the chances of losing either any money or more than 15% or 30% of the value of our portfolio for 5-, 10-, and 20-year time periods. Most of the methods used to get today's numbers are explained there, and won't be repeated. I highly recommend a quick click and review before proceeding further.
Today we'll examine a much more cheerful topic than quantifying the risk of losses; we'll quantify the likelihood of reaping the rewards -- large rewards. For instance, what do you think the chances are of doubling or tripling your current portfolio in 10 years when inflation is included? Take a guess, write down your number, and compare your guess to our calculations below.
As described last week, our tool for today's exercise is the Portfolio Forecaster (free registration), developed by Nobel laureate economist William Sharpe. The nice thing about the Forecaster is that, instead of giving us a single number about what our portfolio might be worth in the future, the program runs thousands of possible future economic scenarios, creating a profile of probabilities. Given an investment in any unique group of stocks or mutual funds, the Forecaster will give you a probability that your portfolio will reach a certain value after a designated time period.
Using the same Vanguard mutual funds as last week to represent surrogate investments in cash, bonds, and stocks, I used the Forecaster to predict the likelihood of either doubling or tripling a portfolio.
As explained last week, the following returns are stated in inflation-adjusted dollars. Inflation will cut into any portfolio gains. If the program calculates we will double our investment, we actually are gaining significantly more in actual dollars than just a simple doubling. It's our portfolio's purchasing power that is doubled, rather than the simple dollar amount.
Here are the numbers, with the first column representing the chance of realizing any (inflation-adjusted) loss, and the next two columns representing the likelihood of either at least doubling (2X) or tripling (3X) our investment:
Chance of Loss/Gain
Any Gain
5 Years Loss >2X >3X
Cash 13% <1% <1%
Bonds 19% 2% <1%
Stocks 22% 9% 1%
Any Gain
10 Years Loss >2X >3X
Cash 7% 1% <1%
Bonds 10% 3% <1%
Stocks 11% 38% 12%
20 Years Loss 2X 3X
Cash 5% 5% <1%
Bonds 8% 14% 1%
Stocks 8% 70% 49%
(Note that for some of the calculations, I made minor extrapolations in order to get the numbers, since the Forecaster results weren't always presented uniformly.)
These numbers present one of the strongest cases I've ever seen that stocks are the place to invest for the long run. Over any time period of 5 years or more, the chances of doubling or tripling the buying power of your investments with stocks far exceeds that of bonds or cash.
Not only is your upside potential much higher with stocks compared with bonds, the risks are not all that different -- especially for time periods greater than five years. For instance, after 10 years, the likelihood of doubling your money is over 10 times higher with stocks than with bonds (38% vs. 3%), but the risk of losing money is almost the same (11% vs. 10%). And after 20 years, you can expect to triple your money in stocks about half the time, but have a minuscule chance of doing the same with bonds -- with virtually the same amount of risk.
Do bear in mind that we are talking about long-term savings in these examples. For most people, money that you expect to need in the next three to five years should not be in stocks or long-term bonds precisely because of the risk of loss shown above. But retirees who expect to spend 10 years or more living off their retirement saving should take a long, hard look at these numbers before selling their stocks and moving into bonds on the theory that bonds are "safer." At least to me, the quantified risk/reward ratios favor stocks to an extraordinary degree.
Of course our individual portfolios, whether invested in the Foolish Four, Beating the S&P, or elsewhere, may have different reward/risk profiles than the one I've presented here (which uses the S&P 500 Index for our stock return surrogate). Foolish Four portfolios, at least historically, have owned fewer disaster stocks and hit more home runs than usual, which is one reason we liked this strategy in the first place.
Use the Forecaster to check out your own portfolio's profile. Even though your stock portfolio might not be a winner each and every year, at least you'll have a pretty good idea about what to expect over the long run. Speaking of the long run, please try to ignore the observation of another preeminent economist, John Maynard Keynes: "In the long run we are all dead." Dead, maybe, but perhaps very wealthy, too.
Beating the S&P year-to-date returns
(as of 09-12-00):
Bank One <% if gsSubBrand = "aolsnapshot" then Response.Write("(NYSE: ONE)") else Response.Write("(NYSE: ONE)") end if %> +22.0%
PepsiCo <% if gsSubBrand = "aolsnapshot" then Response.Write("(NYSE: PEP)") else Response.Write("(NYSE: PEP)") end if %> +25.6%
Ford Motor Co. <% if gsSubBrand = "aolsnapshot" then Response.Write("(NYSE: F)") else Response.Write("(NYSE: F)") end if %> -11.0%*
Bank of America <% if gsSubBrand = "aolsnapshot" then Response.Write("(NYSE: BAC)") else Response.Write("(NYSE: BAC)") end if %> +16.6%
Fannie Mae <% if gsSubBrand = "aolsnapshot" then Response.Write("(NYSE: FNM)") else Response.Write("(NYSE: FNM)") end if %> -1.0%
Beating the S&P +10.4%
Standard & Poor's 500 Index +0.9%
*Includes Visteon <% if gsSubBrand = "aolsnapshot" then Response.Write("(NYSE: VC)") else Response.Write("(NYSE: VC)") end if %> spin-off
Compound Annual Growth Rate from 1-2-87:
Beating the S&P +23.8%
S&P 500 +17.1%
$10,000 invested on 1-2-87 now equals:
Beating the S&P $185,300
S&P 500 $86,300