With Dr. Craig Israelsen, Designer of the 7TwelveⓇ Portfolio, Executive-in-Residence in the Financial Planning Program at Utah Valley University, Contributor to Financial Planning magazine
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How Long Does A Long Term Investing Strategy Need To Be?
Craig Israelsen, Executive-in-Residence in the Financial Planning Program at Utah Valley University and contributor to Financial Planning magazine, joins Steve to talk about how crucial it is as an investor to take a long-term view and long-term positions, the importance of diversification in an investment portfolio, the cyclical performance of different asset classes, and more. Steve starts the conversation by noting that one of the most commonly heard pieces of advice in personal finance is that investment success depends on a long-term investment view and practice. A stock price dips and spooks investors, but their financial advisors urge them to hold on “long-term.” If payoffs for patient investors require many years, exactly how long is long-term? How long do you have to wait before you get close to optimal results on your investments? Craig’s answer is that you should be thinking about 20, 25, or 30-year timelines.
Diverse Asset Classes Fluctuate Cyclically
One of the main reasons for this extended waiting period, Craig explains, is that the different assets you should have in your portfolio—stocks (US and foreign), bonds, cash, and real estate, for example—all have their own “natural” patterns of price fluctuation. Craig uses the metaphor of ingredients in salsa to describe such a diversified investment portfolio, each of which responds to different economic conditions and drivers. Using cash assets (money deposited in a bank savings account) as an example, returns over the past decade have been miserly, but their long-term return averages around 3% before inflation. Steve asks whether this means that cash returns, depressed over the short term, will need to break above 3% for a period of time in order to achieve a 3% long-term return. Craig affirms that this “regression to the mean” describes the way all asset classes will fluctuate (in differently timed cycles) above and below their mean average rates of return. He adds that cash returns only break out above their long-term average when inflation is in overdrive, which in turn suppresses the value of higher cash returns. Because inflation and interest rates have been so low over the past decade, cash returns are also low. Craig points out that not all asset classes suffer in a high-inflation environment; hard assets like commodities and real estate, for example, tend to do very well.
Long Term Market Returns And Short-Term Performance
Turning towards stocks, Steve remarks that the past 9 years have seen a strong bull market, but he asks Craig to put these gains into a historical perspective by talking about the average stock market returns for large-cap US companies over a much longer time period. Craig’s answer is that since 1929, large-cap stocks have returned 10%/year before inflation and 6.9% after inflation. This latter number is still quite good over the long term, capable of generating real wealth. The key, again, is long term. When looking at 5-or-7-year “windows” of time holding then selling stocks, many of these have fallen well short of long-term returns. Because he’s done research into short-term investment windows, Craig is able to delve into details of this subject. Taking a hypothetical scenario of owning a large-cap stock for 5 years, he states that 57% of the time 5-year returns beat the long-term rates. By contrast, looking at a 35-year time frame, an investment in large-cap stocks equals or beats the long-term average 88% of the time.
When it comes to stocks underperforming average long-term returns, the numbers are surprisingly dramatic. For a 5-year investment in large-cap stocks, that 43% of investors that missed the average 10% rate of return missed it by 8%, leaving a measly 2% return. As you look at longer timelines, the magnitude of the underperformance is lower. For those who held onto their stocks for 35% and made less than the 10% average long-term return, they only missed it by a paltry 0.5%, for a 9.5% average return. The performance of small-cap stocks is similarly analyzed, and the results are largely parallel with large-cap stocks, but with more volatility and greater downside risk and upside reward. Steve remarks on the difficulty of recovering from deep declines in the value of an investment, pointing out that a 50% price drop requires a 100% move upward to regain their original value.
Patience And Diversification Win The Investing Game
Returns from bonds are briefly discussed and Craig pegs their average long-term pre-inflation return at around 5%. As mentioned earlier, cash returns around 3% annually and stocks 10%, both pre-inflation. When you subtract an average inflation rate of 3%, cash returns are negligible, bonds are around 2.3%, and stocks are 7%, fairly easy numbers to keep in your head for future reference. The interesting thing is that when you combine these assets in a diversified portfolio, the average return over a very long timeline is around 9.75%, higher than you’d expect with the low returns of cash and bonds in the mix. Craig calls it the “salsa effect” of diversification. Adding another food metaphor to the topic, Craig compares short and long-term investing approaches to cooking with a microwave or a crock pot. The crock pot, of course, is the slow, simmering, long-run method, whereas microwaving is for investors who lack patience. Patience along with diversification are the two indispensable qualities that successful investors must possess, according to Craig. Naturally, many people find patience boring and, therefore, difficult to sustain, often leading them to trade too frequently with less than stellar outcomes. Steve believes that resisting the temptation to sell and buy stocks—doing nothing in the face of market swings—is absolutely an active decision and effort that requires mental exertion and will power.
Steve and Craig wrap up their conversation by talking about how difficult it can be to convince clients that they should buy stocks when they’re “on sale”, having gone down by some significant amount. Many believe that history proves out the maxim that you should “buy when there’s blood in the streets.” Investors like Warren Buffet have built fortunes out of buying stock of companies that they believe in when they perceive these stocks trading at a discount. While insurance companies have a lot of success during market downturns in selling products that appeal to people’s idea of safety, investors would be better off at these moments to take a good, long look at stocks.
Disclosure: The opinions expressed are those of the interviewee and not necessarily United Capital. Interviewee is not a representative of United Capital. Investing involves risk and investors should carefully consider their own investment objectives and never rely on any single chart, graph or marketing piece to make decisions. Content provided is intended for informational purposes only, is not a recommendation to buy or sell any securities, and should not be considered tax, legal, investment advice. Please contact your tax, legal, financial professional with questions about your specific needs and circumstances. The information contained herein was obtained from sources believed to be reliable, however their accuracy and completeness cannot be guaranteed. All data are driven from publicly available information and has not been independently verified by United Capital.
Steve Pomeranz: How many times have you read or heard that in order to be a successful investor you have to think long-term? Well, has anyone actually asked the question well how long is long-term? That’s kind of a pretty vague phrase. Well, we’re going try to answer that today.
So I’ve invited Dr. Craig Israelsen to join the discussion. Dr. Israelsen is an executive in residence in the Financial Planning Program at Utah Valley University. And among many other things, writes for Financial Planning Magazine. Hey, Craig. Welcome to the show.
Craig Israelsen: Thank you, Steve, delighted to be with you.
Steve Pomeranz: So, there’s the question, let me reframe it. I’m an investor; I’m working with an advisor; I’m reading an article and the market goes down. And the advisor says, “Hey, Steve, you need to invest for the long-term, don’t worry about the short term.” What is he actually saying?
Is he saying five years, ten years, is he talking about 30 years or more? How do we figure out what I guess the best outcome is with regards to how long you have to wait for this stuff to work out properly?
Craig Israelsen: Right that’s a great question. In general, it’s 20, 25, even 30 years is really what’s meant by the phrase, quote, “long-term.”
Steve Pomeranz: Why is it so long?
Craig Israelsen: Well, we’ve got natural fluctuations in markets, whether it’s the U.S. stock market or non U.S. stock markets, in the bond markets, in the cash markets, real estate markets. So, we have all these different asset classes that, in essence, are the ingredients of a portfolio if you kind of think of a portfolio like salsa. We have to mix all these things together and all these different ingredients in the, quote, “salsa” are moving under different economic responses, different economic conditions.
Steve Pomeranz: Drivers.
Craig Israelsen: And so, if you’re invested in one particular asset class like cash for example. Cash returns have been depressed for what, seven, eight years? So, we can immediately see that the returns in cash right now, a savings account, are well below the average. Cuz the average is around 5%.
Steve Pomeranz: So, wait a minute, so going back for the long-term— again there’s that term again—we’re talking your return on cash would have been around 5%, but nobody’s getting 5% on cash for the last—what is it?—almost nine, 10 years.
Craig Israelsen: Right.
Steve Pomeranz: So, there’s a period of time where, very simply, you’re getting a much lower than average rate of return.
Craig Israelsen: Exactly.
Steve Pomeranz: Does that assume then, that if 25 years is the period of time that some point, perhaps, the cash rates will go well in excess of that 5% in order so I can get back to an average?
Craig Israelsen: Yeah, and that’s known as regression to the mean, and so as the return patterns of different asset classes, different things we invest in, as those returns fluctuate, they tend to fluctuate down, so they’re below the average. And then they’ll roll up and be above the average. The challenge with cash, the returns on cash, and think of cash as a savings account, is that when cash rates are high, so is inflation.
Steve Pomeranz: Yeah.
Craig Israelsen: And so those kind of neutralize, inflation neutralizes cash and so a high cash returns feels good. But the way we really measure these things is net of inflation, inflation factored out.
Steve Pomeranz: I remember back in the early 80s I started, we had cash at 13% or money markets-
Craig Israelsen: Right.
Steve Pomeranz: At that time. But inflation was running a 10 to 12%, everybody was miserable, prices were rising really dramatically, and because the cash assets don’t really earn that much more than the rate of inflation anyway. So right now inflation’s low, yields are low which kind of goes hand in hand. Right?
Craig Israelsen: Yeah, exactly, and the same is not true necessarily with other asset classes such as commodities does really well when we have high inflation.
Steve Pomeranz: Yeah.
Craig Israelsen: Real estate tends to do better when we have inflation.
Steve Pomeranz: Hard assets
Craig Israelsen: Yeah, right. The thing is inflation fly traps, they catch inflation and respond to it.
Steve Pomeranz: So we’ve got the salsa analogy and now we have the fly trap analogy from-
Craig Israelsen: [LAUGH]
Steve Pomeranz: Dr. Craig Israelsen. There’s more to come, folks. Let’s talk about stocks for a second. Everybody’s always interested in that and we’ve had a nice bull run for the last x number of years here. What over a very long period of time has the average for large cap or large company stock, US stocks been?
Craig Israelsen: Since 1926 the average return is 10.04, so just call it ten. So 10%, now that’s ignoring inflation.
Steve Pomeranz: Okay.
Craig Israelsen: If we factor in inflation that return goes to 6.9.
Steve Pomeranz: Okay, so that’s still pretty good rate of return. So 7% over the rate of inflation. That can create some real wealth over that long period of time.
Craig Israelsen: Absolutely. And the key is long period of time. Because there are plenty of moments, five and seven-year windows of time, during the last 91 years, where the return of stock has been well below ten gross or seven net-
Steve Pomeranz: Yeah, you’ve done some work on that.
Craig Israelsen: And that’s why we have to hang in there.
Steve Pomeranz: You’ve done some work on that, you’ve actually looked at all these time periods. And I don’t know if you did the 10-year, but I know I saw some information on the five-year, about how many five-year periods the market underperformed that long-term average and how many times it outperformed. Can you give us a little indication there?
Craig Israelsen: Yeah, so let’s first think about that in just gross terms. So inflation has not been considered.
Steve Pomeranz: Okay.
Craig Israelsen: So, with large cap stock, over the last 91 years, we have all these smaller time frames or smaller windows. So, if we look at a five- year window, large stock, if that’s your only investment, has outperformed the long-term average, which is 10-
Steve Pomeranz: Okay.
Craig Israelsen: About 57% of the time,
Steve Pomeranz: That seems pretty good.
Craig Israelsen: So, if you’re looking at five-year windows, so about roughly, a little more than half of the time, if you’re investing for five years, you will have a return at or above the long-term average of 10%.
And then the really crucial thing is then, realize if you invest for 35 years in stock, 88% of the time, those 35-year windows have produced a return higher or equal to the long-term average.
Steve Pomeranz: Okay.
Craig Israelsen: So call it 90%. 90% of the time, if you hang in there for 35 years, you’ll get a long-term return. Whereas if it’s only five years, just over half the time, you’ll hit a, quote, “long-term return.”
Steve Pomeranz: Well, if I operated a casino and my odds were 57%, I would feel pretty good about that, I think, even over a shorter period of time. Of course, I would love to have 90% as well. But I don’t think it’s just a question of periods that are outperforming. I think it’s the magnitude. And especially when it comes to the underperforming. So, let’s talk about the other side of the coin.
So we’ve got this time when the markets are outperforming this long-term average. What happens when they underperform?
Craig Israelsen: That’s what’s really dramatic. As we talk about, half the time, you underperform if you’re only hanging in there for 5 years.
Steve Pomeranz: Yeah.
Craig Israelsen: 90% of the time, you’re achieving a longer return if you’re in there for 35 years. But now, what you’re getting at is, well, if you don’t achieve a long-term return, by how much did you miss?
Steve Pomeranz: Right.
Craig Israelsen: And that’s where it’s dramatic, so take the case of just large-cap U.S stock. If you didn’t, if you’re in a five-year investor, you only hung in there for five years and you didn’t hit, you didn’t get the long-run return. Now the question is by how much did you miss it? And it’s by a huge amount, 800 basis points.
Steve Pomeranz: That’s 8%.
Craig Israelsen: Yeah, so If a long run return was ten, and you missed it by 800 basis points or eight percentage points, you had a 2% return. So the shorter you hold the investment the more dramatically you miss the long-run return if you miss it.
Steve Pomeranz: Aye, there’s the rub, right?
Craig Israelsen: Yeah. And as you hold it longer you may miss the long-run return but just barely.
Steve Pomeranz: Mm-hm. Meaning that if you’re below the average, it’s not going to be anywhere near…
Craig Israelsen: Half a percentage point.
Steve Pomeranz: Half a percentage point, so.
Craig Israelsen: Half a percentage point. Yeah, so if you missed the long-run return and you’re a 35-year investor, you got 9.5% instead of 10%.
Steve Pomeranz: Okay, all right, so we talked about large cap stocks. I think we’re doing good here. By the way, my guest is Dr. Craig Israelsen, Executive in Residence in the Financial Planning Program at Utah Valley University and a contributor to Financial Planning magazine. We talked about large cap stocks, another one of these categories or asset classes are small cap stocks, quickly, give us some of the stats on that. Not too much.
Craig Israelsen: It’s pretty similar to large cap, the differences are just more exaggerated. So, if you invest only in small cap stock, and you’re a short-term investor, meaning five years, you have a high likelihood of not achieving the long-run return because it’s more volatile.
Steve Pomeranz: Okay.
Craig Israelsen: So, in other words, a small stock, you’re only in there for five years. You’re just barely just over 50% chance of achieving a long-run return. If you’ll hang in there for at least, say, 25 years in small stock, you have a 75% chance historically of achieving a long-run return. And if you miss it…so in those years that you miss the long run return and you’re investing in small stocks, the degree to which you underperformed is larger than if you had been in large-cap stock. In other words, small-cap stock has more volatility. And so when you’re on the downside of that volatility, it’s worse.
Steve Pomeranz: Yeah, you could be crushed, and—because of this rule that if you lose 50¢, you’ve lost 50%, but to get from 50¢ back to $1, you need a 100% increase—it’s harder to climb out of the hole than it is to get in.
Craig Israelsen: Yeah, both mathematically and emotionally.
Steve Pomeranz: [LAUGH]
Craig Israelsen: We’re sometimes paralyzed by fear when we’re in that hole.
Steve Pomeranz: Right.
Craig Israelsen: We make even worse decisions than we might otherwise make.
Steve Pomeranz: I know, listen, I deal that with quite often in my practice. All right, so we talked about large cap stocks, small cap stocks, bonds, what about bonds?
Craig Israelsen: Yeah, we don’t see as much variation in bonds because they don’t have the volatility in the performance year to year. If you hang in there as a bond investor for 35 years, you have about a 56% chance of achieving a long-run return. If you’re only in for five years, you have a 44% chance of achieving a long-run return. And a long-run return for bonds, historically, has been about 5.3%
Steve Pomeranz: Okay.
Craig Israelsen: If we ignore inflation. So, it’s really easy to just kind of remember broad brushes here, stocks do about ten. Small stocks a little higher, about 11; bonds do about 5%; cash does about—if you look at really long-term—about three and a half. If you don’t look quite so long- term, maybe the last 47 years, cash stays about five. And, so, inflation is going to take roughly 3 percentage points away from all those numbers.
Bonds goes down to about 2.3, cash goes down near to 0, and so forth.
Steve Pomeranz: I think it’s interesting too because if you have stocks at 10, bonds at 5, cash at three, there’s like a 50% relationship between those. It’s kind of easy to remember.
Craig Israelsen: Yeah, it’s a good observation.
Steve Pomeranz: Bonds do half of stocks, cash do half of bonds, that kind of a thing. Just talking in broad. One of the interesting aspects of the article you wrote, which attracted me to this whole idea and having this discussion was that, if you mix these four asset classes together you have a portfolio that includes all of them. The rate of return over the very long period of time was 9.75%, which is just under the stock rate of return even though a fair amount of your portfolio was not even in stock. It’s amazing.
Craig Israelsen: That’s the salsa effect, it’s magical. I mean we…there’s so many ways that diversification manifests itself to us and we want to eat a diversified diet. You know if you’re an athlete, we want to have a diversified training program; among our groups of friends, we have diversified friends and then we get to portfolios and-
Steve Pomeranz: Yeah.
Craig Israelsen: Sometimes people forget the diversification lesson.
Steve Pomeranz: Interesting. You know, there’s an old quote from John Kenneth Galbraith. He said that when everybody talks about long-term, in the long run, he said, in the long run, we’re all dead. So, I mean, your math is based on 89 years. I mean that’s ridiculous for us to have anybody think. I mean, we live in a Twitter world; we live in a world where long-term is maybe 18 months.
Craig Israelsen: Yeah.
Steve Pomeranz: You said it, we were talking off air, you said it’s like a microwave system for a crock pot world. You need slow and simmer, you need patience. And I think that’s why a lot of people will fail at being a successful investor because they don’t have the patience. What do you think?
Craig Israelsen: I agree, I agree 100%. I mean there’s, a lot of my work involves a lot of mathematics and sort of complicated formulas but it really doesn’t come down to that. The crock pot microwave comparison is so appropriate because investing is a crock pot experience. And there’s very few things…I mean, imagine putting like a butt roast in a microwave. Wow, that is going to be a really bad thing when it comes out. It’s going to be a catcher’s mitt.
Steve Pomeranz: [LAUGH] Right.
Craig Israelsen: So, the essence of successful investors, I mean the absolute essential characteristic is patience. And diversification. And diversification requires patience.
Steve Pomeranz: Well, one of the problems here is that this kind of investing is very boring.
Craig Israelsen: Absolutely, and that tells you you’re doing it right.
Steve Pomeranz: Yes, so, well, that’s the truth, I mean if you could just stop. I always say that unless you’re a teenager doing nothing is actually an active decision.
Craig Israelsen: [LAUGH]
Steve Pomeranz: So as a grown up, you think about what the consequences of acting are, you then take a step back, you do the adult thing and you do nothing.
Craig Israelsen: Right.
Steve Pomeranz: And that takes a lot of brain cell power and will power in order to get it right, to be patient, but so many people just really can’t do that.
Craig Israelsen: Absolutely, and so you used the Twitter example. So somebody tweets whatever the right term is—I’m an old man, I don’t know that I guess. So somebody tweets something out that’s kind of offensive to you and it’s aimed at you, what’s the sort of natural man response?
Steve Pomeranz: Yeah.
Craig Israelsen: Well, to fire back.
Steve Pomeranz: Right.
Craig Israelsen: Well, you don’t have to fire back. You can respond with nothing. And that is absolutely an act.
Steve Pomeranz: Mm-hm.
Craig Israelsen: I agree a million percent and, as it pertains to investing, one of the things that—and I can speak unequivocally here—that drives every financial advisor crazy is when the markets are on sale. They have gone down, the real estate market has gone down, US stock market’s gone down if you think of any asset class, the nets have gone down 20%, they are now on sale and people won’t buy.
Steve Pomeranz: They won’t budge, and the insurance companies are selling them guaranteed products right at the wrong time,
Craig Israelsen: Yeah.
Steve Pomeranz: They’re selling them safety, they’re playing into their fears instead of playing into this idea that now it’s on sale, there’s tremendous opportunity. We’ve got to wrap this up. I do want to tell you one quick story though that Abraham Lincoln used to write a lot of letters, but he only mailed a small fraction of them he would stick them in a drawer. So I think when something happened he would have a visceral reaction, write it out, say what he had to say but he never sent it.
Craig Israelsen: Yeah, it was his catharsis.
Steve Pomeranz: That’s right.
Craig Israelsen: It was his catharsis to get that out of his system, to purge it. And he didn’t send it because it wasn’t the right thing to send.
Steve Pomeranz: Right.
Craig Israelsen: But he had to get it out of his system.
Steve Pomeranz: My guest Dr. Craig Israelsen, Executive in Residence at the Financial Planning Program at Utah Valley University, an academic who writes about many wonderful things investment wise, writes for the Financial Planning magazine as well.
Craig, once again, thank you so much for joining us. It was really illuminating.
Craig Israelsen: Always a lot of fun. I appreciate it.
